Fuel

Fuel costs represented 29 percent, 24 percent and 25 percent of total operating expenses during the nine months ended September 30, 2011 (Successor), and the periods February 13 – September 30, 2010 (Successor) and January 1 – February 12, 2010 (Predecessor), respectively. Due to the significance of diesel fuel expenses to the operations of BNSF and the historical volatility of fuel prices, the Company has entered into derivative instruments to partially mitigate the risk of fluctuations in the price of its diesel fuel purchases. The Company enters into fuel-derivative instruments based on management’s evaluation of current and expected diesel fuel price trends with the intent of protecting operating margins and overall profitability from adverse fuel price changes. The Company does not use derivative financial instruments for trading or speculative purposes. However, to the extent the Company hedges portions of its fuel purchases, it may not realize the impact of decreases in fuel prices. Conversely, to the extent the Company does not hedge portions of its fuel purchases, it may be adversely affected by increases in fuel prices.

As of September 30, 2011, BNSF’s total fuel-derivative positions for the remainder of 2011 and 2012, of which the majority are designated as cash flow hedges, covered approximately 19 percent and 3 percent, respectively, of the average annual locomotive fuel consumption over the past three years. Derivative positions are closely monitored to ensure that they will not exceed actual fuel requirements in any period. As of September 30, 2011, and December 31, 2010, BNSF had entered into fuel-derivative agreements covering approximately 100 million gallons and 284 million gallons, respectively.

Derivative Activities

The Company formally documents the relationship between the hedging instrument and the hedged item, as well as the risk management objective and strategy for the use of the hedging instrument. This documentation includes linking the derivatives that are designated as cash flow hedges to specific assets or liabilities on the balance sheet, commitments or forecasted transactions. The Company assesses at the time a derivative contract is entered into, and at least quarterly thereafter, whether the derivative item is effective in offsetting the changes in fair value or cash flows. Any change in fair value resulting from ineffectiveness, as defined by authoritative accounting guidance related to derivatives and hedging, is recognized in current period earnings. For derivative instruments that are designated and qualify as cash flow hedges, the effective portion of the gain or loss on the derivative instrument is recorded in accumulated other comprehensive loss (AOCL) as a separate component of equity and reclassified into earnings in the period during which the hedge transaction affects earnings. Cash flows related to fuel derivatives are classified as operating activities in the Consolidated Statements of Cash Flows.

Upon application of acquisition method accounting due to the Merger, the Company was required to re-designate its outstanding derivatives as hedges under authoritative accounting guidance. Certain costless collar derivatives did not qualify for re-designation as they were in net written positions as of the Merger date. As a result, hedge accounting was discontinued on these instruments. The Company will continue to hold these financial instruments to hedge against increases in diesel fuel prices, recognizing any gains and losses from changes in fair value in current period earnings.

No additional derivative contracts have been entered into subsequent to the Merger.

BNSF monitors its derivative instrument positions and credit ratings of its counterparties and does not anticipate any losses due to counterparty nonperformance. All counterparties were financial institutions with credit ratings of A2/A or higher as of September 30, 2011. The maximum amount of loss the Company could incur from credit risk based on the gross fair value of derivative instruments in asset positions as of September 30, 2011, and December 31, 2010, was $22 million and $87 million, respectively. Other than as disclosed below, the Company’s derivative agreements do not include provisions requiring collateral. Certain of the Company’s derivative instruments are covered by master netting arrangements whereby, in the event of a default, the non-defaulting party has the right to setoff any amounts payable against any obligation of the defaulting party under the same counterparty agreement. As such, the Company’s net asset exposure to counterparty credit risk was $21 million and $86 million as of September 30, 2011, and December 31, 2010, respectively.

Certain of the Company’s fuel-derivative instruments are covered by an agreement which includes a provision such that the Company either receives or posts cash collateral if the fair value of the instruments exceeds a certain net asset or net liability threshold, respectively. The threshold is based on a sliding scale, utilizing either the counterparty’s credit rating, if the instruments are in a net asset position, or BNSF’s credit rating, if the instruments are in a net liability position. If the applicable credit rating should fall below Ba3 (Moody’s) or BB- (S&P), the threshold would be eliminated and collateral would be required for the entire fair value amount. All cash collateral paid is held on deposit by the payee and earns interest to the benefit of the payor based on the London Interbank Offered Rate (LIBOR). The aggregate fair value of all open fuel-derivative instruments under these provisions was in a net liability position on September 30, 2011 and December 31, 2010, of $2 million and $4 million, respectively. The fair value positions at both September 30, 2011, and December 31, 2010 were below the collateral threshold; therefore, there was no posted collateral outstanding at either date.

The amounts recorded in the Consolidated Balance Sheets for derivative transactions were as follows, presented net of any master netting arrangements (in millions):



	Successor
	September 30, 2011			December 31, 2010
Short-term derivative asset	$	21		$	69
Long-term derivative asset	—			17
Short-term derivative liability	(6		)	(4		)
Total derivatives	$	15		$	82

The tables below contain summaries of all derivative positions reported in the Consolidated Financial Statements, presented gross of any master netting arrangements (in millions):



Fair Value of Derivative Instruments
Asset Derivatives
	Successor
	September 30, 2011		December 31, 2010		Balance Sheet Location
Asset derivatives designated as hedging instruments under ASC 815-20
Fuel contracts	$	21	$	60	Other current assets
Fuel contracts	—		17		Other assets
Total asset derivatives designated as hedging instruments under ASC 815-20	$	21	$	77

Asset derivatives not designated as hedging instruments under ASC 815-20
Fuel contracts	$	—	$	10	Other current assets
Fuel contracts	1		—		Accounts payable and other current liabilities
Total asset derivatives not designated as hedging instruments under ASC 815-20	$	1	$	10

Total asset derivatives	$	22	$	87



Liability Derivatives
	Successor
	September 30, 2011		December 31, 2010		Balance Sheet Location
Liability derivatives designated as hedging instruments under ASC 815-20
Fuel contracts	$	1	$	1	Other current assets
Fuel contracts	6		4		Accounts payable and other current liabilities
Total liability derivatives designated as hedging instruments under ASC 815-20	$	7	$	5

Total liability derivatives	$	7	$	5



The Effects of Derivative Instruments Gains and Losses for the Three Month Periods Ended September 30, 2011 and 2010
Derivatives in ASC 815-20 Cash Flow Hedging Relationships
	Amount of Gain or (Loss) Recognized in Other Comprehensive Income (OCI) on Derivatives (Effective Portion)
	Successor
	2011			2010
Fuel Contracts	$	(35	)	$	26
Total derivatives	$	(35	)	$	26



		Amount of Gain or (Loss) Recognized from AOCL into Income (Effective Portion)
	Location of Gain or (Loss) Recognized	Successor
	from AOCL into Income	2011		2010
Fuel Contracts	Fuel expense	$	18	$	—
Total derivatives		$	18	$	—



		Amount of Gain or (Loss) Recognized in Income on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing)^a
	Location of Gain or (Loss) Recognized	Successor
	in Income on Derivatives	2011			2010
Fuel Contracts	Fuel expense	$	(5	)	$	11
Total derivatives		$	(5	)	$	11


a	No portion of the gain or (loss) was excluded from the assessment of hedge effectiveness for the periods then ended.

Derivatives Not Designated as Hedging Instruments under ASC 815-20



		Amount of Gain or (Loss) Recognized in Income on Derivatives
	Location of Gain or (Loss) Recognized	Successor
	in Income on Derivatives	2011			2010
Fuel Contracts	Fuel expense	$	(4	)	$	5
Total derivatives		$	(4	)	$	5



The Effects of Derivative Instruments Gains and Losses for the Nine Months Ended September 30, 2011 (Successor) and for the Periods February 13 – September 30, 2010 (Successor) and January 1 – February 12, 2010 (Predecessor)
Derivatives in ASC 815-20 Cash Flow Hedging Relationships
	Amount of Gain or (Loss) Recognized in OCI on Derivatives (Effective Portion)
	Successor				Predecessor
	Nine Months Ended		February 13 – September 30, 2010		January 1 – February 12, 2010
	September 30, 2011		February 13 – September 30, 2010		January 1 – February 12, 2010
Fuel Contracts	$	20	$	36	$	(79	)
Total derivatives	$	20	$	36	$	(79	)



		Amount of Gain or (Loss) Recognized from AOCL into Income (Effective Portion)
		Successor				Predecessor
	Location of Gain or (Loss) Recognized from AOCL into Income	Nine Months Ended		February 13 – September 30, 2010		January 1 – February 12, 2010
	Location of Gain or (Loss) Recognized from AOCL into Income	September 30, 2011		February 13 – September 30, 2010		January 1 – February 12, 2010
Fuel Contracts	Fuel expense	$	75	$	14	$	(6	)
Total derivatives		$	75	$	14	$	(6	)



		Amount of Gain or (Loss) Recognized in Income on Derivatives (Ineffective Portion and Amount Excluded from Effectiveness Testing)^a
		Successor					Predecessor
	Location of Gain or (Loss) Recognized in Income on Derivatives	Nine Months Ended			February 13 – September 30, 2010		January 1 – February 12, 2010
		September 30, 2011			February 13 – September 30, 2010		January 1 – February 12, 2010
Fuel Contracts	Fuel expense	$	(14	)	$	12	$	(7	)
Total derivatives		$	(14	)	$	12	$	(7	)


a	No portion of the gain or (loss) was excluded from the assessment of hedge effectiveness for the periods then ended.

Derivatives Not Designated as Hedging Instruments under ASC 815-20



		Amount of Gain or (Loss) Recognized in Income on Derivatives
		Successor					Predecessor
	Location of Gain or (Loss) Recognized in Income on Derivatives	Nine Months Ended			February 13 – September 30, 2010		January 1 – February 12, 2010
		September 30, 2011			February 13 – September 30, 2010		January 1 – February 12, 2010
Fuel Contracts	Fuel expense	$	(1	)	$	6	$	—
Total derivatives		$	(1	)	$	6	$	—

As of September 30, 2011, the Company estimates that within the next twelve months approximately $12 million in pre-tax hedge instrument gains will be reclassified from accumulated other comprehensive loss into earnings.

The Company utilizes a market approach using the forward commodity price for the periods hedged to value its fuel-derivative swaps and costless collars. As such, the fair values of these instruments are classified as Level 2 valuations under authoritative accounting guidance related to fair value measurements.

Additional disclosure related to derivative instruments is included in Note 10 to the Consolidated Financial Statements.