(7) DERIVATIVES AND RISK MANAGEMENT

The Company is exposed to volatility in market prices and basis differentials for natural gas and crude oil which impacts the predictability of its cash flows related to the sale of natural gas and oil, and is exposed to volatility in interest rates. These risks are managed by the Company’s use of certain derivative financial instruments. At September 30, 2013 and December 31, 2012, the Company’s derivative financial instruments consisted of fixed price swaps, basis swaps, fixed price call options, and interest rate swaps. A description of the Company’s derivative financial instruments is provided below:


Fixed price swaps	The Company receives a fixed price for the contract and pays a floating market price to the counterparty.

Floating price swaps	The Company receives a floating market price from the counterparty and pays a fixed price.

Costless-collars	Arrangements that contain a fixed floor price (put) and a fixed ceiling price (call). If the market price exceeds the call strike price or falls below the put strike price, the Company receives the fixed price and pays the market price. If the market price is between the call and the put strike price, no payments are due from either party.

Basis swaps	Arrangements that guarantee a price differential for natural gas from a specified delivery point. The Company receives a payment from the counterparty if the price differential is greater than the stated terms of the contract and pays the counterparty if the price differential is less than the stated terms of the contract.

Fixed price call options	The Company sells fixed price call options in exchange for a premium. At the time of settlement, if the market price exceeds the fixed price of the call option, the Company pays the counterparty such excess on sold fixed price call options. If the market price settles below the fixed price of the call option, no payment is due from either party.

Interest rate swaps	Interest-rate swaps are used to fix or float interest rates on existing or anticipated indebtedness. The purpose of these instruments is to manage the Company’s existing or anticipated exposure to unfavorable interest-rate changes.

GAAP requires that all derivatives be recognized in the balance sheet as either an asset or liability and be measured at fair value. Under GAAP, certain criteria must be satisfied in order for derivative financial instruments to be classified and accounted for as either a cash flow or a fair value hedge. Accounting for qualifying hedges requires a derivative’s gains and losses to be recorded either in earnings as a component of the sale of natural gas and oil or as a component of other comprehensive income. Gains and losses on derivatives that are not elected for hedge accounting treatment or that do not meet hedge accounting requirements are recorded in earnings as a component of gain (loss) on derivatives. Within the gain (loss) on derivatives component of the statement of operations are mark to market gain (loss) on derivatives and mark to market gain (loss) on derivatives, settled. The Company calculates mark to market gain (loss) on derivatives, settled, as the summation of gains and losses on positions that have settled within the period reported.

The Company utilizes counterparties for its derivative instruments that it believes are credit-worthy at the time the transactions are entered into and the Company closely monitors the credit ratings of these counterparties. Additionally, the Company performs both quantitative and qualitative assessments of these counterparties based on their credit ratings and credit default swap rates where applicable. However, the events in the financial markets in recent years demonstrate there can be no assurance that a counterparty will be able to meet its obligations to the Company.

The balance sheet classification of the assets related to derivative financial instruments are summarized below at September 30, 2013 and December 31, 2012:


	Derivative Assets
	September 30, 2013			December 31, 2012
	Balance Sheet Classification	Fair Value		Balance Sheet Classification	Fair Value

	(in thousands)
Derivatives designated as hedging instruments:
Fixed price swaps	Hedging asset	$	115,039	Hedging asset	$	279,443
Fixed price swaps	Other long-term assets		5,951	Other long-term assets		8,550
Total derivatives designated as hedging instruments		$	120,990		$	287,993

Derivatives not designated as hedging instruments:
Basis swaps	Hedging asset	$	5,104	Hedging asset	$	3,250
Fixed price swaps	Hedging asset		77,504	Hedging asset		–
Basis swaps	Other long-term assets		679	Other long-term assets		901
Fixed price swaps	Other long-term assets		19,103	Other long-term assets		–
Interest rate swaps	Other long-term assets		5,797	Other long-term assets		–
Total derivatives not designated as hedging instruments		$	108,187		$	4,151

Total derivative assets		$	229,177		$	292,144

	Derivative Liabilities
	September 30, 2013			December 31, 2012
	Balance Sheet Classification	Fair Value		Balance Sheet Classification	Fair Value

	(in thousands)
Derivatives not designated as hedging instruments:
Basis swaps	Other current liabilities	$	164	Other current liabilities	$	138
Fixed price call options	Other long-term liabilities		30,980	Other long-term liabilities		4,128
Interest rate swaps	Other current liabilities		912	Other current liabilities		–
Interest rate swaps	Other long-term liabilities		3,582	Other long-term liabilities		–
Total derivatives not designated as hedging instruments		$	35,638		$	4,266

Total derivative liabilities		$	35,638		$	4,266

As of September 30, 2013, the Company had derivatives designated as cash flow hedges and derivatives not designated as hedges on the following volumes of natural gas production (in Bcf):


Year	Fixed price swaps	Fixed price swaps not designated for hedge accounting	Total
2013	84.4	-	84.4
2014	51.1	181.6	232.7

Cash Flow Hedges

The reporting of gains and losses on cash flow derivative hedging instruments depends on whether the gains or losses are effective at offsetting changes in the cash flows of the hedged item. The effective portion of the gains and losses on the derivative hedging instruments are recorded in other comprehensive income until recognized in earnings during the period that the hedged transaction takes place. The ineffective portion of the gains and losses from the derivative hedging instrument is recognized in earnings immediately.

As of September 30, 2013, the Company recorded a net gain in accumulated other comprehensive income related to its hedging activities of $72.1 million. This amount is net of a deferred income tax liability recorded as of September 30, 2013 of $48.1 million. The amount recorded in accumulated other comprehensive income will be relieved over time and recognized in the statement of operations as the physical transactions being hedged occur. Assuming the market prices of natural gas futures as of September 30, 2013 remain unchanged, the Company would expect to transfer an aggregate after-tax net gain of $68.6 million from accumulated other comprehensive income to earnings during the next 12 months. Gains or losses from derivative instruments designated as cash flow hedges are reflected as adjustments to gas sales in the unaudited condensed consolidated statements of operations. Volatility in earnings and other comprehensive income may occur in the future as a result of the Company’s derivative activities.

The following tables summarize the before tax effect of all cash flow hedges on the unaudited condensed consolidated financial statements for the three- and nine-month periods ended September 30, 2013 and 2012:


		Gain (Loss) Recognized in Other Comprehensive Income
		(Effective Portion)
		For the three months ended				For the nine months ended
		September 30,				September 30,
Derivative Instrument		2013		2012		2013		2012
		(in thousands)
Fixed price swaps		$	12,515	$	(55,039)	$	51,234	$	116,089
Costless-collars		$	–	$	(3,497)	$	–	$	40,644

	Classification of Gain	Gain Reclassified from Accumulated Other
	Reclassified from	Comprehensive Income into Earnings
	Accumulated Other	(Effective Portion)
	Comprehensive Income	For the three months ended				For the nine months ended
	into Earnings	September 30,				September 30,
Derivative Instrument	(Effective Portion)	2013		2012		2013		2012
		(in thousands)
Fixed price swaps	Gas sales	$	93,280	$	102,789	$	218,236	$	337,994
Costless-collars	Gas sales	$	–	$	54,489	$	–	$	175,531

		Gain (Loss) Recognized in Earnings
		(Ineffective Portion)
	Classification of Gain (Loss)	For the three months ended				For the nine months ended
	Recognized in Earnings	September 30,				September 30,
Derivative Instrument	(Ineffective Portion)	2013		2012		2013		2012
		(in thousands)
Fixed price swaps	Gas sales	$	(1,452)	$	(165)	$	(2,183)	$	1,831
Costless-collars	Gas sales	$	–	$	(373)	$	–	$	167

Fair Value Hedges and Other Derivative Contracts

For fair value hedges, the gain or loss on the derivative instrument as well as the offsetting gain or loss on the hedged item are recognized in earnings immediately.

Although the Company’s basis swaps meet the objective of managing commodity price exposure, these trades are typically not entered into concurrent with the Company’s derivative instruments that qualify as cash flow hedges and therefore do not generally qualify for hedge accounting. Basis swap derivative instruments that do not qualify as cash flow hedges are recorded on the balance sheet at their fair values under hedging assets, other long-term assets and other current liabilities, as applicable, and all gains and losses related to these contracts are recognized immediately in the unaudited condensed consolidated statements of operations as a component of gain (loss) on derivatives.

As of September 30, 2013, the Company had basis swaps on natural gas production that did not qualify for hedge accounting treatment of 6.5 Bcf, 16.7 Bcf, and 0.9 Bcf in 2013, 2014, and 2015, respectively.

As of September 30, 2013, the Company had fixed price call options on 199.8 Bcf of 2015 natural gas production that did not qualify for hedge accounting treatment and fixed price swaps of 181.6 Bcf of 2014 natural gas production not designated for hedge accounting.

The Company is a party to an interest rate swap with counterparty banks. The interest rate swap was entered into in order to mitigate the Company’s exposure to volatility in interest rates related to its building lease. The interest rate swap has a notional amount of $170.0 million and expires on June 20, 2020. The Company did not designate the interest rate swap for hedge accounting. Changes in the fair value of the interest rate swap are included in gain (loss) on derivatives in the unaudited condensed consolidated statements of operations. The Company had no interest rate swaps in 2012.

The following table summarizes the before tax effect of fair value hedges, fixed price call options that did not qualify for hedge accounting, fixed price swaps not designated for hedge accounting, basis swaps, and interest rate swaps not designated for hedge accounting on the unaudited condensed consolidated statements of operations for the three- and nine-month periods ended September 30, 2013 and 2012:


		Mark to Market Gain (Loss)
		on Derivatives
		Recognized in Earnings
	Income Statement	For the three months ended				For the nine months ended
	Classification of Mark to Market Gain (Loss)	September 30,				September 30,
Derivative Instrument	on Derivatives	2013		2012		2013		2012
		(in thousands)
Basis swaps	Gain (Loss) on Derivatives	$	(5,279)	$	(1,275)	$	1,606	$	(270)
Fixed price call options	Gain (Loss) on Derivatives	$	7,876	$	–	$	(26,852)	$	–
Fixed price swaps	Gain (Loss) on Derivatives	$	8,819	$	–	$	96,606	$	–
Interest rate swaps	Gain (Loss) on Derivatives	$	(1,312)	$	–	$	1,304	$	–
Fair value swaps	Gain (Loss) on Derivatives	$	–	$	136	$	–	$	1,162

		Mark to Market Gain (Loss)
		on Derivatives, Settled ⁽¹⁾
		Recognized in Earnings
	Income Statement	For the three months ended				For the nine months ended
	Classification of Mark to Market Gain (Loss)	September 30,				September 30,
Derivative Instrument	on Derivatives, Settled ⁽¹⁾	2013		2012		2013		2012
		(in thousands)
Basis swaps	Gain (Loss) on Derivatives	$	2,020	$	624	$	3,115	$	1,773
Fair value swaps	Gain (Loss) on Derivatives	$	–	$	(5,364)	$	–	$	(13,258)

(1) The Company calculates mark to market gain (loss) on derivatives, settled, as the summation of gains and losses on positions that have settled within the period reported.