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 (up to 25% in the Arizona and California jurisdictions) 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 2016 through March 2018. Under such contracts, Southwest pays the counterparty 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, 2016		December 31, 2015
Contract notional amounts		11,985		7,407

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, 2016 and 2015 and their location in the Condensed Consolidated Statements of Income:

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)	September 30						September 30						September 30
Instrument	Recognized in Income on Derivative	2016			2015			2016			2015			2016			2015
Swaps	Net cost of gas sold	$	(2,072	)	$	(3,282	)	$	2,253		$	(4,689	)	$	(656	)	$	(10,682	)
Swaps	Net cost of gas sold		2,072	*		3,282	*		(2,253	)*		4,689	*		656	*		10,682	*

Total		$	—		$	—		$	—		$	—		$	—		$	—

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

No gains (losses) were recognized in net income or other comprehensive income during the periods presented for derivatives designated as cash flow hedging instruments. Previously, Southwest entered into two forward-starting interest rate swaps (“FSIRS”), both of which were designated cash flow hedges, to partially hedge the risk of interest rate variability during the period leading up to the planned issuance of debt. The first FSIRS terminated in December 2010, and the second, in March 2012. Losses on both FSIRS are being amortized over ten-year periods from Accumulated other comprehensive income (loss) into interest expense.

The following table sets forth, the fair values of the Company’s Swaps and their location in the Condensed Consolidated Balance Sheets (thousands of dollars):

Fair values of derivatives not designated as hedging instruments:


September 30, 2016 Instrument	Balance Sheet Location	Asset Derivatives		Liability Derivatives			Net Total
Swaps	Deferred charges and other assets	$	226	$	(33	)	$	193
Swaps	Prepaids and other current assets		1,852		(182	)		1,670
Swaps	Other current liabilities		16		(982	)		(966	)

Total		$	2,094	$	(1,197	)	$	897


December 31, 2015 Instrument	Balance Sheet Location	Asset Derivatives		Liability Derivatives			Net Total
Swaps	Other current liabilities	$	—	$	(4,267	)	$	(4,267	)
Swaps	Other deferred credits		4		(1,223	)		(1,219	)

Total		$	4	$	(5,490	)	$	(5,486	)

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 (in the settlement month) 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 any period presented 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 counterparties for settlements of matured Swaps.


	Three Months Ended		Nine Months Ended		Twelve Months Ended
(Thousands of dollars)	September 30, 2016		September 30, 2016		September 30, 2016
Paid to counterparties	$	—	$	4,483	$	6,792

Received from counterparties	$	351	$	351	$	351

The following table details the regulatory assets/(liabilities) offsetting the derivatives at fair value in the Condensed Consolidated Balance Sheets (thousands of dollars).


September 30, 2016 Instrument	Balance Sheet Location	Net Total
Swaps	Other deferred credits	$	(193	)
Swaps	Other current liabilities		(1,670	)
Swaps	Prepaids and other current assets		966

December 31, 2015 Instrument	Balance Sheet Location	Net Total
Swaps	Prepaids and other current assets	$	4,267
Swaps	Deferred charges and other assets		1,219

Fair Value Measurements. The estimated fair values of Southwest’s Swaps were determined at September 30, 2016 and December 31, 2015 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 measurement.

The following table sets forth, by level within the three-level fair value hierarchy that ranks the inputs used to measure fair value by their reliability, the Company’s financial assets and liabilities that were accounted for at fair value:

Level 2 - Significant other observable inputs


(Thousands of dollars)	September 30, 2016			December 31, 2015
Assets at fair value:
Prepaids and other current assets - Swaps	$	1,670		$	—
Deferred charges and other assets - Swaps		193			—
Liabilities at fair value:
Other current liabilities - Swaps		(966	)		(4,267	)
Other deferred credits - Swaps		—			(1,219	)

Net Assets (Liabilities)	$	897		$	(5,486	)

No financial assets or liabilities associated with the Swaps, which were accounted for at fair value, fell within Level 1 (quoted prices in active markets for identical financial assets) or Level 3 (significant unobservable inputs) of the fair value hierarchy.

With regard to the fair values of assets associated with the Company’s pension and postretirement benefit plans, asset values were last updated as required as of December 2015. Refer to Note 10 – Pension and Other Post Retirement Benefits in the 2015 Annual Report to Shareholders on Form 10-K.