Derivatives, Hedges, Financial Instruments and Carbon Credits

6 Months Ended

Jun. 30, 2011

Derivatives, Hedges, Financial Instruments and Carbon Credits [Abstract]

Derivatives, Hedges, Financial Instruments and Carbon Credits

Note 11: Derivatives, Hedges, Financial Instruments and Carbon Credits We have three classes of contracts that are accounted for on a fair value basis, which are commodities futures/forward contracts (“commodities contracts”), foreign exchange contracts and interest rate contracts as discussed below. All of these contracts are used as economic hedges for risk management purposes but are not designated as hedging instruments. In addition as discussed below, periodically we are issued carbon credits, which a certain portion of the carbon credits are to be sold and the proceeds given to Bayer Material Science LLC (“Bayer”). The carbon credits are accounted for on a fair value basis as discussed below. Also the contractual obligations associated with these carbon credits are accounted for on a fair value basis (as discussed below) unless we enter into a firm sales commitment to sell the carbon credits as discussed in Note 1 — Summary of Significant Accounting Policies. The valuations of these assets and liabilities were determined based on quoted market prices or, in instances where market quotes are not available, other valuation techniques or models used to estimate fair values.

The valuations of contracts classified as Level 1 are based on quoted prices in active markets for identical contracts. The valuations of contracts classified as Level 2 are based on quoted prices for similar contracts and valuation inputs other than quoted prices that are observable for these contracts. At June 30, 2011, the valuations of contracts classified as Level 2 related to interest rate swap contracts. For interest rate swap contracts, we utilize valuation software and market data from a third-party provider. These interest rate contracts are valued using a discounted cash flow model that calculates the present value of future cash flows pursuant to the terms of the contracts and using market information for forward interest-rate yield curves. The valuation inputs included the total contractual weighted-average pay rate of 3.30% and the total estimated market weighted-average receive rate of 2.01%. No valuation input adjustments were considered necessary relating to nonperformance risk for the contracts. The valuations of assets and liabilities classified as Level 3 are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. At June 30, 2011, the valuations ($2.00 per carbon credit) of the carbon credits and the contractual obligations associated with these carbon credits are classified as Level 3 and are based on the range of ask/bid prices ($2.00 to $4.00) per carbon credit obtained from a broker involved in this low volume market, pricing terms included in sales agreements entered into during the first six months of 2011, and inquiries from market participants concerning our listed ask price through a broker. The valuations are using undiscounted cash flows based on management’s assumption that the carbon credits would be sold and the associated contractual obligations would be extinguished in the near term.

In addition, no valuation input adjustments were considered necessary relating to nonperformance risk for the carbon credits and associated contractual obligations. At December 31, 2010, the valuations ($3.25 per carbon credit) of contracts classified as Level 3 related to carbon credits and contractual obligations associated with these carbon credits.

Commodities Contracts

Raw materials for use in our manufacturing processes include copper used by our Climate Control Business and anhydrous ammonia and natural gas used by our Chemical Business. As part of our raw material price risk management, we periodically enter into futures/forward contracts for these materials, which contracts are generally accounted for on a mark-to-market basis. At December 31, 2010, our futures/forward copper contracts were for 750,000 pounds of copper through May 2011 at a weighted-average cost of $3.75 per pound. At June 30, 2011, our futures/forward copper contracts were for 375,000 pounds of copper through December 2011 at a weighted-average cost of $4.44 per pound. At December 31, 2010, our futures/forward natural gas contracts were for 800,000 MMBtu of natural gas through February 2011 at a weighted-average cost of $4.10 per MMBtu. At June 30, 2011, we did not have any futures/forward natural gas contracts. The cash flows relating to these contracts are included in cash flows from continuing operating activities.

Foreign Exchange Contracts

One of our business operations purchases industrial machinery and related components from vendors outside of the United States. As part of our foreign currency risk management, we periodically enter into foreign exchange contracts, which set the U.S. Dollar/Euro exchange rates. These contracts are free-standing derivatives and are accounted for on a mark-to-market basis. At December 31, 2010, our foreign exchange contracts were for the receipt of approximately 783,000 Euros through June 2011 and for the payment of approximately 110,000 Euros through March 2011, at the total contractual weighted-average exchange rate of 1.26 (U.S. Dollar/Euro). At June 30, 2011, we did not have any foreign exchange contracts. The cash flows relating to these contracts are included in cash flows from continuing operating activities.

Interest Rate Contracts

As part of our interest rate risk management, we periodically purchase and/or enter into various interest rate contracts. In April 2008, we entered into an interest rate swap at no cost, which sets a fixed three-month LIBOR rate of 3.24% on $25 million and matures in April 2012. In September 2008, we acquired an interest rate swap at a cost basis of $0.4 million, which sets a fixed three-month LIBOR rate of 3.595% on $25 million and matures in April 2012. In February 2011, we entered into an interest rate swap at no cost, which sets a fixed three-month LIBOR rate of 3.23% on a declining balance (from $23.8 million to $18.8 million) for the period beginning in April 2012 through March 2016.

These contracts are free-standing derivatives and are accounted for on a mark-to-market basis. During the six months ended June 30, 2011 and 2010, no cash flows occurred relating to the purchase or sale of interest rate contracts. The cash flows associated with the interest rate swap payments are included in cash flows from continuing operating activities.

Carbon Credits and Associated Contractual Obligation

During December 2010 and May 2011, we were issued carbon credits by the Climate Action Reserve in relation to a greenhouse gas reduction project (“Project”) performed at the Baytown Facility. Pursuant to the terms of the agreement with Bayer (the “Bayer Agreement”), a certain portion of the carbon credits are to be used to recover the costs of the Project, and any balance thereafter to be allocated between Bayer and EDN. We have no obligation to reimburse Bayer for their costs associated with the Project, except through the transfer or sale of the carbon credits when such credits are issued to us. The carbon credits are accounted for on a fair value basis and the contractual obligations associated with these carbon credits are also accounted for on a fair value basis (unless we enter into a firm sales commitment to sell the carbon credits). At December 31, 2010, we had approximately 198,000 carbon credits, all of which are subject to contractual obligations. At June 30, 2011, we had a minimal amount of carbon credits, of which most were subject to contractual obligations. The cash flows associated with the carbon credits and the associated contractual obligations are included in cash flows from continuing investing activities.

The following details our assets and liabilities that are measured at fair value on a recurring basis at June 30, 2011 and December 31, 2010:

			Fair Value Measurements at
			June 30, 2011 Using
			Quoted Prices		Significant
	Total Fair		in Active		Other		Significant		Total Fair
	Value at		Markets for		Observable		Unobservable		Value at
	June 30,		Identical Assets		Inputs		Inputs		December 31,
Description	2011		(Level 1)		(Level 2)		(Level 3)		2010
	(In Thousands)
Assets — Supplies, prepaid items and other:
Commodities contracts	$	—	$	—	$	—	$	—	$	761
Carbon credits		9		—		—		9		644
Foreign exchange contracts		—		—		—		—		49
Total	$	9	$	—	$	—	$	9	$	1,454
Liabilities — Current and noncurrent accrued and other liabilities:
Commodities contracts	$	52	$	52	$	—	$	—	$	—
Contractual obligations — carbon credits		7		—		—		7		644
Interest rate contracts		2,135		—		2,135		—		1,895
Total	$	2,194	$	52	$	2,135	$	7	$	2,539

During the six months ended June 30, 2011 and 2010, none of our assets or liabilities measured at fair value on a recurring basis transferred between Level 1 and Level 2 classifications. In addition, the following is a reconciliation of the beginning and ending balances for assets and liabilities measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during the six and three months ended June 30, 2011 (not applicable for the six and three months ended June 30, 2010):

	Six Months Ended						Three Months Ended
	June 30, 2011						June 30, 2011
	Assets			Liabilities			Assets			Liabilities
	(In Thousands)
Beginning balance	$	644		$	(644	)	$	11		$	—
Transfers into Level 3		—			—			—			—
Transfers out of Level 3		—			—			—			—
Total realized and unrealized gain (loss) included in earnings		1,030			(936	)		990			(896	)
Purchases		—			—			—			—
Issuances		—			—			—			—
Sales		(1,665	)		—			(992	)		—
Settlements		—			1,573			—			889
Ending balance	$	9		$	(7	)	$	9		$	(7	)

Realized and unrealized net losses included in earnings and the income statement classifications are as follows:

	Six Months Ended						Three Months Ended
	June 30,						June 30,
	2011			2010			2011			2010
	(In Thousands)
Total net gains (losses) included in earnings:
Cost of sales — Commodities contracts	$	(194	)	$	(904	)	$	(43	)	$	(216	)
Cost of sales — Foreign exchange contracts		46			(24	)		6			—
Other income — Carbon credits		1,030			—			990			—
Other expense — Contractual obligations relating to carbon credits		(936	)		—			(896	)		—
Interest expense — Interest rate contracts		(1,026	)		(1,137	)		(688	)		(523	)
	$	(1,080	)	$	(2,065	)	$	(631	)	$	(739	)

	Six Months Ended						Three Months Ended
	June 30,						June 30,
	2011			2010			2011			2010
	(In Thousands)
Change in unrealized gains (losses) relating to contracts still held at period end:
Cost of sales — Commodities contracts	$	(52	)	$	(246	)	$	(20	)	$	(313	)
Other income — Carbon credits		9			—			9			—
Other expense — Contractual obligations relating to carbon credits		(7	)		—			(7	)		—
Interest expense — Interest rate contracts		(240	)		(348	)		(292	)		(128	)
	$	(290	)	$	(594	)	$	(310	)	$	(441	)

The following discussion of fair values is not indicative of the overall fair value of our assets and liabilities since it does not include all assets, including intangibles.

Our long-term debt agreements are the only financial instruments with fair values significantly different from their carrying amounts. At June 30, 2011 and December 31, 2010, the fair value for variable debt (excluding the secured term loan at December 31, 2010) is believed to approximate their carrying value. At December 31, 2010, the estimated fair value of the secured term loan is based on defined LIBOR rates plus 6% utilizing information obtained from the lender. The fair values of fixed rate borrowings, other than the 2007 Debentures, are estimated using a discounted cash flow analysis that applies interest rates currently being offered on borrowings of similar amounts and terms to those currently outstanding while also taking into consideration our current credit worthiness. At June 30, 2011, the estimated fair value of the 2007 Debentures is based on the conversion rate and market price of LSB common stock. At December 31, 2010, the estimated fair value of the 2007 Debentures is based on quoted prices obtained from a broker for these debentures.

The estimated fair value and carrying value of our long-term debt are as follows:

	June 30, 2011				December 31, 2010
	Estimated		Carrying		Estimated		Carrying
	Fair Value		Value		Fair Value		Value
	(In Thousands)
Variable Rate:
Secured Term Loan (1)	$	74,063	$	74,063	$	26,721	$	48,773
Working Capital Revolver Loan		—		—		—		—
Other debt (2)		8		8		2,437		2,437
Fixed Rate:
5.5% Convertible Senior Subordinated Notes		3,906		2,500		27,976		26,900
Other bank debt and equipment financing		10,209		10,258		17,251		17,282
	$	88,186	$	86,829	$	74,385	$	95,392

(1)	Includes a fixed interest rate of 5.15% on the principal amount of $24.7 million at June 30, 2011.
(2)	At December 31, 2010, the balance includes a variable rate debt agreement with a minimum interest rate of 6%, which interest rate was 6%.