DERIVATIVE INSTRUMENTS

We use derivative and non-derivative contracts to engage in trading activities and manage risks related to obtaining adequate supplies and the price fluctuations of natural gas, electricity and propane. Our natural gas, electric and propane distribution operations have entered into agreements with suppliers to purchase natural gas, electricity and propane for resale to our customers. Aspire Energy has entered into contracts with producers to secure natural gas to meet its obligations. Purchases under these contracts typically either do not meet the definition of derivatives or are considered “normal purchases and sales” and are accounted for on an accrual basis. Our propane distribution and natural gas marketing operations may also enter into fair value hedges of their inventory or cash flow hedges of their future purchase commitments in order to mitigate the impact of wholesale price fluctuations. As of December 31, 2016, our natural gas and electric distribution operations did not have any outstanding derivative contracts.

Hedging Activities in 2016

In 2016, Sharp entered into swap agreements to mitigate the risk of fluctuations in wholesale propane index prices associated with 4.8 million gallons expected to be purchased through September 2017, of which 4.1 million gallons were outstanding at December 31, 2016. Under the swap agreements, Sharp will receive the difference between the index prices (Mont Belvieu prices in October 2016 through September 2017) and the swap prices, which range between $0.5225 and $0.5650 per gallon, to the extent the index prices exceed the swap prices. If the index prices are lower than the swap price, Sharp will pay the difference. The swap agreement essentially fixed the price of the 4.8 million gallons that we expect to purchase through September 2017. We accounted for these swap agreements as cash flow hedges, and there is no ineffective portion of these hedges. At December 31, 2016, the outstanding swap agreements had a fair value of approximately $693,000. The change in the fair value of the swap agreements is recorded as unrealized gain/loss in other comprehensive income (loss).

In December 2016, Sharp paid a total of $33,000 to purchase a put option to protect against a decline in propane prices and related potential inventory losses associated with 630,000 gallons for its propane price cap program in the 2016-2017 heating season. The put option is exercised if propane prices fall below the strike price of $0.5650 per gallon in December 2016, January 2017, and February 2017. If exercised, we will receive the difference between the market price and the strike price during those months. We accounted for the put option as a fair value hedge, and there is no ineffective portion of this hedge. As of December 31, 2016, the put option had a fair value of $9,000. The change in fair value of the put option effectively reduced our propane inventory balance.

In January 2016, PESCO entered into a SCO supplier agreement with Columbia Gas of Ohio to provide natural gas supply for one of its local distribution customer pools. PESCO also assumed the obligation to store natural gas inventory to satisfy its obligations under the SCO supplier agreement, which terminates on March 31, 2017.

In conjunction with the SCO supplier agreement, PESCO entered into natural gas futures contracts during the second quarter of 2016 in order to protect its natural gas inventory against market price fluctuations. The contracts expire by March 31, 2017. We had previously accounted for these contracts as fair value hedges with any ineffective portion being reported directly in earnings and offset by any associated gain (loss) on the inventory value being hedged. During the third quarter of 2016, we de-designated the hedges as they were no longer deemed to be highly effective. We are now accounting for them as derivatives on a mark-to-market basis, with the change in fair value reflected as unrealized gain (loss) in current period earnings, and these are no longer offset by any associated gain (loss) in the value of the inventory previously hedged. As of December 31, 2016, we had a total of 1.3 million Dts in natural gas futures contracts with a mark-to-market liability of $773,000.

Beginning in October 2015, PESCO entered into natural gas futures contracts associated with the purchase and sale of natural gas to other specific customers. These contracts expire within two years, and we have accounted for them as cash flow hedges. There is no ineffective portion of these hedges. At December 31, 2016, PESCO had a total of 3.7 million Dts hedged under natural gas futures contracts, with an asset fair value of approximately $113,000. The change in fair value of the natural gas futures contracts is recorded as unrealized gain (loss) in other comprehensive income (loss).

Fair Value Hedges

The impact of our natural gas futures commodity contracts previously designated as fair value hedges and the related hedged item on our consolidated income statement for the year ended December 31, 2016, is presented below:



	Year Ended
(in thousands)	December 31, 2016 ⁽¹⁾
Commodity contracts	$	(233	)
Fair value adjustment for natural gas inventory designated as the hedged item	681
Total increase in purchased gas cost	$	448

The increase in purchased gas cost is comprised of the following:
Basis ineffectiveness	$	(83	)
Timing ineffectiveness	531
Total ineffectiveness	$	448


⁽¹⁾	There were no natural gas futures commodity contracts designated as fair value hedges in 2015 or 2014.

Basis ineffectiveness arises from natural gas market price differences between the locations of the hedged inventory and the delivery location specified in the hedging instruments. Timing ineffectiveness arises due to changes in the difference between the spot price and the futures price, as well as the difference between the timing of the settlement of the futures and the valuation of the underlying physical commodity. As the commodity contract nears the settlement date, spot-to-forward price differences should converge, which should reduce or eliminate the impact of this ineffectiveness on purchased gas cost. To the extent that our natural gas inventory does not qualify as a hedged item in a fair-value hedge, or has not been designated as such, the natural gas inventory is valued at the lower of cost or market.

Hedging Activities in 2015

In March, May and June 2015, Sharp paid a total of $143,000 to purchase put options to protect against a decline in propane prices and related potential inventory losses associated with 2.5 million gallons for the propane price cap program in the 2015-2016 heating season. We exercised the put options as propane prices fell below the strike prices of $0.4950, $0.4888 and $0.4500 per gallon in December 2015 through February 2016 and $0.4200 per gallon in January through March 2016. We received approximately $239,000, which represented the difference between the market prices and the strike prices during those months. We accounted for the put options as fair value hedges.

In March, May and June 2015, Sharp entered into swap agreements to mitigate the risk of fluctuations in wholesale propane index prices associated with 2.5 million gallons expected to be purchased for the 2015-2016 heating season. Under these swap agreements, Sharp would have received the difference between the index prices (Mont Belvieu prices in December 2015 through March 2016) and the swap prices, which ranged from $0.5200 to $0.5950 per gallon, for each swap agreement, to the extent the index prices exceeded the swap prices. If the index prices were lower than the swap prices, Sharp would have paid the difference. These swap agreements essentially fixed the price of the 2.5 million gallons that we purchased during this period. We accounted for the swap agreements as cash flow hedges. Sharp paid approximately $484,000, which represented the difference between the index prices and swap prices during the months of December 2015 through March 2016.

Hedging Activities in 2014

In August and October 2014, Sharp entered into call options to protect against an increase in propane prices associated with 1.3 million gallons purchased at market-based prices to supply the demands of our propane price cap program customers. The retail price that we charged those customers during the heating season was capped at a pre-determined level. We would have exercised the call options if the propane prices had risen above the strike price of $1.0875 per gallon in December 2014 through February of 2015, and $1.0650 per gallon in January through March 2015. We paid $98,000 to purchase the call options, which expired without exercise as the market prices were below the strike prices. We accounted for the call options as cash flow hedges.

In May 2014, Sharp entered into swap agreements to mitigate the risk of fluctuations in wholesale propane index prices associated with 630,000 gallons purchased in December 2014 through February 2015. Under these swap agreements, Sharp would have received the difference between the index prices (Mont Belvieu prices in December 2014 through February 2015) and the swap prices of $1.1350, $1.0975 and $1.0475 per gallon for each swap agreement, to the extent the index prices exceeded the swap prices. If the index prices were lower than the swap prices, Sharp would have paid the difference. These swap agreements essentially fixed the price of the 630,000 gallons purchased during this period. We had initially accounted for them as cash flow hedges as the swap agreements met all the requirements. We paid $1.1 million, representing the difference between the market prices and strike prices during the months of December 2014 through February 2015. At December 31, 2015, we elected to discontinue hedge accounting on the swap agreements and reclassified $735,000 of unrealized loss from other comprehensive loss to propane cost of sales. Subsequently, we accounted for them as derivative instruments on a mark-to-market basis with the change in fair value reflected in current period earnings.

In May 2014, Sharp entered into put options to protect against declines in propane prices and related potential inventory losses associated with 630,000 gallons purchased for the propane price cap program in December 2014 through February 2015. We exercised the put options because propane prices fell below the strike prices of $1.0350, $0.9975 and $0.9475 per gallon, for each option agreement in December 2014 through February 2015, respectively. We paid $128,000 to purchase the put options and received $868,000 from the exercise of the options, representing the difference between the market prices and strike prices during those months. We accounted for them as fair value hedges.

Commodity Contracts for Trading Activities

Xeron engages in trading activities using forward and futures contracts for propane and crude oil. These contracts are considered derivatives and have been accounted for using the mark-to-market method of accounting. Under this method, the trading contracts are recorded at fair value, and the changes in fair value of those contracts are recognized as unrealized gains or losses in the statements of income for the period of change. As of December 31, 2016 and 2015, Xeron had no outstanding contracts that were accounted for as derivatives.

Xeron entered into master netting agreements with two counterparties to mitigate exposure to counterparty credit risk. The master netting agreements enable Xeron to net these two counterparties' outstanding accounts receivable and payable, which are presented on a gross basis in the accompanying consolidated balance sheets. At December 31, 2016, Xeron had no accounts receivable or accounts payable balances to offset with these two counterparties. At December 31, 2015, Xeron had a right to offset $431,000 of accounts payable, but did not have outstanding accounts receivable, with these two counterparties.

The following tables present information about the fair value and related gains and losses of our derivative contracts. We did not have any derivative contracts with a credit-risk-related contingency.

Fair values of the derivative contracts recorded in the consolidated balance sheets as of December 31, 2016 and 2015, are as follows:



	Asset Derivatives
		Fair Value As Of
(in thousands)	Balance Sheet Location	December 31, 2016		December 31, 2015
Derivatives not designated as hedging instruments
Forward contracts	Mark-to-market energy assets	$	—	$	1
Propane swap agreements	Mark-to-market energy assets	8		—
Derivatives designated as fair value hedges
Put options	Mark-to-market energy assets	9		152
Derivatives designated as cash flow hedges
Natural gas futures contracts	Mark-to-market energy assets	113		—
Propane swap agreements	Mark-to-market energy assets	693		—
Total asset derivatives		$	823	$	153



	Liability Derivatives
		Fair Value As Of
(in thousands)	Balance Sheet Location	December 31, 2016		December 31, 2015
Derivatives not designated as hedging instruments
Forward contracts	Mark-to-market energy liabilities	$	—	$	1
Natural gas futures contracts	Mark-to-market energy liabilities	773		—
Derivatives designated as cash flow hedges
Propane swap agreements	Mark-to-market energy liabilities	—		323
Natural gas futures contracts	Mark-to-market energy liabilities	—		109
Total liability derivatives		$	773	$	433

The effects of gains and losses from derivative instruments are as follows:



	Amount of Gain (Loss) on Derivatives:
	Location of Gain (Loss) on Derivatives	For the Year Ended December 31,
(in thousands)	Location of Gain (Loss) on Derivatives	2016			2015			2014
Derivatives not designated as hedging instruments:
Realized (loss) gain on forward contracts and options ⁽¹⁾	Revenue	$	(546	)	$	426		$	1,423
Unrealized (loss) gain on forward contracts ⁽¹⁾	Revenue	—			(126		)	57
Natural gas futures contracts	Cost of sales	(541		)	—			—
Propane swap agreements	Cost of sales	7			18			(735		)
Derivatives designated as fair value hedges:
Put/Call option	Cost of Sales	49			528			235
Put/Call option ⁽²⁾	Propane Inventory	—			43			517
Natural gas futures contracts	Natural Gas Inventory	(233		)	—			—
Derivatives designated as cash flow hedges
Propane swap agreements	Cost of Sales	(364		)	(120		)	(341		)
Propane swap agreements	Other Comprehensive Income	1,016			(323		)	—
Call options	Cost of Sales	—			(81		)	(17		)
Call options	Other Comprehensive Income	—			—			(55		)
Natural gas futures contracts	Cost of sales	345			—			—
Natural gas futures contracts	Other Comprehensive Income	222			109			—
Total		$	(45	)	$	474		$	1,084


(1)	All of the realized and unrealized gain (loss) on forward contracts represents the effect of trading activities on our consolidated statements of income.

(2)

As a fair value hedge with no ineffective portion, the unrealized gains and losses associated with this call option are recorded in cost of sales, offset by the corresponding change in the value of propane inventory (hedged item), which is also recorded in cost of sales. The amounts in cost of sales offset to zero and the unrealized gains and losses of this call option effectively changed the value of propane inventory.