Hedges and Derivative Financial Instruments

3 Months Ended

Mar. 31, 2012

General Discussion of Derivative Instruments and Hedging Activities [Abstract]

Derivative Instruments and Hedging Activities Disclosure

HEDGES AND DERIVATIVE FINANCIAL INSTRUMENTS

Derivative instruments are accounted for at fair value based on market rates. Derivatives where we elect hedge accounting are designated as either cash flow or fair value hedges. Derivatives that are not accounted for based on hedge accounting are marked to market through earnings. The accounting for changes in the fair value of a derivative depends on the intended use and designation of the derivative instrument. For a derivative instrument designated as a fair value hedge, the gain or loss on the derivative is recognized in earnings in the period of change in fair value together with the offsetting gain or loss on the hedged item. For a derivative instrument designated as a cash flow hedge, the effective portion of the derivative’s gain or loss is initially reported as a component of Other Comprehensive Income (“OCI”) and is subsequently recognized in earnings when the hedged exposure affects earnings. Hedging ineffectiveness and a net earnings impact occur when the change in the fair value of the hedge does not offset the change in the fair value of the hedged item. The ineffective portion of the gain or loss is recognized in earnings.

Using derivative instruments means assuming counterparty credit risk. Counterparty credit risk relates to the loss we could incur if a counterparty were to default on a derivative contract. We generally deal with investment grade counterparties and monitor the overall credit risk and exposure to individual counterparties. We do not anticipate nonperformance by any counterparties. The amount of counterparty credit exposure is limited to the unrealized gains, if any, on such derivative contracts. We do not require, nor do we post collateral or other security on such contracts.

Hedging strategy

In the normal course of business, we manage risks relating to our ongoing business operations including those arising from changes in foreign exchange rates, interest rates and commodity prices. Fluctuations in these rates and prices can affect our operating results and financial condition. We use a variety of strategies, including the use of derivative instruments. We do not enter into derivative financial instruments for trading or speculative purposes.

Foreign currency exchange rate risk

We incur expenses associated with the procurement and production of products in a limited number of countries, while we sell in the local currencies of a large number of countries. Our primary foreign currency exchange exposures result from cross-currency sales of products. As a result, we enter into foreign exchange contracts to hedge certain firm commitments and forecasted transactions to acquire products and services that are denominated in foreign currencies.

We enter into certain undesignated non-functional currency asset and liability hedges that relate primarily to short-term payables, receivables, inventory and intercompany loans. These forecasted cross-currency cash flows relate primarily to foreign currency denominated expenditures and intercompany financing agreements, royalty agreements and dividends. When we hedge a foreign currency denominated payable or receivable with a derivative, the effect of changes in the foreign exchange rates are reflected currently in interest and sundry income (expense) for both the payable/receivable and the derivative. Therefore, as a result of the economic hedge, we do not elect hedge accounting.

Commodity price risk

We enter into forward contracts on various commodities to manage the price risk associated with forecasted purchases of materials used in our manufacturing process. The objective of these hedges is to reduce the variability of cash flows associated with the forecasted purchase of commodities.

Interest rate risk

We may enter into interest rate swap agreements to manage interest rate risk exposure. Our interest rate swap agreements, if any, effectively modify our exposure to interest rate risk, primarily through converting certain of our floating rate debt to a fixed rate basis, and certain fixed rate debt to a floating rate basis. These agreements involve either the receipt or payment of floating rate amounts in exchange for fixed rate interest payments or receipts, respectively, over the life of the agreements without an exchange of the underlying principal amounts. We also may utilize a cross-currency interest rate swap agreement to manage our exposure relating to certain intercompany debt denominated in one foreign currency that will be repaid in another foreign currency. At March 31, 2012 and December 31, 2011 there were no outstanding swap agreements.

We enter into treasury rate lock agreements to effectively modify our exposure to interest rate risk by locking-in interest rates on probable long-term debt issuances.

The following table summarizes our outstanding derivative contracts and their effects on our Consolidated Balance Sheets at March 31, 2012 and December 31, 2011:

					Fair Value of								Type  of Hedge (1)
Millions of dollars	Notional Amount				Hedge Assets				Hedge Liabilities					Maximum Term (Months)
	2012		2011		2012		2011		2012		2011			2012	2011
Derivatives accounted for as hedges
Foreign exchange forwards/options	$	852	$	862	$	10	$	24	$	16	$	19	(CF/FV)	21	18
Commodity swaps/options	301		316		19		9		15		28		(CF/FV)	34	36
Interest rate derivatives	250		250		1		—		—		5		(CF)	3	6
Total derivatives accounted for as hedges					$	30	$	33	$	31	$	52
Derivatives not accounted for as hedges
Foreign exchange forwards/options	$	1,616	$	1,261	$	7	$	6	$	22	$	43		10	3
Commodity swaps/options	4		3		—		—		—		1			9	11
Total derivatives not accounted for as hedges					7		6		22		44
Total derivatives					$	37	$	39	$	53	$	96
Current					$	33	$	36	$	51	$	91
Noncurrent					4		3		2		5
Total derivatives					$	37	$	39	$	53	$	96

(1) Derivatives accounted for as hedges are either considered cash flow (CF) or fair value (FV) hedges.

The following tables summarize the effects of derivative instruments on our Consolidated Statements of Comprehensive Income for the three months ended March 31:

Cash Flow Hedges - Millions of dollars	Gain (Loss) Recognized in OCI (Effective Portion) (1)						Gain (Loss) Reclassified from OCI into Earnings (Effective Portion) (2)
	2012			2011			2012			2011
Foreign exchange forwards/options	$	(7	)	$	(6	)	$	(1	)	$	(6	)	(a)(b)
Commodity swaps/options	20			16			(2		)	34			(b)
Interest rate derivatives	6			—			—			—			(a)
	$	19		$	10		$	(3	)	$	28

Fair Value Hedges - Millions of dollars	Hedged Item	Gain (Loss) Recognized on Derivatives(3)					Gain (Loss) Recognized on Related Hedged Items (3)
		2012			2011		2012		2011
Foreign exchange forwards/options	Non-functional currency assets and liabilities	$	(1	)	$	—	$	1	$	—

Derivatives not Accounted for as Hedges - Millions of dollars	Gain (Loss) Recognized on Derivatives not Accounted for as Hedges (4)
	2012		2011
Foreign exchange forwards/options	$	12	$	17

(1) Gains and losses recognized in OCI are included within total comprehensive income.

(2) Gains and losses reclassified from accumulated OCI and recognized in earnings are recorded in (a) interest and sundry income (expense) or (b) cost of products sold.

(3) Gains and losses recognized in earnings are recorded in interest and sundry income (expense).

(4) Mark to market gains and losses recognized in earnings are recorded in interest and sundry income (expense).

For cash flow hedges, the amount of ineffectiveness recognized in interest and sundry income (expense) was nominal during 2012 and 2011. The net amount of unrealized gain or loss on derivative instruments included in accumulated OCI related to contracts maturing and expected to be realized during the next twelve months is a gain of $5 million at March 31, 2012.