Alcoa 2012 Annual Report Download - page 163

valued using the probability and interrelationship of future LME prices, Australian dollar to U.S. dollar exchange rates,
and the U.S. consumer price index. Significant increases or decreases in the LME price would result in a higher or
lower fair value measurement. An increase in actual LME price over the inputs used in the valuation model will result
in a higher cost of power and a decrease to the embedded derivative asset.
In 2010, Alcoa entered into derivative contracts that will hedge the anticipated power requirements at Alcoa’s two
smelters in Australia once the existing contracts expire in 2014 and 2016. These derivatives hedge forecasted power
purchases through December 2036. Beyond the term where market information is available, management has
developed a forward curve, for valuation purposes, based on independent consultant market research. The effective
portion of gains and losses on these contracts were recorded in Other comprehensive (loss) income on the
accompanying Consolidated Balance Sheet until the designated hedge periods begin in 2014 and 2016. Once the hedge
periods begin, realized gains and losses will be recorded in Cost of goods sold. Significant increases or decreases in the
power market may result in a higher or lower fair value measurement. Higher prices in the power market would cause
the derivative asset to increase in value.
Also, Alcoa has a six-year natural gas supply contract, which has an LME-linked ceiling. This contract is valued using
probabilities of future LME aluminum prices and the price of Brent crude oil (priced on Platts), including the
interrelationships between the two commodities subject to the ceiling. Any change in the interrelationship would result
in a higher or lower fair value measurement. An LME ceiling was embedded into the contract price to protect against
an increase in the price of oil without a corresponding increase in the price of LME. An increase in oil prices with no
similar increase in the LME price would limit the increase of the price paid for natural gas. At inception, this contract
had a fair value of $5. Unrealized gains and losses from this contract were included in Other (income) expenses, net on
the accompanying Statement of Consolidated Operations, while realized gains and losses will be included in Cost of
goods sold on the accompanying Statement of Consolidated Operations as gas purchases are made under the contract.
Additionally, an embedded derivative in a power contract that indexes the difference between the long-term debt
ratings of Alcoa and the counterparty from any of the three major credit rating agencies is included in Level 3.
Management uses market prices, historical relationships, and forecast services to determine fair value. Significant
increases or decreases in any of these inputs would result in a lower or higher fair value measurement. A wider credit
spread between Alcoa and the counterparty would result in an increase of the future liability and a higher cost of
power. Realized gains and losses for this embedded derivative were included in Cost of goods sold on the
accompanying Statement of Consolidated Operations and unrealized gains and losses were included in Other (income)
expenses, net on the accompanying Statement of Consolidated Operations.
Furthermore, included within Level 3 measurements are derivative financial instruments that hedge the cost of electricity.
Transactions involving on-peak power are observable as there is an active market. However, there are certain off-peak
times when there is not an actively traded market for electricity. Therefore, management utilizes market prices, historical
relationships, and various forecast services to determine the fair value. Management utilized these same valuation
techniques for an existing power contract associated with a smelter in the U.S. that no longer qualified for the normal
purchase normal sale exception under derivative accounting in late 2009. Unrealized gains and losses for this physical
power contract were included in Other (income) expenses, net on the accompanying Statement of Consolidated
Operations, while realized gains and losses were included in Cost of goods sold on the accompanying Statement of
Consolidated Operations. Additionally, a financial contract related to the same U.S. smelter utilized by management to
hedge the price of electricity of the aforementioned power contract no longer qualified for cash flow hedge accounting
near the end of 2009. Realized gains and losses of this financial contract were included in Cost of goods sold on the
accompanying Statement of Consolidated Operations. In periods prior to January 1, 2010, unrealized gains and losses
were included in Other comprehensive (loss) income; in periods subsequent to December 31, 2009, such changes were
included in Other (income) expenses, net on the accompanying Statement of Consolidated Operations. Both the physical
power contract and the financial contract related to this U.S. smelter expired in September 2011.
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