Eversource 2003 Annual Report Download - page 29

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natural gas or oil. A derivative that effectively hedges exposure to the
variable cash flows of a forecasted transaction (a cash flow hedge) is
initially recorded at fair value with changes in fair value recorded in other
comprehensive income, which is a component of equity. Hedges impact
earnings when the forecasted transaction being hedged occurs, when
hedge ineffectiveness is measured and recorded, when the forecasted
transaction being hedged is no longer probable of occurring, or when
there is accumulated other comprehensive loss and the hedge and the
forecasted transaction being hedged are in a loss position on a combined
basis. At December 31, 2003, Select Energy had hedging derivative assets
of $55.8 million and hedging derivative liabilities of $12.7 million. At
December 31, 2002, Select Energy had hedging derivative assets of $22.8
million and hedging derivative liabilities of $2 million.
The increase in hedging derivative assets and liabilities from December 31,
2002 to December 31, 2003 resulted primarily from new financial contracts
entered into during 2003 to hedge gas-indexed power purchases in New
England and new financial transmission rights (FTR) contracts to hedge
congestion in both New England and the Pennsylvania, New Jersey,
Maryland, and Delaware (PJM) regions.
Non-trading: Non-trading derivative contracts are used for delivery of
energy related to wholesale and retail marketing activities. These contracts
are not entered into for trading purposes, but are subject to fair value
accounting because these contracts cannot be designated as normal
purchases and sales, as defined in applicable accounting principles or
because management has not elected hedge accounting or normal
purchases and sales accounting. At December 31, 2003, Select Energy
had non-trading derivative assets of $1.6 million and non-trading
derivative liabilities of $0.8 million, compared to non-trading derivative
assets of $2.9 million and no non-trading derivative liabilities at
December 31, 2002. Changes to the non-trading derivatives portfolio,
which are not significant, were recognized in revenues.
Wholesale Contracts Defined as “Energy Trading”: Energy trading
transactions at Select Energy include financial transactions and physical
delivery transactions for electricity, natural gas and oil in which Select
Energy is attempting to profit from changes in market prices. Energy
trading contracts are recorded at fair value, and changes in fair value
affect net income.
At December 31, 2003, Select Energy had trading derivative assets of
$123.9 million and trading derivative liabilities of $91.4 million on a
counterparty-by-counterparty basis, for a net positive position of $32.5
million for the entire trading portfolio.
At December 31, 2002, trading derivative assets were $102.9 million and
trading derivative liabilities were $61.9 million. The increase in both asset
and liability amounts relates primarily to price increases, as trading activity
has decreased. These amounts are combined with other derivatives
and are included in derivative assets and derivative liabilities on the
accompanying consolidated balance sheets.
There can be no assurances that Select Energy will realize cash
corresponding to the present positive net fair value of its trading
positions. Numerous factors either could positively or negatively affect
the realization of the net fair value amount in cash. These include the
volatility of commodity prices, changes in market design or settlement
mechanisms, the outcome of future transactions, the performance of
counterparties, and other factors.
Select Energy has policies and procedures requiring all trading positions
to be marked-to-market at the end of each business day and segregating
responsibilities between the individuals actually trading (front office) and
those confirming the trades (middle office). The determination of the
portfolio’s fair value is the responsibility of the middle office independent
from the front office.
The methods used to determine the fair value of energy trading contracts
are identified and segregated in the table of fair value of contracts at
December 31, 2003. A description of each method is as follows:
1) prices actively quoted primarily represent New York Mercantile
Exchange futures and options that are marked to closing exchange
prices; 2) prices provided by external sources primarily include over-the-
counter forwards and options, including bilateral contracts for the
purchase or sale of electricity or natural gas, and are marked to the
mid-point of bid and ask market prices; and 3) prices based on models
or other valuation methods primarily include transactions for which specific
quotes are not available. The option component of a forward electricity
purchase contract had a fair value of $4.5 million at December 31,
2002, and was the only amount included in this method of determining
fair value at December 31, 2002. The fair value of the option component
of this contract was reduced to zero in 2003 with a credit reserve that
was established in 2003, and at December 31, 2003, Select Energy has
no other contracts for which fair value is determined based on a model
or other valuation method. Broker quotes for electricity are available
through the year 2005. Broker quotes for natural gas are available
through 2013.
Generally, valuations of short-term contracts derived from quotes or other
external sources are more reliable should there be a need to liquidate the
contracts, while valuations for longer-term contracts are less certain.
Accordingly, there is a risk that contracts will not be realized at the
amounts recorded. However, Select Energy has obtained corresponding
purchase or sale contracts for substantially all of the trading contracts that
have maturities in excess of one year. Because these contracts are sourced,
changes in the value of these contracts due to changes in commodity
prices are not expected to affect Select Energy’s earnings.
As of and for the years ended December 31, 2003 and 2002, the
sources of the fair value of trading contracts and the changes in fair
value of these trading contracts are included in the following tables.
Intercompany transactions are eliminated and not reflected in the
amounts below.
(Millions of Dollars) Fair Value of Trading Contracts at December 31, 2003
Maturity Maturity Maturity
Less Than of One to in Excess of Total
Sources of Fair Value One Year Four Years Four Years Fair Value
Prices actively quoted $0.2 $0.1 $ — $ 0.3
Prices provided by
external sources 6.9 9.6 15.7 32.2
Prices based on models
or other valuation methods ————
Totals $7.1 $9.7 $15.7 $32.5
(Millions of Dollars) Fair Value of Trading Contracts at December 31, 2002
Maturity Maturity Maturity
Less Than of One to in Excess of Total
Sources of Fair Value One Year Four Years Four Years Fair Value
Prices actively quoted $(1.2) $ 0.1 $ — $ (1.1)
Prices provided by
external sources 2.8 20.2 14.6 37.6
Prices based on models
or other valuation methods — 4.5 — 4.5
Totals $ 1.6 $24.8 $14.6 $41.0