Derivative Instruments and Hedging Activities

Commodity Price Risk Management

Our primary market risk is commodity price risk. We are exposed to market risks related to the volatility in crude oil and refined products, as well as volatility in the price of natural gas used in our refining operations. We periodically enter into derivative contracts in the form of commodity price swaps, forward purchase and sales and futures contracts to mitigate price exposure with respect to:


•	our inventory positions;


•	natural gas purchases;


•	costs of crude oil and related grade differentials;


•	prices of refined products; and


•	our refining margins.

Accounting Hedges

We have swap contracts serving as cash flow hedges against price risk on forecasted purchases of natural gas and WTI crude oil and forecasted sales of refined product. We also have forward sales and purchase contracts that lock in the prices of future sales and purchases of refined product. These contracts have been designated as accounting hedges and are measured at fair value with offsetting adjustments (gains/losses) recorded directly to other comprehensive income. These fair value adjustments are later reclassified to earnings as the hedging instruments mature. On a quarterly basis, hedge ineffectiveness is measured by comparing the change in fair value of the swap contracts against the expected future cash inflows/outflows on the respective transaction being hedged. Any hedge ineffectiveness is also recognized in earnings.

The following table presents the pre-tax effect on other comprehensive income (“OCI”) and earnings due to fair value adjustments and maturities of commodity price swaps and forward sales under hedge accounting:



	Unrealized Gain (Loss) Recognized in OCI			Gain (Loss) Recognized in Earnings Due to Settlements				Gain (Loss) Attributable to Hedge Ineffectiveness Recognized in Earnings
	Unrealized Gain (Loss) Recognized in OCI			Location	Amount			Location	Amount
	(In thousands)
Three Months Ended June 30, 2015
Change in fair value	$	8,501		Sales and other revenues	$	49,752
Gain reclassified to earnings due to settlements	(14,802		)	Cost of products sold	(30,964		)	Sales and other revenues	$	(140	)
Amortization of discontinued hedges reclassified to earnings	270			Operating expenses	(4,256		)	Cost of products sold	2,494
Total	$	(6,031	)		$	14,532			$	2,354

Three Months Ended June 30, 2014
Change in fair value	$	47,988		Sales and other revenues	$	(48,942	)
Gain reclassified to earnings due to settlements	(13,197		)	Cost of products sold	61,124
Amortization of discontinued hedges reclassified to earnings	270			Operating expenses	745			Operating expenses	$	1,354
Total	$	35,061			$	12,927			$	1,354

Six Months Ended June 30, 2015
Change in fair value	$	(5,647	)	Sales and other revenues	$	98,932		Sales and other revenues	$	(274	)
Gain reclassified to earnings due to settlements	(19,494		)	Cost of products sold	(71,733		)	Cost of products sold	3,738
Amortization of discontinued hedge reclassified to earnings	540			Operating expenses	(8,245		)	Operating expenses	547
Total	$	(24,601	)		$	18,954			$	4,011

Six Months Ended June 30, 2014
Change in fair value	$	140,466		Sales and other revenues	$	(74,273	)
Gain reclassified to earnings due to settlements	(18,957		)	Cost of products sold	90,441
Amortization of discontinued hedge reclassified to earnings	540			Operating expenses	2,249			Operating expenses	$	(806	)
Total	$	122,049			$	18,417			$	(806	)

As of June 30, 2015, we have the following notional contract volumes related to outstanding derivative instruments serving as cash flow hedges against price risk on forecasted purchases of natural gas and crude oil and sales of refined products:



		Notional Contract Volumes by Year of Maturity
Derivative Instrument	Total Outstanding Notional	2015	2016	2017	Unit of Measure

Natural gas - long	24,000,000	4,800,000	9,600,000	9,600,000	MMBTU
WTI crude oil - long	2,208,000	2,208,000	—	—	Barrels
Ultra-low sulfur diesel - short	2,208,000	2,208,000	—	—	Barrels
Forward diesel sales	1,500,000	1,500,000	—	—	Barrels
Forward diesel purchases	1,125,000	1,125,000	—	—	Barrels

In 2013, we dedesignated certain commodity price swaps (long positions) that previously received hedge accounting treatment. These contracts now serve as economic hedges against price risk on forecasted natural gas purchases totaling 24,000,000 MMBTU's to be purchased ratably through 2017. As of June 30, 2015, we have an unrealized loss of $2.7 million classified in accumulated other comprehensive income that relates to the application of hedge accounting prior to dedesignation that is amortized as a charge to operating expenses as the contracts mature.

Economic Hedges

We also have swap contracts that serve as economic hedges (derivatives used for risk management, but not designated as accounting hedges) to fix our purchase price on forecasted purchases of WTI crude oil, and to lock in basis spread differentials on forecasted purchases of crude oil and natural gas. Also, we have NYMEX futures contracts to lock in prices on forecasted purchases of inventory. These contracts are measured at fair value with offsetting adjustments (gains/losses) recorded directly to income.

The following table presents the pre-tax effect on income due to maturities and fair value adjustments of our economic hedges:



	Three Months Ended June 30,						Six Months Ended June 30,
Location of Gain (Loss) Recognized in Income	2015			2014			2015			2014
	(In thousands)
Cost of products sold	$	5,292		$	(24,432	)	$	27,574		$	(24,406	)
Operating expenses	(248		)	(140		)	(544		)	(188		)
Total	$	5,044		$	(24,572	)	$	27,030		$	(24,594	)

As of June 30, 2015, we have the following notional contract volumes related to our outstanding derivative contracts serving as economic hedges:



		Notional Contract Volumes by Year of Maturity
Derivative Instrument	Total Outstanding Notional	2015	2016	2017	Unit of Measure

Commodity price swap (crude basis spread) - long	4,412,000	3,680,000	732,000	—	Barrels
Commodity price swap (natural gas basis spread) - long	17,820,000	4,020,000	6,900,000	6,900,000	MMBTU
Commodity price swap (natural gas) - long	24,000,000	4,800,000	9,600,000	9,600,000	MMBTU
Commodity price swap (natural gas) - short	24,000,000	4,800,000	9,600,000	9,600,000	MMBTU
NYMEX futures (WTI) - short	1,095,000	1,095,000	—	—	Barrels

Interest Rate Risk Management

HEP uses interest rate swaps to manage its exposure to interest rate risk.

As of June 30, 2015, HEP had three interest rate swap contracts that hedge its exposure to the cash flow risk caused by the effects of LIBOR changes on $305.0 million in credit agreement advances. The first interest rate swap effectively converts $155.0 million of LIBOR based debt to fixed-rate debt having an interest rate of 0.99% plus an applicable margin of 2.00% as of June 30, 2015, which equaled an effective interest rate of 2.99%. This swap matures in February 2016. HEP has two additional interest rate swaps with identical terms which effectively convert $150.0 million of LIBOR based debt to fixed rate debt having an interest rate of 0.74% plus an applicable margin of 2.00% as of June 30, 2015, which equaled an effective interest rate of 2.74%. Both of these swap contracts mature in July 2017. All of these swap contracts have been designated as cash flow hedges. To date, there has been no ineffectiveness on these cash flow hedges.

The following table presents the pre-tax effect on other comprehensive income and earnings due to fair value adjustments and maturities of HEP's interest rate swaps under hedge accounting:



	Unrealized Gain (Loss) Recognized in OCI			Loss Recognized in Earnings Due to Settlements
	Unrealized Gain (Loss) Recognized in OCI			Location	Amount
	(In thousands)
Three Months Ended June 30, 2015
Interest rate swaps
Change in fair value	$	(306	)
Loss reclassified to earnings due to settlements	528			Interest expense	$	(528	)
Total	$	222			$	(528	)

Three Months Ended June 30, 2014
Interest rate swaps
Change in fair value	$	(1,299	)
Loss reclassified to earnings due to settlements	553			Interest expense	$	(553	)
Total	$	(746	)		$	(553	)

Six Months Ended June 30, 2015
Interest rate swaps
Change in fair value	$	(1,586	)
Loss reclassified to earnings due to settlements	1,059			Interest expense	$	(1,059	)
Total	$	(527	)		$	(1,059	)

Six Months Ended June 30, 2014
Interest rate swaps
Change in fair value	$	(1,742	)
Loss reclassified to earnings due to settlements	1,091			Interest expense	$	(1,091	)
Total	$	(651	)		$	(1,091	)

The following table presents the fair value and balance sheet locations of our outstanding derivative instruments. These amounts are presented on a gross basis with offsetting balances that reconcile to a net asset or liability position in our consolidated balance sheets. We present on a net basis to reflect the net settlement of these positions in accordance with provisions of our master netting arrangements.



	Derivatives in Net Asset Position							Derivatives in Net Liability Position
	Gross Assets		Gross Liabilities Offset in Balance Sheet			Net Assets Recognized in Balance Sheet		Gross Liabilities		Gross Assets Offset in Balance Sheet			Net Liabilities Recognized in Balance Sheet
			(In thousands)
June 30, 2015
Derivatives designated as cash flow hedging instruments:
Commodity price swap contracts	$	62,370	$	(49,711	)	$	12,659	$	42,647	$	(21,026	)	$	21,621
Forward contracts	223		(166		)	57		2,563		(439		)	2,124
Interest rate swap contracts	134		—			134		707		—			707
	$	62,727	$	(49,877	)	$	12,850	$	45,917	$	(21,465	)	$	24,452

Derivatives not designated as cash flow hedging instruments:
Commodity price swap contracts	$	24,580	$	(7,461	)	$	17,119	$	27,282	$	(23,475	)	$	3,807
NYMEX futures contracts	—		—			—		236		—			236
	$	24,580	$	(7,461	)	$	17,119	$	27,518	$	(23,475	)	$	4,043

Total net balance						$	29,969						$	28,495

Balance sheet classification:	Prepayment and other					$	29,295	Accrued liabilities					$	4,727
	Intangibles and other					674		Other long-term liabilities					23,768
						$	29,969						$	28,495



	Derivatives in Net Asset Position							Derivatives in Net Liability Position
	Gross Assets		Gross Liabilities Offset in Balance Sheet			Net Assets Recognized in Balance Sheet		Gross Liabilities		Gross Assets Offset in Balance Sheet			Net Liabilities Recognized in Balance Sheet
			(In thousands)
December 31, 2014
Derivatives designated as cash flow hedging instruments:
Commodity price swap contracts	$	173,658	$	(142,115	)	$	31,543	$	21,441	$	—		$	21,441
Interest rate swap contracts	1,019		—			1,019		1,065		—			1,065
	$	174,677	$	(142,115	)	$	32,562	$	22,506	$	—		$	22,506

Derivatives not designated as cash flow hedging instruments:
Commodity price swap contracts	$	17,630	$	(12,942	)	$	4,688	$	20,398	$	(17,007	)	$	3,391
NYMEX futures contracts	17,619		—			17,619		—		—			—
	$	35,249	$	(12,942	)	$	22,307	$	20,398	$	(17,007	)	$	3,391

Total net balance						$	54,869						$	25,897

Balance sheet classification:	Prepayment and other					$	53,850
	Intangibles and other					1,019		Other long-term liabilities					$	25,897
						$	54,869						$	25,897

At June 30, 2015, we had a pre-tax net unrealized loss of $13.3 million classified in accumulated other comprehensive income that relates to all accounting hedges having contractual maturities through 2017. Assuming commodity prices and interest rates remain unchanged, an unrealized gain of $9.3 million will be effectively transferred from accumulated other comprehensive income into the statement of income as the hedging instruments contractually mature over the next twelve-month period.