Derivative Instruments and Hedging Activities

Commodity Price Risk Management

Our primary market risk is commodity price risk. We are exposed to market risks related to the volatility in crude oil and refined products, as well as volatility in the price of natural gas used in our refining operations. We periodically enter into derivative contracts in the form of commodity price swaps, forward purchase and sales and futures contracts to mitigate price exposure with respect to:


•	our inventory positions;


•	natural gas purchases;


•	costs of crude oil and related grade differentials;


•	prices of refined products; and


•	our refining margins.

Accounting Hedges

We have swap contracts serving as cash flow hedges against price risk on forecasted purchases of natural gas. We also periodically have forward sales contracts that lock in the prices of future sales of crude oil and refined product and swap contracts serving as cash flow hedges against price risk on forecasted purchases of WTI crude oil and forecasted sales of refined product. These contracts have been designated as accounting hedges and are measured at fair value with offsetting adjustments (gains/losses) recorded directly to other comprehensive income. These fair value adjustments are later reclassified to earnings as the hedging instruments mature. On a quarterly basis, hedge ineffectiveness is measured by comparing the change in fair value of the swap contracts against the expected future cash inflows/outflows on the respective transaction being hedged. Any hedge ineffectiveness is also recognized in earnings.

The following table presents the pre-tax effect on other comprehensive income (“OCI”) and earnings due to fair value adjustments and maturities of commodity price swaps and forward sales under hedge accounting:



	Unrealized Gain (Loss) Recognized in OCI			Gain (Loss) Recognized in Earnings Due to Settlements				Gain (Loss) Attributable to Hedge Ineffectiveness Recognized in Earnings
	Unrealized Gain (Loss) Recognized in OCI			Location	Amount			Location	Amount
	(In thousands)
Three Months Ended June 30, 2017
Change in fair value	$	1,378
Gain reclassified to earnings due to settlements	(325		)	Sales and other revenues	$	4,476
Amortization of discontinued hedges reclassified to earnings	270			Operating expenses	(4,421		)	Operating expenses	$	(18	)
Total	$	1,323			$	55			$	(18	)

Three Months Ended June 30, 2016
Change in fair value	$	(5,138	)
Loss reclassified to earnings due to settlements	21,910			Sales and other revenue	$	(15,897	)
Amortization of discontinued hedges reclassified to earnings	270			Operating expenses	(6,283		)	Operating expenses	$	—
Total	$	17,042			$	(22,180	)		$	—

Six Months Ended June 30, 2017
Change in fair value	$	4,715		Sales and other revenues	$	8,426
Loss reclassified to earnings due to settlements	49			Cost of products sold	(299		)
Amortization of discontinued hedge reclassified to earnings	540			Operating expenses	(8,716		)	Operating expenses	$	(18	)
Total	$	5,304			$	(589	)		$	(18	)

Six Months Ended June 30, 2016
Change in fair value	$	(17,059	)
Loss reclassified to earnings due to settlements	32,966			Sales and other revenues	$	(20,653	)
Amortization of discontinued hedge reclassified to earnings	540			Operating expenses	(12,853		)	Operating expenses	$	—
Total	$	16,447			$	(33,506	)		$	—

As of June 30, 2017, we have the following notional contract volumes related to outstanding derivative instruments serving as cash flow hedges against price risk on forecasted transactions:



		Notional Contract Volumes by Year of Maturity
Derivative Instrument	Total Outstanding Notional	2017	2018	2019	2020	2021	Unit of Measure

Natural gas price swaps - long	12,000,000	4,800,000	1,800,000	1,800,000	1,800,000	1,800,000	MMBTU

In 2013, we dedesignated certain commodity price swaps (long positions) that previously received hedge accounting treatment. These contracts now serve as economic hedges against price risk on forecasted natural gas purchases totaling 4,800,000 MMBTU’s to be purchased ratably through 2017. As of June 30, 2017, we have an unrealized loss of $0.5 million classified in accumulated other comprehensive income that relates to the application of hedge accounting prior to dedesignation that is amortized as a charge to operating expenses as the contracts mature.

Economic Hedges

We also have swap contracts that serve as economic hedges (derivatives used for risk management, but not designated as accounting hedges) to lock in basis spread differentials on forecasted purchases of crude oil and natural gas. Also, we have commodity forward contracts and NYMEX futures contracts to lock in prices on forecasted purchases of inventory. In addition, we had Canadian currency swap contracts that effectively fixed the conversion rate on $1.125 billion Canadian dollars (the PCLI purchase price), which were settled on February 1, 2017, in connection with the closing of the PCLI acquisition. These contracts are measured at fair value with offsetting adjustments (gains/losses) recorded directly to income.

The following table presents the pre-tax effect on income due to maturities and fair value adjustments of our economic hedges:



	Three Months Ended June 30,					Six Months Ended June 30,
Location of Gain (Loss) Recognized in Earnings	2017			2016		2017			2016
	(In thousands)
Cost of products sold	$	6,983		$	828	$	14,035		$	1,302
Operating expenses	(1,541		)	8,083		(5,763		)	4,614
Gain on foreign currency swap	—			—		24,545			—
Total	$	5,442		$	8,911	$	32,817		$	5,916

As of June 30, 2017, we have the following notional contract volumes related to our outstanding derivative contracts serving as economic hedges:



		Notional Contract Volumes by Year of Maturity
Derivative Instrument	Total Outstanding Notional	2017	2018	Unit of Measure

Crude price swaps (basis spread) - long	1,836,000	1,836,000	—	Barrels
Natural gas price swaps (basis spread) - long	5,154,000	5,154,000	—	MMBTU
Natural gas price swaps - long	4,800,000	4,800,000	—	MMBTU
Natural gas price swaps - short	4,800,000	4,800,000	—	MMBTU
NYMEX futures (WTI) - short	1,240,000	1,040,000	200,000	Barrels
Forward gasoline and diesel contracts - long	465,000	465,000	—	Barrels

Interest Rate Risk Management

HEP uses interest rate swaps to manage its exposure to interest rate risk.

As of June 30, 2017, HEP had two interest rate swap contracts with identical terms that hedge its exposure to the cash flow risk caused by the effects of LIBOR changes on $150.0 million in credit agreement advances. The swaps effectively convert $150.0 million of LIBOR based debt to fixed rate debt having an interest rate of 0.74% plus an applicable margin of 2.25% as of June 30, 2017, which equaled an effective interest rate of 2.99%. Both of these swap contracts matured in July 2017 and have been designated as cash flow hedges. To date, there has been no ineffectiveness on these cash flow hedges.

The following table presents the pre-tax effect on other comprehensive income and earnings due to fair value adjustments and maturities of HEP’s interest rate swaps under hedge accounting:



	Unrealized Gain (Loss) Recognized in OCI			Gain (Loss) Recognized in Earnings Due to Settlements
	Unrealized Gain (Loss) Recognized in OCI			Location	Amount
	(In thousands)
Three Months Ended June 30, 2017
Interest rate swaps
Change in fair value	$	11
Gain reclassified to earnings due to settlements	(102		)	Interest expense	$	102
Total	$	(91	)		$	102

Three Months Ended June 30, 2016
Interest rate swaps
Change in fair value	$	(255	)
Loss reclassified to earnings due to settlements	113			Interest expense	$	(113	)
Total	$	(142	)		$	(113	)

Six Months Ended June 30, 2017
Interest rate swaps
Change in fair value	$	87
Gain reclassified to earnings due to settlements	(115		)	Interest expense	$	115
Total	$	(28	)		$	115

Six Months Ended June 30, 2016
Interest rate swaps
Change in fair value	$	(938	)
Loss reclassified to earnings due to settlements	343			Interest expense	$	(343	)
Total	$	(595	)		$	(343	)

The following table presents the fair value and balance sheet locations of our outstanding derivative instruments. These amounts are presented on a gross basis with offsetting balances that reconcile to a net asset or liability position in our consolidated balance sheets. We present on a net basis to reflect the net settlement of these positions in accordance with provisions of our master netting arrangements.



	Derivatives in Net Asset Position						Derivatives in Net Liability Position
	Gross Assets		Gross Liabilities Offset in Balance Sheet		Net Assets Recognized in Balance Sheet		Gross Liabilities		Gross Assets Offset in Balance Sheet			Net Liabilities Recognized in Balance Sheet
			(In thousands)
June 30, 2017
Derivatives designated as cash flow hedging instruments:
Commodity price swap contracts	$	—	$	—	$	—	$	10,018	$	—		$	10,018
Interest rate swap contracts	63		—		63		—		—			—
	$	63	$	—	$	63	$	10,018	$	—		$	10,018

Derivatives not designated as cash flow hedging instruments:
Commodity price swap contracts	$	—	$	—	$	—	$	10,613	$	(7,863	)	$	2,750
NYMEX futures contracts	662		—		662		—		—			—
Forward contracts	1,447		—		1,447		1,218		—			1,218
	$	2,109	$	—	$	2,109	$	11,831	$	(7,863	)	$	3,968

Total net balance					$	2,172						$	13,986

Balance sheet classification:							Accrued liabilities					$	13,308
							Other long-term liabilities					678
	Prepayment and other				$	2,172						$	13,986



	Derivatives in Net Asset Position							Derivatives in Net Liability Position
	Gross Assets		Gross Liabilities Offset in Balance Sheet			Net Assets Recognized in Balance Sheet		Gross Liabilities		Gross Assets Offset in Balance Sheet			Net Liabilities Recognized in Balance Sheet
			(In thousands)
December 31, 2016
Derivatives designated as cash flow hedging instruments:
Commodity price swap contracts	$	—	$	—		$	—	$	13,185	$	(431	)	$	12,754
Commodity forward contracts	—		—			—		2,978		—			2,978
Interest rate swap contracts	91		—			91		—		—			—
	$	91	$	—		$	91	$	16,163	$	(431	)	$	15,732

Derivatives not designated as cash flow hedging instruments:
Commodity price swap contracts	$	4,244	$	(756	)	$	3,488	$	12,903	$	(9,887	)	$	3,016
NYMEX futures contracts	—		—			—		1,975		—			1,975
Commodity forward contracts	5,905		—			5,905		5,338		—			5,338
Foreign currency forward contracts	—		—			—		6,519		—			6,519
	$	10,149	$	(756	)	$	9,393	$	26,735	$	(9,887	)	$	16,848

Total net balance						$	9,484						$	32,580

Balance sheet classification:	Prepayment and other					$	9,484	Accrued liabilities					$	32,580

At June 30, 2017, we had a pre-tax net unrealized loss of $10.5 million classified in accumulated other comprehensive income that relates to all accounting hedges having contractual maturities through 2021. Assuming commodity prices and interest rates remain unchanged, an unrealized loss of $9.8 million will be effectively transferred from accumulated other comprehensive income into the statement of income as the hedging instruments contractually mature over the next twelve-month period.