Alcoa 2010 Annual Report Download - page 152

As reflected in the table above, the net unrealized loss on derivative contracts using Level 3 valuation techniques was
$779 and $831 as of December 31, 2010 and 2009, respectively. These losses were mainly attributed to embedded
derivatives in power contracts that index the price of power to the London Metal Exchange (LME) price of aluminum.
These embedded derivatives are primarily valued using observable market prices. However, due to the length of the
contracts, the valuation model also requires management to estimate the long-term price of aluminum based upon
anticipated changes in worldwide supply and demand. The embedded derivatives have been designated as hedges of
forward sales of aluminum and their realized gains and losses were included in Sales on the accompanying Statement
of Consolidated Operations.
Also, 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 utilizes 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 expenses (income), 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 income; in periods subsequent to December 31, 2009, such
changes were included in Other expenses (income), net on the accompanying Statement of Consolidated Operations.
In 2010, Alcoa entered into contracts to hedge the anticipated power requirements at two smelters in Australia. 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 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.
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. Realized gains
and losses for this embedded derivative were included in Other income, net on the accompanying Statement of
Consolidated Operations.
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