Alcoa 2014 Annual Report Download - page 176

The following section describes the valuation methodologies used by Alcoa to measure its Level 3 derivative
instruments at fair value. Derivative instruments classified as Level 3 in the fair value hierarchy represent those in
which management has used at least one significant unobservable input in the valuation model. Alcoa uses a
discounted cash flow model to fair value all Level 3 derivative instruments. Where appropriate, the description below
includes the key inputs to those models and any significant assumptions. These valuation models are reviewed and
tested at least on an annual basis.
Inputs in the valuation models for Level 3 derivative instruments are composed of the following: (i) quoted market
prices (e.g., aluminum prices on the 10-year London Metal Exchange (LME) forward curve and energy prices),
(ii) significant other observable inputs (e.g., information concerning time premiums and volatilities for certain option
type embedded derivatives and regional premiums for aluminum contracts), and (iii) unobservable inputs (e.g.,
aluminum and energy prices beyond quoted in the market). For periods beyond the term of quoted market prices for
aluminum, Alcoa estimates the price of aluminum by extrapolating the 10-year LME forward curve. Additionally, for
periods beyond the term of quoted market prices for energy, management has developed a forward curve based on
independent consultant market research. Where appropriate, valuations are adjusted for various factors such as
liquidity, bid/offer spreads, and credit considerations. Such adjustments are generally based on available market
evidence (Level 2). In the absence of such evidence, management’s best estimate is used (Level 3). If a significant
input that is unobservable in one period becomes observable in a subsequent period, the related asset or liability would
be transferred to the appropriate classification (Level 1 or 2) in the period of such change (there were no such transfers
in the periods presented).
Alcoa has embedded derivatives in two power contracts that index the price of power to the LME price of aluminum.
Additionally, in late 2014, Alcoa renewed three power contracts, each of which contain an embedded derivative that
indexes the price of power to the LME price of aluminum plus the Midwest premium. The embedded derivatives in
these five power contracts are primarily valued using observable market prices; however, due to the length of the
contracts, the valuation models also require management to estimate the long-term price of aluminum based upon an
extrapolation of the 10-year LME forward curve and/or 5-year Midwest premium curve. Significant increases or
decreases in the actual LME price beyond 10 years and/or the Midwest premium beyond 5 years would result in a
higher or lower fair value measurement. An increase in actual LME price and/or the Midwest premium over the inputs
used in the valuation models will result in a higher cost of power and a corresponding decrease to the derivative asset
or increase to the derivative liability. The embedded derivatives have been designated as cash flow hedges of forward
sales of aluminum. Unrealized gains and losses were included in Other comprehensive loss on the accompanying
Consolidated Balance Sheet while realized gains and losses were included in Sales on the accompanying Statement of
Consolidated Operations.
Also, Alcoa has a power contract separate from above that contains an LME-linked embedded derivative. 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 corresponding decrease to the derivative asset. This
embedded derivative did not qualify for hedge accounting treatment. 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 were made under the contract. At the time this derivative asset was recognized, an
equivalent amount was recognized as a deferred credit in Other noncurrent liabilities and deferred credits (see Note L).
This deferred credit is recognized in Other income, net on the accompanying Statement of Consolidated Operations as
power is received over the life of the contract. Alcoa had a similar power contract and related embedded derivative
associated with another smelter and rolling mill combined; however, the contract and related derivative instrument
matured in July 2014.
Additionally, Alcoa has a natural gas supply contract, which has an LME-linked ceiling. This embedded derivative 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
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