Alcoa 2013 Annual Report Download - page 172

As reflected in the table above, the net unrealized loss on derivative contracts using Level 3 valuation techniques was $76
and $88 as of December 31, 2013 and 2012, respectively. The unrealized losses related to aluminum contracts recognized
as liabilities were mainly attributed to embedded derivatives in power contracts that index the price of power to the 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 an extrapolation of the 10-year LME forward curve. Significant increases or decreases in the actual LME price
beyond 10 years would result in a higher or lower fair value measurement. An increase of actual LME price over the
inputs used in the valuation model will result in a higher cost of power and a corresponding increase to the liability. The
embedded derivatives have been designated as hedges of forward sales of aluminum and related realized gains and losses
were included in Sales on the accompanying Statement of Consolidated Operations.
In July 2012, as provided for in the arrangements, management elected to modify the pricing for two existing power
contracts, which end in 2014 and 2016 (see directly below), for Alcoa’s two smelters in Australia and the Point Henry
rolling mill in Australia. These contracts contain an LME-linked embedded derivative, which previously was not
recorded as an asset in Alcoa’s Consolidated Balance Sheet. Beginning on January 1, 2001, all derivative contracts
were required to be measured and recorded at fair value on an entity’s balance sheet under GAAP; however, an
exception existed for embedded derivatives upon meeting certain criteria. The LME-linked embedded derivative in
these two contracts met such criteria at that time. Management’s election to modify the pricing of these contracts
qualifies as a significant change to the contracts thereby requiring that the contracts now be evaluated under derivative
accounting as if they were new contracts. As a result, Alcoa recorded a derivative asset in the amount of $596 with an
offsetting liability (deferred credit) recorded in Other current and non-current liabilities. Unrealized gains and losses
from the embedded derivative were included in Other 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 as electricity purchases are made under the contracts. The deferred credit is recognized in
Other income, net on the accompanying Statement of Consolidated Operations as power is received over the life of the
contracts. The embedded derivative is 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.
Also, included within Level 3 measurements is a derivative contract that will hedge the anticipated power requirements
at Alcoa’s Portland smelter in Australia once the existing contract expires in 2016. This derivative hedges 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 this contract was recorded in Other comprehensive loss on the accompanying
Consolidated Balance Sheet until the designated hedge period begins in 2016. Once the hedge period begins, 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. Alcoa had a similar contract for its Point Henry smelter in Australia once the existing contract
expires in 2014, but elected to terminate the new contract in early 2013. This election was available to Alcoa under the
terms of the contract and was made due to a projection that suggested the contract would be uneconomical. Prior to
termination, the new contract was accounted for in the same manner as the contract for the Portland smelter.
Additionally, 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. Unrealized gains
and losses from this contract were included in Other income, 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.
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