Sunoco 2006 Annual Report Download - page 35

During 2006, Sunoco increased its use of ethanol as an oxygenate component in gasoline
in response to the new renewable fuels mandate for ethanol and the discontinuance of the
use of MTBE as a gasoline blending component. Currently, most of the ethanol purchased
by Sunoco is through normal purchase fixed-price contracts. To reduce the margin risk
created by these fixed-price contracts, the Company entered into derivative contracts to
sell gasoline at a fixed price to hedge a similar volume of forecasted floating-price gasoline
sales over the term of the ethanol contracts. In effect, these derivative contracts have
locked in an acceptable differential between the gasoline price and the cost of the ethanol
purchases for gasoline blending during this period. As a result of the significant decrease in
the price of gasoline, the fair value of these fixed-price gasoline contracts increased $82
million ($48 million after tax) in 2006. As these derivative contracts have been designated
as cash flow hedges, this increase in fair value is not initially included in net income but
rather is reflected in the net hedging gains component of comprehensive income. The fair
value of these contracts at the time the positions are closed is recognized in income when
the hedged items are recognized in income, with Sunoco’s margin reflecting the differential
between the gasoline sales prices hedged to a fixed price and the cost of fixed-price ethanol
purchases. An $11 million net gain ($6 million after tax) was reclassified to net income in
2006, when the hedged items were recognized in net income.
Sunoco is at risk for possible changes in the market value of all of its derivative contracts,
including the fixed-price gasoline sales contracts discussed above; however, such risk would
be mitigated by price changes in the underlying hedged items. At December 31, 2006,
Sunoco had accumulated net derivative deferred gains, before income taxes, of $62 million
on all of its open derivative contracts. Open contracts as of December 31, 2006 vary in
duration but generally do not extend beyond 2007. The potential decline in the market
value of these derivatives from a hypothetical 10 percent adverse change in the year-end
market prices of the underlying commodities that were being hedged by derivative con-
tracts at December 31, 2006 was estimated to be $58 million. This hypothetical loss was
estimated by multiplying the difference between the hypothetical and the actual year-end
market prices of the underlying commodities by the contract volume amounts.
Sunoco also is exposed to credit risk in the event of nonperformance by derivative counter-
parties. Management believes this risk is negligible as its counterparties are either regulated
by securities exchanges or are major international financial institutions or corporations
with investment-grade credit ratings. (See Note 18 to the consolidated financial
statements.)
Interest Rate Risk
Sunoco has market risk exposure for changes in interest rates relating to its outstanding
borrowings. Sunoco manages this exposure to changing interest rates through the use of a
combination of fixed- and floating-rate debt. Sunoco also has market risk exposure relating
to its cash and cash equivalents. At December 31, 2006, the Company had $1,529 million
of fixed-rate debt, $458 million of floating-rate debt and $263 million of cash and cash
equivalents. The unfavorable impact of a hypothetical 1 percent increase in interest rates
on its floating-rate debt would be partially offset by the favorable impact of such an in-
crease on the cash and cash equivalents. Sunoco also has market risk exposure for changes
in interest rates relating to its retirement benefit plans (see “Critical Accounting
Policies—Retirement Benefit Liabilities” below). Sunoco generally does not use de-
rivatives to manage its market risk exposure to changing interest rates.
Dividends and Share Repurchases
On July 7, 2005, the Company’s Board of Directors approved a two-for-one split of Suno-
co’s common stock to be effected in the form of a stock dividend. The shares were dis-
tributed on August 1, 2005 to shareholders of record as of July 18, 2005. In connection
with the common stock split, the number of authorized shares of common stock was in-
creased from 200 million to 400 million, and the shares of common stock reserved for issu-
ance pertaining to Sunoco’s 6
3
⁄ 4 percent convertible debentures and various employee
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