Objectives and Strategies for Using Derivatives

12 Months Ended

Dec. 31, 2011

Objectives and Strategies for Using Derivatives

Objectives and Strategies for Using Derivatives

Objectives and Strategies for Using Derivatives

As a multinational enterprise, we are exposed to financial risks, such as changes in foreign currency exchange rates, interest rates, commodity prices and the value of investments of our defined benefit pension plans. We employ a number of practices to manage these risks, including operating and financing activities and, where deemed appropriate, the use of derivative instruments. Our policies allow the use of derivatives for risk management purposes and prohibit their use for speculation. Our policies also prohibit the use of any leveraged derivative instrument. Consistent with our policies, foreign currency derivative instruments, interest rate swaps and locks, equity collars and the majority of commodity hedging contracts are entered into with major financial institutions.

On the date a derivative contract is entered into, we formally designate certain derivatives as cash flow, fair value or net investment hedges and establish how the effectiveness of these hedges will be assessed and measured. This process links the derivatives to the transactions or financial balances they are hedging. Changes in the fair value of derivatives not designated as hedging instruments are recorded in earnings as they occur.

Set forth below is a summary of the fair values of our derivative instruments classified by the risks they are used to manage as of December 31, 2011.

	Assets				Liabilities
	2011		2010		2011		2010
	(Millions of dollars)
Foreign currency exchange risk	$	45	$	46	$	33	$	39
Interest rate risk	16		24		75		2
Commodity price risk	—		—		12		7
Total	$	61	$	70	$	120	$	48

Foreign Currency Exchange Risk Management

We have a centralized U.S. dollar functional currency international treasury operation (“In-House Bank”) that manages foreign currency exchange risks by netting, on a daily basis, our exposures to recorded non-U.S. dollar assets and liabilities and entering into derivative instruments with third parties whenever our net exposure in any single currency exceeds predetermined limits. These derivative instruments are not designated as hedging instruments. Changes in the fair value of these instruments are recorded in earnings when they occur. The In-House Bank also records the gain or loss on the remeasurement of its non-U.S. dollar-denominated monetary assets and liabilities in earnings. Consequently, the net effect on earnings from the use of these non-designated derivatives is substantially neutralized by transactional gains and losses recorded on the underlying assets and liabilities. The In-House Bank’s daily notional derivative positions with third parties averaged $1.4 billion during 2011 and its average net exposure for the year was $1.2 billion. The In-House Bank used nine counterparties for its foreign exchange derivative contracts.

We enter into derivative instruments to hedge a portion of the net foreign currency exposures of our non-U.S. operations, principally for their forecasted purchases of pulp, which are priced in U.S. dollars, and imports of intercompany finished goods and work-in-process priced predominately in U.S. dollars and euros. The derivative instruments used to manage these exposures are designated and qualify as cash flow hedges. As of December 31, 2011, outstanding derivative contracts of $850 million notional

value were designated as cash flow hedges related to the forecasted purchases of pulp and intercompany finished goods and work-in-process.

The foreign currency exposure on non-functional currency denominated monetary assets and liabilities managed outside the In-House Bank, primarily intercompany loans and accounts payable, is hedged with derivative instruments with third parties. At December 31, 2011, the notional amount of these predominantly undesignated derivative instruments was $700 million.

Foreign Currency Translation Risk Management

Translation adjustments result from translating foreign entities’ financial statements to U.S. dollars from their functional currencies. Translation exposure, which results from changes in translation rates between functional currencies and the U.S. dollar, generally is not hedged. The risk to any particular entity's net assets is minimized to the extent that the entity is financed with local currency borrowing. There were no net investment hedges in place at December 31, 2011.

Interest Rate Risk Management

Interest rate risk is managed using a portfolio of variable- and fixed-rate debt composed of short- and long-term instruments and interest rate swaps. From time to time, interest rate swap contracts, which are derivative instruments, are entered into to facilitate the maintenance of the desired ratio of variable- and fixed-rate debt. These derivative instruments are designated and qualify as fair value hedges or, to a lesser extent, cash flow hedges.

From time to time, we hedge the anticipated issuance of fixed-rate debt, using forward-starting swaps or “treasury locks” (e.g., a 10-year “treasury lock” hedging the anticipated underlying U.S. Treasury interest rate related to issuance of 10-year debt at a future date). These contracts are designated as cash flow hedges.

At December 31, 2011, the aggregate notional values of outstanding interest rate contracts designated as fair value hedges and cash flow hedges were $700 million and $580 million, respectively.

Commodity Price Risk Management

We use derivative instruments to hedge a portion of our exposure to market risk arising from changes in the price of natural gas. Hedging of this risk is accomplished by entering into forward swap contracts, which are designated as cash flow hedges of specific quantities of natural gas expected to be purchased in future months.

As of December 31, 2011, outstanding commodity forward contracts were in place to hedge forecasted purchases of about 30 percent of our estimated natural gas requirements in 2012 and a lesser percentage for future periods.

Effect of Derivative Instruments on Results of Operations and Other Comprehensive Income

Fair Value Hedges

Derivative instruments that are designated and qualify as fair value hedges are predominantly used to manage interest rate risk. The fair values of these derivative instruments are recorded as an asset or liability, as appropriate, with the offset recorded in current earnings. The offset to the change in fair values of the related hedged items also is recorded in current earnings. Any realized gain or loss on the derivatives that hedge interest rate risk is amortized to interest expense over the life of the related debt.

Fair value hedges resulted in no significant ineffectiveness in the years ended December 31, 2011, 2010 and 2009. For the years ended December 31, 2011, 2010 and 2009, no gain or loss was recognized in earnings as a result of a hedged firm commitment no longer qualifying as a fair value hedge.

Cash Flow Hedges

For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is initially recorded in AOCI, net of related income taxes, and recognized in earnings in the same period that the hedged exposure affects earnings.

Cash flow hedges resulted in no significant ineffectiveness in the years ended December 31, 2011, 2010 and 2009. For the years ended December 31, 2011, 2010 and 2009, no gains or losses were reclassified into earnings as a result of the discontinuance of cash flow hedges due to the original forecasted transaction no longer being probable of occurring. At December 31, 2011, $10 million of after-tax gains are expected to be reclassified from AOCI primarily to cost of sales during the next twelve months, consistent with the timing of the underlying hedged transactions. The maximum maturity of cash flow hedges in place at December 31, 2011 is January 2014.

Quantitative Information About our Use of Derivative Instruments

The following tables display the location and amount of pretax gains and losses reported in the Consolidated Income Statement and Consolidated Statement of Other Comprehensive Income (“OCI”) and the location and fair values of derivative instruments presented in the Consolidated Balance Sheet.

	Income Statement Classifications	(Gain) or Loss Recognized in Income
		2011			2010			2009
		(Millions of dollars)
Undesignated foreign exchange hedging instruments	Other (income) and expense, net(a)	$	(3	)	$	(57	)	$	95
Fair Value Hedges
Foreign exchange contracts	Other (income) and expense, net	$	—		$	(1	)	$	6
Hedged foreign exchange monetary assets and liabilities	Other (income) and expense, net	$	—		$	1		$	(6	)
Interest rate swap contracts	Interest expense	$	(14	)	$	(8	)	$	(9	)
Hedged debt instruments	Interest expense	$	14		$	8		$	9

	Amount of (Gain) or Loss Recognized In AOCI								Income Statement Classification of (Gain) or Loss Reclassified from AOCI	(Gain) or Loss Reclassified from AOCI to Income
	2011			2010		2009				2011			2010			2009
	(Millions of dollars)									(Millions of dollars)
Cash Flow Hedges
Interest rate contracts	$	81		$	21	$	(29	)	Interest expense	$	(3	)	$	(3	)	$	(3	)
Foreign exchange contracts	(7		)	—		32			Cost of products sold	40			7			5
Foreign exchange contracts	(8		)	—		—			Other (income) and expense, net	(8		)	—			—
Commodity contracts	15			16		26			Cost of products sold	10			13			43
Total	$	81		$	37	$	29			$	39		$	17		$	45
Net Investment Hedges
Foreign exchange contracts	$	(6	)	$	6	$	18			$	—		$	—		$	—

(a) (Gains) and losses on these instruments primarily relate to derivatives entered into with third parties to manage foreign currency exchange exposure on remeasurement of non-functional currency denominated monetary assets and liabilities. Consequently, the effect on earnings from the use of these non-designated derivatives is substantially neutralized by the recorded transactional gains and losses recorded on the underlying assets and liabilities.

Fair Values of Derivative Instruments
	Balance Sheet Location	2011		2010
Assets		(Millions of dollars)
Derivatives designated as hedging instruments:
Interest rate contracts	Other current assets	$	3	$	—
Interest rate contracts	Other assets	11		24
Foreign exchange contracts	Other current assets	25		4
Foreign exchange contracts	Other assets	9		1
Total		48		29
Undesignated derivatives:
Foreign exchange contracts and other	Other current assets	13		41
Total asset derivatives		$	61	$	70
Liabilities
Derivatives designated as hedging instruments:
Interest rate contracts	Accrued expenses	$	44	$	—
Interest rate contracts	Other liabilities	31		2
Foreign exchange contracts	Accrued expenses	6		16
Foreign exchange contracts	Other liabilities	—		3
Commodity contracts	Accrued expenses	11		7
Commodity contracts	Other liabilities	1		—
Total		93		28
Undesignated derivatives:
Foreign exchange contracts and other	Accrued expenses	27		20
Total liability derivatives		$	120	$	48