Note 5. Derivative Instruments and Hedging Activities

Objective and Strategies for Using Derivative Instruments In order to reduce commodity price uncertainty and enhance the predictability of cash flows relating to the marketing of our crude oil and natural gas, we enter into crude oil and natural gas price hedging arrangements with respect to a portion of our expected production. The derivative instruments we use include variable to fixed price commodity swaps, two-way and three-way collars and basis swaps.

The fixed price swap, two-way collar, and basis swap contracts entitle us (floating price payor) to receive settlement from the counterparty (fixed price payor) for each calculation period in amounts, if any, by which the settlement price for the scheduled trading days applicable for each calculation period is less than the fixed strike price or floor price. We would pay the counterparty if the settlement price for the scheduled trading days applicable for each calculation period is more than the fixed strike price or ceiling price. The amount payable by us, if the floating price is above the fixed or ceiling price, is the product of the notional quantity per calculation period and the excess of the floating price over the fixed or ceiling price in respect of each calculation period. The amount payable by the counterparty, if the floating price is below the fixed or floor price, is the product of the notional quantity per calculation period and the excess of the fixed or floor price over the floating price in respect of each calculation period.

A three-way collar consists of a two-way collar contract combined with a put option contract sold by us with a strike price below the floor price of the two-way collar. We receive price protection at the purchased put option floor price of the two-way collar if commodity prices are above the sold put option strike price. If commodity prices fall below the sold put option strike price, we receive the cash market price plus the delta between the two put option strike prices. This type of instrument allows us to capture more value in a rising commodity price environment, but limits our benefits in a downward commodity price environment.

We also enter into forward contracts or swap agreements to hedge exposure to interest rate risk.

While these instruments mitigate the cash flow risk of future reductions in commodity prices or increases in interest rates, they may also curtail benefits from future increases in commodity prices or decreases in interest rates.

See Note 6. Fair Value Measurements and Disclosures for a discussion of methods and assumptions used to estimate the fair values of our derivative instruments.

Counterparty Credit Risk Derivative instruments expose us to counterparty credit risk. Our commodity derivative instruments are currently with a diversified group of highly rated major banks or market participants, and we control our level of financial exposure. Our commodity derivative contracts are executed under master agreements which allow us, in the event of default, to elect early termination of all contracts with the defaulting counterparty. If we choose to elect early termination, all asset and liability positions with the defaulting counterparty would be net settled at the time of election.

We monitor the creditworthiness of our counterparties. However, we are not able to predict sudden changes in counterparties' creditworthiness. In addition, even if such changes are not sudden, we may be limited in our ability to mitigate an increase in counterparty credit risk. Possible actions would be to transfer our position to another counterparty or request a voluntary termination of the derivative contracts resulting in a cash settlement. Should one of these financial counterparties not perform, we may not realize the benefit of some of our derivative instruments under lower commodity prices or higher interest rates, and could incur a loss.

Interest Rate Derivative Instrument In January 2010, we entered into an interest rate forward starting swap to effectively fix the cash flows related to interest payments on our anticipated debt issuance. On February 15, 2011 we settled the interest rate swap, which had a net liability position of $40 million. Approximately $26 million, net of tax, was recorded in accumulated other comprehensive loss (AOCL) and is being reclassified to interest expense over the term of the notes. The ineffective portion of the interest rate swap was de minimis. See Note 4. Debt.

Unsettled Derivative Instruments

As of June 30, 2011, we had entered into the following crude oil derivative instruments:

					Swaps		Collars
Period	Type of Contract	Index	Bbls Per Day		Weighted Average Fixed Price		Weighted Average Short Put Price		Weighted Average Floor Price		Weighted Average Ceiling Price
Instruments Entered Into as of June 30, 2011
2011	Swaps	NYMEX WTI (1)		5,000	$	85.52	$	-	$	-	$	-
2011	Two-Way Collars	NYMEX WTI		13,000		-		-		80.15		94.63
2011	Three-Way Collars	NYMEX WTI		12,000		-		58.33		78.33		100.71
2012	Swaps	NYMEX WTI		5,000		91.84		-		-		-
2012	Swaps	Dated Brent		8,000		89.06		-		-		-
2012	Three-Way Collars	NYMEX WTI		23,000		-		61.09		83.04		101.66
2012	Three-Way Collars	Dated Brent		3,000		-		70.00		95.83		105.00
2013	Swaps	Dated Brent		3,000		98.03		-		-		-
2013	Three-Way Collars	NYMEX WTI		5,000		-		65.00		85.00		113.63
2013	Three-Way Collars	Dated Brent		12,000		-		75.83		97.50		125.93

(1)	West Texas Intermediate

As of June 30, 2011, we had entered into the following natural gas derivative instruments:

					Swaps		Collars
Period	Type of Contract	Index	MMBtu Per Day		Weighted Average Fixed Price		Weighted Average Short Put Price		Weighted Average Floor Price		Weighted Average Ceiling Price
Instruments Entered Into as of June 30, 2011
2011	Swaps	NYMEX HH (1)		25,000	$	6.41	$	-	$	-	$	-
2011	Two-Way Collars	NYMEX HH		140,000		-		-		5.95		6.82
2011	Three-Way Collars	NYMEX HH		50,000		-		4.00		5.00		6.70
2012	Swaps	NYMEX HH		30,000		5.10		-		-		-
2012	Three-Way Collars	NYMEX HH		110,000		-		4.44		5.25		6.66
2013	Swaps	NYMEX HH		30,000		5.25		-		-		-
2013	Three-Way Collars	NYMEX HH		50,000		-		4.00		5.25		5.59

(1)

Henry Hub

As of June 30, 2011, we had entered into the following natural gas basis swaps:

Period	Index	Index Less Differential	MMBtu Per Day	Weighted Average Differential
2011	IFERC CIG (1)	NYMEX HH	140,000	$	(0.70	)
2012	IFERC CIG	NYMEX HH	150,000		(0.52	)

(1)	Colorado Interstate Gas – Northern System

Fair Value Amounts and Gains and Losses on Derivative Instruments The fair values of derivative instruments in our consolidated balance sheets were as follows:

Fair Value of Derivative Instruments

	Asset Derivative Instruments						Liability Derivative Instruments
	June 30,			December 31,			June 30,			December 31,
	2011			2010			2011			2010
	Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value		Balance Sheet Location	Fair Value
(millions)
Commodity Derivative Instruments (Not Designated as Hedging Instruments)	Current Assets	$	5	Current Assets	$	62	Current Liabilities	$	61	Current Liabilities	$	24
	Noncurrent Assets		-	Noncurrent Assets		-	Noncurrent Liabilities		119	Noncurrent Liabilities		51

Interest Rate Derivative Instruments (Designated as Hedging Instruments)	Current Assets		-	Current Assets		-	Current Liabilities		-	Current Liabilities		63
Total		$	5		$	62		$	180		$	138

The effect of derivative instruments on our consolidated statements of operations was as follows:

Commodity Derivative Instruments Not Designated as Hedging Instruments

Amount of (Gain) Loss on Derivative Instruments Recognized in Income

	Three Months Ended June 30,						Six Months Ended June 30,
	2011			2010			2011			2010
(millions)
Realized Mark-to-Market Gain	$	(1	)	$	(33	)	$	(17	)	$	(32	)
Unrealized Mark-to-Market (Gain) Loss		(142	)		(63	)		160			(210	)
Total (Gain) Loss on Commodity Derivative Instruments	$	(143	)	$	(96	)	$	143		$	(242	)

Derivative Instruments in Cash Flow Hedging Relationships

	Amount of (Gain) Loss on Derivative Instruments Recognized in Other Comprehensive (Income) Loss						Amount of (Gain) Loss on Derivative Instruments Reclassified from Accumulated Other Comprehensive Loss
		2011			2010		2011		2010
(millions)
Three Months Ended June 30,
Commodity Derivative Instruments in Previously Designated Cash Flow Hedging Relationships (1)
Crude Oil Derivative Instruments		$	-		$	-	$	-	$	4
Natural Gas Derivative Instruments			-			-		-		-

Interest Rate Derivative Instruments in Cash Flow Hedging Relationships			-			83		-		-
Total		$	-		$	83	$	-	$	4
Six Months Ended June 30,
Commodity Derivative Instruments in Previously Designated Cash Flow Hedging Relationships (1)
Crude Oil Derivative Instruments		$	-		$	-	$	-	$	9
Natural Gas Derivative Instruments			-			-		-		1

Interest Rate Derivative Instruments in Cash Flow Hedging Relationships			(23	)		94		1		-
Total		$	(23	)	$	94	$	1	$	10

(1)	Includes effect of commodity derivative instruments previously accounted for as cash flow hedges. All net derivative gains and losses that were deferred in AOCL as a result of previous cash flow hedge accounting, had been reclassified to earnings by December 31, 2010.

AOCL at June 30, 2011 included deferred losses of $27 million, net of tax, related to interest rate derivative instruments. This amount will be reclassified to earnings as an adjustment to interest expense over the terms of our senior notes due April 2014 and March 2041. Approximately $2 million of deferred losses (net of tax) will be reclassified to earnings during the next 12 months and will be recorded as an increase in interest expense.