Note 4 – Derivatives and Fair Value Measurements

Derivatives. In managing its natural gas supply portfolios, Southwest has historically entered into fixed- and variable-price contracts, which qualify as derivatives. Additionally, Southwest utilizes fixed-for-floating swap contracts (“Swaps”) to supplement its fixed-price contracts. The fixed-price contracts, firm commitments to purchase a fixed amount of gas in the future at a fixed price, qualify for the normal purchases and normal sales exception that is allowed for contracts that are probable of delivery in the normal course of business, and are exempt from fair value reporting. The variable-price contracts have no significant market value. The Swaps are recorded at fair value.

The fixed-price contracts and Swaps are utilized by Southwest under its volatility mitigation programs to effectively fix the price on a portion (currently ranging from 25% to 35%, depending on the jurisdiction) of its natural gas supply portfolios. The maturities of the Swaps highly correlate to forecasted purchases of natural gas, during time frames ranging from October 2013 through March 2015. Under such contracts, Southwest pays the counterparty at a fixed rate and receives from the counterparty a floating rate per MMBtu (“dekatherm”) of natural gas. Only the net differential is actually paid or received. The differential is calculated based on the notional amounts under the contracts, which are detailed in the table below (thousands of dekatherms):


	September 30, 2013		December 31, 2012

Contract notional amounts		15,662		14,579

Southwest does not utilize derivative financial instruments for speculative purposes, nor does it have trading operations.

The following table sets forth the gains and (losses) recognized on the Company’s Swaps (derivatives) for the three-, nine-, and twelve-month periods ended September 30, 2013 and 2012 and their location in the Condensed Consolidated Statements of Income (thousands of dollars):

Gains (losses) recognized in income for derivatives not designated as hedging instruments:

(Thousands of dollars)


		Three Months Ended						Nine Months Ended						Twelve Months Ended
	Location of Gain or (Loss) Recognized in Income on Derivative	September 30						September 30						September 30
Instrument		2013			2012			2013			2012			2013			2012

Swaps	Net cost of gas sold	$	(353	)	$	3,617		$	(2,946	)	$	(945	)	$	(6,855	)	$	(9,607	)
Swaps	Net cost of gas sold		353	*		(3,617	)*		2,946	*		945	*		6,855	*		9,607	*

Total		$	—		$	—		$	—		$	—		$	—		$	—

*	Represents the impact of regulatory deferral accounting treatment under U.S. GAAP for rate-regulated entities.

In January 2010, Southwest entered into two forward-starting interest rate swaps (“FSIRS”) to hedge the risk of interest rate variability during the period leading up to the planned issuance of fixed-rate debt to replace $200 million of debt that matured in February 2011 and $200 million that matured in May 2012. Both were designated cash flow hedges. The first FSIRS terminated in December 2010 concurrent with the related issuance of $125 million 4.45% 10-year Senior Notes. The second FSIRS had a notional amount of $100 million, and terminated in March 2012 concurrent with the related issuance of $250 million 3.875% 10-year Senior Notes. No gain or loss was recognized in income (ineffective portion) for either FSIRS during any period, including the periods presented in the following table. See Note 7 – Equity, Other Comprehensive Income, and Accumulated Other Comprehensive Income for additional information on both FSIRS contracts.

Gains (losses) recognized in other comprehensive income for derivatives designated as cash flow hedging instruments:

(Thousands of dollars)


	Three Months Ended				Nine Months Ended				Twelve Months Ended
	September 30				September 30				September 30
	2013		2012		2013		2012		2013		2012
Amount of gain/(loss) realized/ unrealized on FSIRS recognized in other comprehensive income on derivative	$	—	$	—	$	—	$	2,959	$	—	$	1,383

The following table sets forth the fair values of the Company’s Swaps and their location in the balance sheets (thousands of dollars):

Fair values of derivatives not designated as hedging instruments:


September 30, 2013		Asset		Liability
Instrument	Balance Sheet Location	Derivatives		Derivatives			Net Total
Swaps	Other current liabilities	$	25	$	(4,282	)	$	(4,257	)
Swaps	Other deferred credits		8		(787	)		(779	)

Total		$	33	$	(5,069	)	$	(5,036	)


December 31, 2012		Asset		Liability
Instrument	Balance Sheet Location	Derivatives		Derivatives			Net Total
Swaps	Deferred charges and other assets	$	132	$	(126	)	$	6
Swaps	Other current liabilities		391		(2,467	)		(2,076	)
Swaps	Other deferred credits		233		(552	)		(319	)

Total		$	756	$	(3,145	)	$	(2,389	)

The estimated fair values of the natural gas derivatives were determined using future natural gas index prices (as more fully described below). The Company has master netting arrangements with each counterparty that provide for the net settlement of all contracts through a single payment. As applicable, the Company has elected to reflect the net amounts in its balance sheets. The Company had no outstanding collateral associated with the Swaps during either period shown in the above table.

Pursuant to regulatory deferral accounting treatment for rate-regulated entities, Southwest records the unrealized gains and losses in fair value of the Swaps as a regulatory asset and/or liability. When the Swaps mature, Southwest reverses any prior positions held and records the settled position as an increase or decrease of purchased gas under the related purchased gas adjustment (“PGA”) mechanism in determining its deferred PGA balances. Neither changes in fair value, nor settled amounts, of Swaps have a direct effect on earnings or other comprehensive income.

The following table shows the amounts Southwest paid to and received from counterparties for settlements of matured Swaps.


(Thousands of dollars)	Three Months Ended September 30, 2013		Nine Months Ended September 30, 2013		Twelve Months Ended September 30, 2013
Paid to counterparties	$	342	$	1,214	$	2,260

Received from counterparties	$	7	$	915	$	1,549

The following table details the regulatory assets/(liabilities) offsetting the derivatives at fair value in the balance sheets (thousands of dollars).


September 30, 2013
Instrument	Balance Sheet Location	Net Total
Swaps	Prepaids and other current assets	$	4,257
Swaps	Deferred charges and other assets		779


December 31, 2012
Instrument	Balance Sheet Location	Net Total
Swaps	Other deferred credits	$	(6	)
Swaps	Prepaids and other current assets		2,076
Swaps	Deferred charges and other assets		319

Fair Value Measurements. The estimated fair values of Southwest’s Swaps were determined at September 30, 2013 and December 31, 2012 using New York Mercantile Exchange (“NYMEX”) futures settlement prices for delivery of natural gas at Henry Hub adjusted by the price of NYMEX ClearPort basis Swaps, which reflect the difference between the price of natural gas at a given delivery basin and the Henry Hub pricing points. These Level 2 inputs (inputs, other than quoted prices, for similar assets or liabilities) are observable in the marketplace throughout the full term of the Swaps, but have been credit-risk adjusted with no significant impact to the overall fair value measure.

The following table sets forth the Company’s Level 2 financial assets and liabilities recorded at fair value:

Level 2 – Significant other observable inputs


(Thousands of dollars)	September 30, 2013			December 31, 2012

Assets at fair value:
Deferred charges and other assets - Swaps	$	—		$	6

Liabilities at fair value:
Other current liabilities - Swaps		(4,257	)		(2,076	)
Other deferred credits - Swaps		(779	)		(319	)

Net Assets (Liabilities)	$	(5,036	)	$	(2,389	)

No financial assets or liabilities accounted for at fair value fell within Level 1 or Level 3 of the fair value hierarchy.