8. DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

We are exposed to financial market risks, including changes in commodity prices, in the course of our normal business operations. We use derivative instruments to manage risks.

Interest Rate Derivatives

From time to time, we utilize forward-starting interest rate swaps to hedge the variability of the forecasted interest payments on anticipated debt issuances that may result from changes in the benchmark interest rate until the expected debt is issued. When entering into interest rate swap transactions, we become exposed to both credit risk and market risk. We are subject to credit risk when the change in fair value of the swap instrument is positive and the counterparty may fail to perform under the terms of the contract. We are subject to market risk with respect to changes in the underlying benchmark interest rate that impacts the fair value of the swaps. We manage our credit risk by entering into swap transactions only with major financial institutions with investment-grade credit ratings. We manage our market risk by aligning the swap instrument with the existing underlying debt obligation or a specified expected debt issuance, generally associated with the maturity of an existing debt obligation. We designate the swap agreements as cash flow hedges at inception and expect the changes in values to be highly correlated with the changes in value of the underlying borrowings.

During the third quarter of 2016, we entered into four forward-starting interest rate swaps with a total aggregate notional amount of $200.0 million, which we entered into in anticipation of the issuance of debt on or before January 15, 2018, and six forward-starting interest rate swaps with a total aggregate notional amount of $300.0 million, which we entered into in anticipation of the issuance of debt on or before November 15, 2018. We expect to issue new fixed-rate debt on or before January 15, 2018 to repay the $300.0 million of 6.050% Notes that are due on January 15, 2018, and on or before November 15, 2018 to repay the $400.0 million of 2.650% Notes that are due on November 15, 2018, although no assurances can be given that the issuance of fixed-rate debt will be possible on acceptable terms.

During the three and nine months ended September 30, 2016, unrealized gains of $1.1 million were recorded in accumulated other comprehensive income (“AOCI”) to reflect the change in the fair values of the forward-starting interest rate swaps.

Commodity Derivatives

Our Merchant Services segment primarily uses exchange-traded refined petroleum product futures contracts to manage the risk of market price volatility on its refined petroleum product inventories and its physical derivative contracts which we designated as fair value hedges with changes in fair value of both the futures contracts and physical inventory reflected in earnings. Physical forward contracts and futures contracts that have not been designated in a hedge relationship are marked-to-market.

The following table summarizes our commodity derivative instruments outstanding at September 30, 2016 (amounts in thousands of gallons):



	Volume (1)		Accounting
Derivative Purpose	Current	Long-Term	Treatment
Derivatives NOT designated as hedging instruments:
Physical fixed price derivative contracts	8,504	1,073	Mark-to-market
Physical index derivative contracts	31,274	—	Mark-to-market
Futures contracts for refined petroleum products	24,819	16,926	Mark-to-market

Derivatives designated as hedging instruments:
Physical fixed price derivative contracts	1,176	—	Fair Value Hedge
Futures contracts for refined petroleum products	163,800	—	Fair Value Hedge


(1)	Volume represents absolute value of net notional volume position.

The following table sets forth the fair value of each classification of derivative instruments and the locations of the derivative instruments on our unaudited condensed consolidated balance sheets at the dates indicated (in thousands):



	September 30, 2016
	Derivatives NOT Designated as Hedging Instruments			Derivatives Designated as Hedging Instruments			Derivative Carrying Value			Netting Balance Sheet Adjustment (1)			Net Total
Physical fixed price derivative contracts	$	4,046		$	67		$	4,113		$	(505	)	$	3,608
Physical index derivative contracts	67			—			67			(1		)	66
Futures contracts for refined products	20,655			1,005			21,660			(21,660		)	—
Total current derivative assets	24,768			1,072			25,840			(22,166		)	3,674
Physical fixed price derivative contracts	293			—			293			(8		)	285
Futures contracts for refined products	84			—			84			(84		)	—
Interest rates derivatives	—			1,052			1,052			—			1,052
Total non-current derivative assets	377			1,052			1,429			(92		)	1,337
Physical fixed price derivative contracts	(2,673		)	—			(2,673		)	505			(2,168		)
Physical index derivative contracts	(41		)	—			(41		)	1			(40		)
Futures contracts for refined products	(29,231		)	(12,257		)	(41,488		)	21,660			(19,828		)
Total current derivative liabilities	(31,945		)	(12,257		)	(44,202		)	22,166			(22,036		)
Physical fixed price derivative contracts	(27		)	—			(27		)	8			(19		)
Futures contracts for refined products	(4,042		)	—			(4,042		)	84			(3,958		)
Total non-current derivative liabilities	(4,069		)	—			(4,069		)	92			(3,977		)
Net derivative liabilities	$	(10,869	)	$	(10,133	)	$	(21,002	)	$	—		$	(21,002	)


(1)	Amounts represent the netting of physical fixed and index contracts’ assets and liabilities when a legal right of offset exists. Futures contracts are subject to settlement through margin requirements and are additionally presented on a net basis.



	December 31, 2015
	Derivatives NOT Designated as Hedging Instruments			Derivatives Designated as Hedging Instruments			Derivative Carrying Value			Netting Balance Sheet Adjustment (1)			Net Total
Physical fixed price derivative contracts	$	26,698		$	—		$	26,698		$	(79	)	$	26,619
Physical index derivative contracts	87			—			87			(62		)	25
Futures contracts for refined products	136,131			36,834			172,965			(121,324		)	51,641
Total current derivative assets	162,916			36,834			199,750			(121,465		)	78,285
Physical fixed price derivative contracts	1,057			—			1,057			—			1,057
Total non-current derivative assets	1,057			—			1,057			—			1,057
Physical fixed price derivative contracts	(535		)	—			(535		)	79			(456		)
Physical index derivative contracts	(116		)	—			(116		)	62			(54		)
Futures contracts for refined products	(119,506		)	(1,818		)	(121,324		)	121,324			—
Total current derivative liabilities	(120,157		)	(1,818		)	(121,975		)	121,465			(510		)
Futures contracts for refined products	(703		)	—			(703		)	—			(703		)
Total non-current derivative liabilities	(703		)	—			(703		)	—			(703		)
Net derivative assets	$	43,113		$	35,016		$	78,129		$	—		$	78,129


(1)	Amounts represent the netting of physical fixed and index contracts’ assets and liabilities when a legal right of offset exists. Futures contracts are subject to settlement through margin requirements and are additionally presented on a net basis.

Our futures contracts designated as fair value hedges related to our inventory portfolio extend to the second quarter of 2017. The unrealized loss at September 30, 2016 for fair value hedges of inventory represented by future contracts of $11.3 million will be realized by the second quarter of 2017. At September 30, 2016, open refined petroleum product derivative contracts (represented by the physical fixed-price contracts, physical index contracts, and futures contracts for refined products contracts noted above) varied in duration in the overall portfolio, but did not extend beyond December 2018. In addition, at September 30, 2016, we had refined petroleum product inventories that we intend to use to satisfy a portion of the physical derivative contracts.

The gains and losses on our derivative instruments recognized in income were as follows for the periods indicated (in thousands):



		Three Months Ended September 30,						Nine Months Ended September 30,
	Location	2016			2015			2016			2015
Derivatives NOT designated as hedging instruments:
Physical fixed price derivative contracts	Product sales	$	301		$	15,731		$	(7,263	)	$	19,660
Physical index derivative contracts	Product sales	142			(299		)	130			(309		)
Physical fixed price derivative contracts	Cost of product sales	479			3,600			7,965			10,191
Physical index derivative contracts	Cost of product sales	30			(288		)	193			(224		)
Futures contracts for refined products	Cost of product sales	(307		)	(10,992		)	4,326			2,591

Derivatives designated as fair value hedging instruments:
Futures contracts for refined products	Cost of product sales	$	(635	)	$	54,514		$	(27,590	)	$	21,959
Physical inventory - hedged items	Cost of product sales	3,620			(55,424		)	43,627			(34,848		)

Ineffectiveness excluding the time value component on fair value hedging instruments:
Fair value hedge ineffectiveness (excluding time value)	Cost of product sales	$	(4,262	)	$	2,626		$	(4,275	)	$	2,476
Time value excluded from hedge assessment	Cost of product sales	7,247			(3,536		)	20,312			(15,365		)
Net gain (loss) in income		$	2,985		$	(910	)	$	16,037		$	(12,889	)

The change in value recognized in other comprehensive income (“OCI”) and the losses reclassified from AOCI to income attributable to our derivative instruments designated as cash flow hedges were as follows for the periods indicated (in thousands):



	Gain Recognized in OCI on Derivatives for the
	Three Months Ended September 30,				Nine Months Ended September 30,
	2016		2015		2016		2015
Derivatives designated as cash flow hedging instruments:
Interest rate contracts	$	1,052	$	—	$	1,052	$	—
Commodity derivatives	—		11,168		—		7,311
Total	$	1,052	$	11,168	$	1,052	$	7,311



		(Loss) Gain Reclassified from AOCI to Income (Effective Portion) for the
		Three Months Ended September 30,						Nine Months Ended September 30,
	Location	2016			2015			2016			2015
Derivatives designated as cash flow hedging instruments:
Interest rate contracts	Interest and debt expense	$	(3,037	)	$	(3,037	)	$	(9,112	)	$	(9,113	)
Commodity derivatives	Product Sales	—			—			1,266			—
Total		$	(3,037	)	$	(3,037	)	$	(7,846	)	$	(9,113	)

Over the next twelve months, we expect to reclassify $12.2 million of net losses attributable to interest rate derivative instruments from AOCI to earnings as an increase to interest and debt expense. For additional information on the net losses attributable to interest rate derivative instruments, see our Annual Report on Form 10-K for the year ended December 31, 2015.