Risk Management and Trading Activities

3 Months Ended

Mar. 31, 2012

Risk Management and Trading Activities [Abstract]

Risk Management and Trading Activities

12. Risk Management and Trading Activities

In the normal course of its business, the Corporation is exposed to commodity risks related to changes in the prices of crude oil, natural gas, refined petroleum products and electricity, as well as to changes in interest rates and foreign currency values. In the disclosures that follow, risk management activities are referred to as energy marketing and corporate risk management activities. The Corporation also has trading operations, principally through a 50% voting interest in a consolidated partnership, that trades energy-related commodities, securities and derivatives. These activities are also exposed to commodity price risks primarily related to the prices of crude oil, natural gas, refined petroleum products and electricity.

The Corporation maintains a control environment under the direction of its chief risk officer and through its corporate risk policy, which the corporation’s senior management has approved. Controls include volumetric, term and value at risk limits. The chief risk officer must approve the trading of new instruments or commodities. Risk limits are monitored and reported on a daily basis to business units and senior management. The Corporation’s risk management department also performs independent price verifications (IPV) of sources of fair values, validations of valuation models and analyzes changes in fair value measurements on a daily, monthly and/or quarterly basis. These controls apply to all of the Corporation’s risk management and trading activities, including the consolidated trading partnership. The Corporation’s treasury department is responsible for administering foreign exchange rate and interest rate hedging programs using similar controls and processes, where applicable.

The Corporation’s risk management department, in performing the IPV procedures, utilizes independent sources and valuation models that are specific to the individual contracts and pricing locations to identify positions that require adjustments to better reflect the market. This review is performed quarterly and the results are presented to the chief risk officer and senior management. The IPV process considers the reliability of the pricing services through assessing the number of available quotes, the frequency at which data is available and, where appropriate, the comparability between pricing sources.

Following is a description of the Corporation’s activities that use derivatives as part of their operations and strategies. Derivatives include both financial instruments and forward purchase and sale contracts. Gross notional amounts of both long and short positions are presented in the volume tables below. These amounts include long and short positions that offset in closed positions and have not reached contractual maturity. Gross notional amounts do not quantify risk or represent assets or liabilities of the Corporation, but are used in the calculation of cash settlements under the contracts.

Energy Marketing Activities: In its energy marketing activities the Corporation sells refined petroleum products, natural gas and electricity principally to commercial and industrial businesses at fixed and floating prices for varying periods of time. Commodity contracts such as futures, forwards, swaps and options, together with physical assets such as storage and pipeline capacity, are used to obtain supply and reduce margin volatility or lower costs related to sales contracts with customers.

The table below shows the gross volume of the Corporation’s energy marketing commodity contracts outstanding:

		September 30		September 30
	March 31, 2012		December 31, 2011
Crude oil and refined petroleum products (millions of barrels)		26		28
Natural gas (millions of mcf)		2,587		2,616
Electricity (millions of megawatt hours)		345		244

The changes in fair value of certain energy marketing commodity contracts that are not designated as hedges are recognized currently in earnings. Revenues from the sales contracts are recognized in Sales and other operating revenues in the Statement of Consolidated Income, while supply contract purchases and net settlements from financial derivatives related to these energy marketing activities are recognized in Cost of products sold in the Statement of Consolidated Income. Net realized and unrealized pre-tax gains and losses on derivative contracts not designated as hedges amounted to a gain of $55 million and a loss of $3 million for the three months ended March 31, 2012 and 2011, respectively.

At March 31, 2012, a portion of energy marketing commodity contracts are designated as cash flow hedges to hedge variability of expected future cash flows of forecasted supply transactions. The length of time over which the Corporation hedges exposure to variability in future cash flows is predominantly one year or less. For contracts outstanding at March 31, 2012, the maximum duration was approximately two years.

The Corporation records the effective portion of changes in the fair value of cash flow hedges as a component of Accumulated other comprehensive income (loss) in the Consolidated Balance Sheet and then reclassifies amounts to Cost of products sold in the Statement of Consolidated Income as the hedged transactions are recognized in earnings. At March 31, 2012, the after-tax deferred losses relating to energy marketing activities recorded in Accumulated other comprehensive income (loss) were $62 million ($64 million at December 31, 2011). The Corporation estimates that after-tax losses of approximately $42 million will be reclassified into earnings over the next twelve months. The amounts of ineffectiveness recognized immediately in Cost of products sold were losses of approximately $1 million and $4 million for the three months ended March 31, 2012 and 2011, respectively. The pre-tax amount of deferred hedge losses is reflected in Accounts payable and the related income tax benefits are recorded as deferred income tax assets, which are included in Other current assets in the Consolidated Balance Sheet.

Corporate Risk Management Activities: Corporate risk management activities include transactions designed to reduce risk in the selling prices of crude oil, refined petroleum products or natural gas produced by the Corporation or to reduce exposure to foreign currency or interest rate movements. Generally, futures, swaps or option strategies may be used to fix the forward selling price of a portion of the Corporation’s crude oil, refined petroleum products or natural gas production. Forward contracts may also be used to purchase certain currencies in which the Corporation does business with the intent of reducing exposure to foreign currency fluctuations. These forward contracts comprise various currencies including the British Pound and Thai Baht. Interest rate swaps may be used to convert interest payments on certain long-term debt from fixed to floating rates.

The table below shows the gross volume of the Corporate risk management derivative contracts outstanding:

		September 30		September 30
	March 31, 2012		December 31, 2011
Commodity, primarily crude oil (millions of barrels)		47		51
Foreign exchange (millions of U.S. Dollars)	$	1,022	$	900
Interest rate swaps (millions of U.S. Dollars)	$	895	$	895

During 2008, the Corporation closed Brent crude oil cash flow hedges covering 24,000 barrels per day through 2012, by entering into offsetting contracts with the same counterparty. As a result, the valuation of those contracts is no longer subject to change due to price fluctuations. The deferred hedge losses as of the date that the hedges were closed are being recorded in earnings as the hedged transactions occur. For 2012, the Corporation has entered into Brent crude oil hedges using fixed-price swap contracts to hedge the variability of forecasted future cash flows from 120,000 barrels per day of crude oil sales volumes for the full year. The average price for these hedges is $107.70 per barrel.

Realized losses from Exploration and Production hedging activities reduced Sales and other operating revenues by $244 million and $128 million for the three months ended March 31, 2012 and 2011, respectively ($151 million and $81 million after-taxes, respectively). At March 31, 2012, the after-tax deferred losses in Accumulated other comprehensive income (loss) related to Brent crude oil hedges were $483 million ($286 million at December 31, 2011), which will be reclassified into earnings during the remainder of 2012 as the hedged crude oil sales are recognized. The amount of ineffectiveness from Brent crude oil hedges that was recognized immediately in Sales and other operating revenues was a loss of $11 million and zero for the three months ended March 31, 2012 and 2011, respectively.

At March 31, 2012 and December 31, 2011, the Corporation had interest rate swaps with gross notional amounts of $895 million, which were designated as fair value hedges. Changes in the fair value of interest rate swaps and the hedged fixed-rate debt are recorded in Interest expense in the Statement of Consolidated Income. For the three months ended March 31, 2012 and 2011, the Corporation recorded a decrease of $3 million and $2 million (excluding accrued interest), respectively, in the fair value of interest rate swaps and a corresponding adjustment in the carrying value of the hedged fixed-rate debt.

Gains or losses on foreign exchange contracts that are not designated as hedges are recognized immediately in Other, net in Revenues and non-operating income in the Statement of Consolidated Income.

Net realized and unrealized pre-tax gains (losses) on derivative contracts used for Corporate risk management and not designated as hedges amounted to the following:

		September 30		September 30
	Three Months Ended March  31,
	2012		2011
	(Millions of dollars)
Commodity	$	—	$	1
Foreign exchange		26		19
Total	$	26	$	20

Trading Activities: Trading activities are conducted principally through a trading partnership in which the Corporation has a 50% voting interest. This consolidated entity intends to generate earnings through various strategies primarily using energy-related commodities, securities and derivatives. The Corporation also takes trading positions for its own account. The information that follows represents 100% of the trading partnership and the Corporation’s proprietary trading accounts.

The table below shows the gross volume of derivative contracts outstanding relating to trading activities:

		September 30		September 30
	March 31, 2012		December 31, 2011
Commodity
Crude oil and refined petroleum products (millions of barrels)		2,220		2,169
Natural gas (millions of mcf)		4,531		4,203
Electricity (millions of megawatt hours)		227		304
Foreign exchange (millions of U.S. Dollars)	$	859	$	581
Other
Interest rate (millions of U.S. Dollars)	$	161	$	182
Equity securities (millions of shares)		12		16

Pre-tax unrealized and realized gains (losses) recorded in Sales and other operating revenues in the Statement of Consolidated Income from trading activities amounted to the following:

		September 30		September 30
	Three Months Ended March  31,
	2012		2011
	(Millions of dollars)
Commodity	$	33	$	122
Foreign exchange		—		(5	)
Other		1		13
Total	$	34	$	130

Fair Value Measurements: The table below reflects the gross and net fair values of the Corporation’s risk management and trading derivative instruments:

		September 30			September 30
	Accounts Receivable			Accounts Payable
	(Millions of dollars)
March 31, 2012
Derivative contracts designated as hedging instruments
Commodity	$	70		$	(560	)
Other		52			(2	)
Total derivative contracts designated as hedging instruments		122			(562	)
Derivative contracts not designated as hedging instruments (*)
Commodity		11,403			(11,530	)
Foreign exchange		18			(7	)
Other		21			(13	)
Total derivative contracts not designated as hedging instruments		11,442			(11,550	)
Gross fair value of derivative contracts		11,564			(12,112	)
Master netting arrangements		(9,414	)		9,414
Cash collateral (received) posted		(201	)		95
Net fair value of derivative contracts	$	1,949		$	(2,603	)
December 31, 2011
Derivative contracts designated as hedging instruments
Commodity	$	181		$	(216	)
Other		61			(3	)
Total derivative contracts designated as hedging instruments		242			(219	)
Derivative contracts not designated as hedging instruments (*)
Commodity		9,350			(9,823	)
Foreign exchange		6			(21	)
Other		12			(24	)
Total derivative contracts not designated as hedging instruments		9,368			(9,868	)
Gross fair value of derivative contracts		9,610			(10,087	)
Master netting arrangements		(7,962	)		7,962
Cash collateral (received) posted		(121	)		117
Net fair value of derivative contracts	$	1,527		$	(2,008	)

(*) Includes trading derivatives and derivatives used for risk management.

The Corporation generally enters into master netting arrangements to mitigate counterparty credit risk. Master netting arrangements are standardized contracts that govern all specified transactions with the same counterparty and allow the Corporation to terminate all contracts upon occurrence of certain events, such as a counterparty’s default or bankruptcy. Where these arrangements provide the right of offset and the Corporation’s intent and practice is to offset amounts in the case of contract terminations, the Corporation’s policy is to record the fair value of derivative assets and liabilities on a net basis.

The Corporation determines fair value in accordance with the fair value measurements accounting standard (Accounting Standards Codification 820 – Fair Value Measurements and Disclosures), which established a hierarchy that categorizes the sources of inputs, which generally range from quoted prices for identical instruments in a principal trading market (Level 1) to estimates determined using related market data (Level 3). Measurements derived indirectly from observable inputs or from quoted prices from markets that are less liquid are considered Level 2.

When Level 1 inputs are available within a particular market, those inputs are selected for determination of fair value over Level 2 or 3 inputs in the same market. To value derivatives that are characterized as Level 2 and 3, the Corporation uses observable inputs for similar instruments that are available from exchanges, pricing services or broker quotes. These observable inputs may be supplemented with other methods, including internal extrapolation or interpolation, that result in the most representative prices for instruments with similar characteristics. Multiple inputs may be used to measure fair value, however, the level of fair value for each physical derivative and financial asset or liability presented below is based on the lowest significant input level within this fair value hierarchy.

The following table provides the Corporation’s net physical derivative and financial assets and (liabilities) that are measured at fair value based on this hierarchy:

		September 30			September 30			September 30			September 30			September 30
	Level 1			Level 2			Level 3			Collateral and counterparty netting			Balance
	(Millions of dollars)
March 31, 2012
Assets
Derivative contracts
Commodity	$	460		$	1,333		$	583		$	(148	)	$	2,228
Foreign exchange		—			12			—			—			12
Interest rate and other		2			59			5			(1	)		65
Collateral and counterparty netting		(21	)		(103	)		(31	)		(201	)		(356	)
Total derivative contracts		441			1,301			557			(350	)		1,949
Other assets measured at fair value on a recurring basis		2			17			—			—			19
Total assets measured at fair value on a recurring basis	$	443		$	1,318		$	557		$	(350	)	$	1,968
Liabilities
Derivative contracts
Commodity	$	(59	)	$	(2,082	)	$	(852	)	$	148		$	(2,845	)
Foreign exchange		—			(1	)		—			—			(1	)
Interest rate and other		—			(4	)		(4	)		1			(7	)
Collateral and counterparty netting		21			103			31			95			250
Total derivative contracts		(38	)		(1,984	)		(825	)		244			(2,603	)
Other liabilities measured at fair value on a recurring basis		(2	)		(23	)		—			—			(25	)
Total liabilities measured at fair value on a recurring basis	$	(40	)	$	(2,007	)	$	(825	)	$	244		$	(2,628	)
Other fair value measurement disclosures
Long-term debt	$	—		$	(8,144	)	$	—		$	—		$	(8,144	)

		September 30			September 30			September 30			September 30			September 30
	Level 1			Level 2			Level 3			Collateral and counterparty netting			Balance
	(Millions of dollars)
December 31, 2011
Assets
Derivative contracts
Commodity	$	135		$	1,188		$	511		$	(67	)	$	1,767
Interest rate and other		—			66			—			—			66
Collateral and counterparty netting		(33	)		(148	)		(4	)		(121	)		(306	)
Total derivative contracts		102			1,106			507			(188	)		1,527
Other assets measured at fair value on a recurring basis		7			34			—			(2	)		39
Total assets measured at fair value on a recurring basis	$	109		$	1,140		$	507		$	(190	)	$	1,566
Liabilities
Derivative contracts
Commodity	$	(191	)	$	(1,501	)	$	(650	)	$	67		$	(2,275	)
Foreign exchange		—			(15	)		—			—			(15	)
Other		—			(18	)		(2	)		—			(20	)
Collateral and counterparty netting		33			148			4			117			302
Total derivative contracts		(158	)		(1,386	)		(648	)		184			(2,008	)
Other liabilities measured at fair value on a recurring basis		—			(52	)		(2	)		2			(52	)
Total liabilities measured at fair value on a recurring basis	$	(158	)	$	(1,438	)	$	(650	)	$	186		$	(2,060	)
Other fair value measurement disclosures
Long-term debt	$	—		$	(7,317	)	$	—		$	—		$	(7,317	)

The following table provides changes in physical derivatives and financial assets and (liabilities) that are measured at fair value based on Level 3 inputs:

		September 30			September 30
	Three Months Ended March  31,
	2012			2011
	(Millions of dollars)
Balance at beginning of period	$	(143	)	$	412
Unrealized pre-tax gains (losses)
Included in earnings (a)		(123	)		312
Included in other comprehensive income (b)		—			10
Purchases (c)		220			815
Sales (c)		(234	)		(819	)
Settlements (d)		37			20
Transfers into Level 3		27			83
Transfers out of Level 3		(52	)		(46	)
Balance at end of period	$	(268	)	$	787

(a) The unrealized pre-tax gains (losses) included in earnings for the three months ended March 31, 2012 are comprised of $(153) million of losses reflected in Sales and other operating revenues and $30 million of gains reflected in Cost of products sold in the Statement of Consolidated Income.

(b) The unrealized pre-tax gains (losses) included in Other comprehensive income are reflected in the net change in fair value of cash flow hedges in the Statement of Consolidated Comprehensive Income.

(c) Purchases and sales primarily represent option premiums paid or received, respectively, during the reporting period.

(d) Settlements represent realized gains and (losses) on derivatives settled during the reporting period.

The following table provides net transfers into and out of each level of the fair value hierarchy:

		September 30			September 30
	Three Months Ended March  31,
	2012			2011
	(Millions of dollars)
Transfers into Level 1	$	4		$	(26	)
Transfers out of Level 1		(9	)		214
	$	(5	)	$	188
Transfers into Level 2	$	49		$	8
Transfers out of Level 2		(19	)		(233	)
	$	30		$	(225	)
Transfers into Level 3	$	27		$	83
Transfers out of Level 3		(52	)		(46	)
	$	(25	)	$	37

The Corporation’s policy is to recognize transfers in and transfers out as of the end of the reporting period. Transfers between levels result from the passage of time as contracts move closer to their maturities, fluctuations in the market liquidity for certain contracts and/or changes in the level of significance of fair value measurement inputs.

The significant unobservable inputs used in Level 3 fair value measurements for the Corporation’s physical commodity contracts and derivative instruments primarily include less liquid delivered locations for physical commodity contracts or volatility assumptions for out-of-the-money options. The following table provides information about the Corporation’s significant recurring unobservable inputs used in the Level 3 fair value measurements. Natural gas contracts are usually quoted and transacted using basis pricing relative to an active pricing location (e.g., Henry Hub), for which price inputs represent the approximate value of differences in geography and local market conditions. All other price inputs below represent full contract prices. Significant changes in any of the inputs below, independently or correlated, may result in a different fair value.

	September 30	September 30
	Unit of Measurement	Range / Weighted Average
March 31, 2012
Assets
Commodity contracts with a fair value of $583 million Contract prices
Crude oil and refined petroleum products	$ / bbl	$ 83.15 - 146.51 / 103.95
Electricity	$ / MWH	$ 16.85 - 94.01 / 39.98
Basis prices
Natural gas	$ / MMBTU	$ (1.20) - 3.85 / 0.48
Contract volatilities
Crude oil and refined petroleum products	%	20.00 - 28.00 / 26.00
Natural gas	%	17.00 - 48.00 / 33.00
Electricity	%	6.00 - 64.00 / 32.00
Liabilities
Commodity contracts with a fair value of $852 million Contract prices
Crude oil and refined petroleum products	$ / bbl	$ 87.34 - 146.64 / 108.69
Electricity	$ / MWH	$ 17.60 - 94.01 / 40.68
Basis prices
Natural gas	$ MMBTU	$ (1.20) - 3.85 / 0.87
Contract volatilities
Crude oil and refined petroleum products	%	21.00 - 28.00 / 26.00
Natural gas	%	17.00 - 48.00 / 38.00

Note: Fair value measurement for all recurring inputs was performed using an income approach technique.

Credit Risk: The Corporation is exposed to credit risks that may at times be concentrated with certain counterparties, groups of counterparties or customers. Accounts receivable are generated from a diverse domestic and international customer base. The Corporation’s net receivables at March 31, 2012 are concentrated with the following counterparty and customer industry segments: Integrated Oil Companies – 15%, Government Entities – 13%, Services – 11%, Real Estate – 10%, Trading Companies – 9% and Manufacturing – 8%. The Corporation reduces its risk related to certain counterparties by using master netting arrangements and requiring collateral, generally cash or letters of credit. The Corporation records the cash collateral received or posted as an offset to the fair value of derivatives executed with the same counterparty. At March 31, 2012 and December 31, 2011, the Corporation held cash from counterparties of $201 million and $121 million, respectively. The Corporation posted cash to counterparties at March 31, 2012 and December 31, 2011 of $95 million and $117 million, respectively.

At March 31, 2012, the Corporation had outstanding letters of credit totaling $2.1 billion, primarily issued to satisfy margin requirements. Certain of the Corporation’s agreements also contain contingent collateral provisions that could require the Corporation to post additional collateral if the Corporation’s credit rating declines. As of March 31, 2012, the net liability related to derivatives with contingent collateral provisions was approximately $1.5 billion before cash collateral posted of $3 million. At March 31, 2012, all three major credit rating agencies that rate the Corporation’s debt had assigned an investment grade rating. If two of the three agencies were to downgrade the Corporation’s rating to below investment grade, as of March 31, 2012, the Corporation would be required to post additional collateral of approximately $320 million.