Dominion Power 2002 Annual Report Download - page 36

Dominion management. For individual contracts, the use of dif-
ferent assumptions could have a material effect on the contract’s
estimated fair value. In addition, for hedges of forecasted transac-
tions, Dominion must estimate the expected future cash flows of
the forecasted transactions, as well as evaluate the probability of
occurrence and timing of such transactions. Changes in condi-
tions or the occurrence of unforeseen events could affect the tim-
ing of recognition of changes in fair value of certain hedging
derivatives. See Selected Information — Energy Trading Activities
and Market Rate Sensitive Instruments and Risk Management
in MD&A and Notes 2, 4 and 15 to the Consolidated
Financial Statements.
Accounting for Gas and Oil Operations
Dominion follows the full cost method of accounting for gas
and oil exploration and production activities prescribed by the
SEC. Under the full cost method, all direct costs of property
acquisition, exploration and development activities are capital-
ized and subsequently depreciated using a unit-of-production
method. The depreciable base of costs includes estimated future
costs to be incurred in developing proved gas and oil reserves, as
well as dismantlement and abandonment costs, net of projected
salvage values. The calculations under this accounting method
are dependent on engineering estimates of proved reserve quan-
tities and estimates of the amount and timing of future expendi-
tures to develop the proved reserves. Proved reserves, and the
cash flows related to these reserves, are estimated based on a
combination of historical data and estimates of future activity.
Actual reserve quantities and development expenditures may
differ from the forecasted amounts. In addition, Dominion has
significant investments in unproved properties, which are ini-
tially excluded from the depreciable base. Until the properties
are evaluated, a ratable portion of the capitalized costs is period-
ically reclassified to the depreciable base, determined on a
property-by-property basis, over terms of underlying leases.
Once a property has been evaluated, any remaining capitalized
costs are then transferred to the depreciable base. Capitalized
costs in the depreciable base are subject to a ceiling test pre-
scribed by the SEC. The test limits capitalized amounts to a
ceiling—the present value of estimated future net revenues to
be derived from the production of proved gas and oil reserves.
Dominion performs the test quarterly, on a country-by-country
basis, and would recognize asset impairments to the extent that
total capitalized costs exceed the ceiling. Any impairment of
excess gas and oil property costs over the ceiling is charged to
operations. Given the volatility of natural gas and oil prices, it
is possible that Dominion’s estimate of discounted future net
cash flows from proved natural gas and oil reserves could change
in the near term. If natural gas or oil prices decline, even if for
only a short period, or if Dominion revises its estimated proved
reserves downward, recognition of natural gas and oil property
2003, Dominion’s electric transmission operations became a part
of the Dominion Energy operating segment.
Dominion Exploration & Production manages Dominion’s
onshore and offshore gas and oil exploration, development
and production operations. They are located in several major
producing basins in the lower 48 states, including the outer
continental shelf and deep-water areas of the Gulf of Mexico,
and Western Canada. Dominion Exploration & Production’s
operating results reflect successful discovery of and production
from natural gas and oil reserves, as well as changes in prices of
natural gas and oil. Dominion Exploration & Production’s com-
modity risk is managed by the Dominion Energy Clearinghouse
(the Clearinghouse) by using derivative instruments, such as
forwards, swaps, and options.
In addition, Dominion also presents its corporate
functions, financial services and other operations as an
operating segment.
For more information on Dominion’s segments, see Note
32 to the Consolidated Financial Statements.
Critical Accounting Policies
Dominion has identified the following accounting policies that,
as a result of the judgments, uncertainties, uniqueness and com-
plexities of the underlying accounting standards and operations
involved, could result in material changes to its financial condi-
tion or results of operations under different conditions or using
different assumptions.
Accounting for Risk Management and Energy Trading
Contracts At Fair Value
Dominion uses derivative instruments to manage its commodity
and financial market risks. In addition, Dominion purchases and
sells commodity-based contracts in the natural gas, electricity
and oil markets for trading purposes. Accounting requirements
for derivatives and hedging activities are complex; interpretation
of these requirements by standard-setting bodies is ongoing. All
derivatives, other than specific exceptions, are reported on the
Consolidated Balance Sheets at fair value, beginning in 2001.
Energy trading contracts are also reported on the Consolidated
Balance Sheets at fair value. Changes in fair value, except those
related to derivative instruments designated as cash flow hedges,
are generally included in the determination of Dominion’s net
income at each financial reporting date until the contracts are
ultimately settled. The measurement of fair value is based on
actively quoted market prices, if available. In their absence,
Dominion seeks indicative price information from external
sources, including broker quotes and industry publications. If
pricing information from external sources is not available, mea-
surement involves judgment and estimates. These estimates are
based on valuation methodologies deemed appropriate by
Management’s Discussion and Analysis of Financial Condition
and Results of Operations, Continued
34 Dominion ’02 Annual Report