Sunoco 2008 Annual Report Download - page 58

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Sunoco uses ethanol as an oxygenate component in gasoline. Most of the ethanol purchased by Sunoco in
recent years has been through normal fixed-price purchase contracts. However, increasingly in 2008, Sunoco has
satisfied its ethanol purchase commitments utilizing contracts based on spot-market prices. To reduce the margin
risk created by the purchases utilizing fixed-price contracts, the Company enters 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 lock in an acceptable differential between the gasoline
price and the cost of the fixed-price ethanol purchases for gasoline blending.
As a result of changes in the price of gasoline, the fair value of the fixed-price gasoline contracts increased
(decreased) $(3), $(97) and $82 million ($(2), $(58) and $48 million after tax) in 2008, 2007 and 2006,
respectively. As these derivative contracts have been designated as cash flow hedges, these changes in fair value
are not initially included in earnings but rather are reflected in the net hedging losses component of
comprehensive income. The fair value of these contracts at the time the positions are closed is recognized in
earnings when the hedged items are recognized in earnings, 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. Net gains
(losses) totaling $(35), $(14) and $11 million ($(21), $(8) and $6 million after tax) were reclassified to earnings
in 2008, 2007 and 2006, respectively, when the hedged items were recognized in earnings.
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, 2008, Sunoco had net derivative losses, before income taxes, of
$17 million on all of its open derivative contracts. Open contracts as of December 31, 2008 vary in duration but
generally do not extend beyond 2009. 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 contracts at December 31, 2008 was estimated to be $10 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 counterparties.
Management believes this risk is not significant as the Company has established credit limits with such
counterparties which require the settlement of net positions when these credit limits are reached. As a result, the
Company had no significant derivative counterparty credit exposure at December 31, 2008 (see Note 18 to the
Consolidated Financial Statements under Item 8).
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. At December 31, 2008, the Company had $1,517 million of fixed-rate debt and $646 million of floating-
rate debt. A hypothetical one-percentage point decrease in interest rates would increase the fair value of the
Company’s fixed-rate borrowings at December 31, 2008 by approximately $65 million. However, such change in
interest rates would not have a material impact on income or cash flows as the majority of the outstanding
borrowings consisted of fixed-rate instruments. 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 derivatives to manage its market risk exposure to changing interest rates.
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