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. We also periodically have forward sales contracts that lock in the prices of future sales of crude oil and refined product and swap contracts serving as cash flow hedges against price risk on forecasted purchases of WTI crude oil and forecasted sales 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, 2016
Change in fair value	$	(5,138	)
Loss reclassified to earnings due to settlements	21,910			Sales and other revenunes	$	(15,897	)
Amortization of discontinued hedges reclassified to earnings	270			Operating expenses	(6,283		)	Operating expenses	$	—
Total	$	17,042			$	(22,180	)		$	—

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

Six Months Ended June 30, 2016
Change in fair value	$	(17,059	)
Loss reclassified to earnings due to settlements	32,966			Sales and other revenues	$	(20,653	)
Amortization of discontinued hedge reclassified to earnings	540			Operating expenses	(12,853		)	Operating expenses	$	—
Total	$	16,447			$	(33,506	)		$	—

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

As of June 30, 2016, we have the following notional contract volumes related to outstanding derivative instruments serving as cash flow hedges against price risk on forecasted transactions:



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

Natural gas price swaps - long	14,400,000	4,800,000	9,600,000	MMBTU
Forward diesel contracts - short	75,000	75,000	—	Barrels
Physical crude contracts - short	275,000	275,000	—	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 14,400,000 MMBTU’s to be purchased ratably through 2017. As of June 30, 2016, we have an unrealized loss of $1.6 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 Earnings	2016		2015			2016		2015
	(In thousands)
Cost of products sold	$	828	$	5,292		$	1,302	$	27,574
Operating expenses	8,083		(248		)	4,614		(544		)
Total	$	8,911	$	5,044		$	5,916	$	27,030

As of June 30, 2016, 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	2016	2017	Unit of Measure

Crude price swaps (basis spread) - long	6,983,000	5,888,000	1,095,000	Barrels
Natural gas price swaps (basis spread) - long	15,462,000	5,154,000	10,308,000	MMBTU
Natural gas price swaps - long	14,400,000	4,800,000	9,600,000	MMBTU
Natural gas price swaps - short	14,400,000	4,800,000	9,600,000	MMBTU
NYMEX futures (WTI) - short	910,000	710,000	200,000	Barrels

Interest Rate Risk Management

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

As of June 30, 2016, HEP had two interest rate swap contracts with identical terms that hedge its exposure to the cash flow risk caused by the effects of LIBOR changes on $150.0 million in credit agreement advances. The swaps 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 2.25% as of June 30, 2016, which equaled an effective interest rate of 2.99%. Both of these swap contracts mature in July 2017 and 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, 2016
Interest rate swaps
Change in fair value	$	(255	)
Loss reclassified to earnings due to settlements	113			Interest expense	$	(113	)
Total	$	(142	)		$	(113	)

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	)

Six Months Ended June 30, 2016
Interest rate swaps
Change in fair value	$	(938	)
Loss reclassified to earnings due to settlements	343			Interest expense	$	(343	)
Total	$	(595	)		$	(343	)

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	)

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, 2016
Derivatives designated as cash flow hedging instruments:
Commodity price swap contracts	$	—	$	—		$	—	$	22,448	$	—		$	22,448
Forward contracts	442		—			442		933		—			933
Interest rate swap contracts	—		—			—		405		—			405
	$	442	$	—		$	442	$	23,786	$	—		$	23,786

Derivatives not designated as cash flow hedging instruments:
Commodity price swap contracts	$	2,231	$	(1,648	)	$	583	$	23,082	$	(20,940	)	$	2,142
NYMEX futures contracts	115		—			115		—		—			—
Forward contracts	—		—			—		—		—			—
	$	2,346	$	(1,648	)	$	698	$	23,082	$	(20,940	)	$	2,142

Total net balance						$	1,140						$	25,928

Balance sheet classification:								Accrued liabilities					$	16,471
	Prepayment and other					$	1,140	Other long-term liabilities					9,457
						$	1,140						$	25,928



	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, 2015
Derivatives designated as cash flow hedging instruments:
Commodity price swap contracts	$	—	$	—	$	—	$	38,755	$	—		$	38,755
Interest rate swap contracts	304		—		304		114		—			114
	$	304	$	—	$	304	$	38,869	$	—		$	38,869

Derivatives not designated as cash flow hedging instruments:
Commodity price swap contracts	$	—	$	—	$	—	$	60,196	$	(37,118	)	$	23,078
NYMEX futures contracts	3,469		—		3,469		—		—			—
	$	3,469	$	—	$	3,469	$	60,196	$	(37,118	)	$	23,078

Total net balance					$	3,773						$	61,947

Balance sheet classification:	Prepayment and other				$	3,469	Accrued liabilities					$	36,976
	Intangibles and other				304		Other long-term liabilities					24,971
					$	3,773						$	61,947

At June 30, 2016, we had a pre-tax net unrealized loss of $24.7 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 loss of $16.2 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.