14. DERIVATIVE INSTRUMENTS

NW Natural enters into financial derivative contracts to hedge a portion of the utility’s natural gas sales requirements. These contracts include swaps, options and combinations of option contracts. These derivative financial instruments are used to manage commodity price variability. A small portion of the derivative hedging strategy involves foreign currency exchange contracts.

NW Natural enters into these financial derivatives, up to prescribed limits, primarily to hedge price variability related to physical gas supply contracts as well as to hedge spot purchases of natural gas. The foreign currency forward contracts are used to hedge the fluctuation in foreign currency exchange rates for pipeline demand charges paid in Canadian dollars.

In the normal course of business, NW Natural also enters into indexed-price physical forward natural gas commodity purchase contracts and options to meet the requirements of utility customers. These contracts qualify for regulatory deferral accounting treatment.

NW Natural also enters into exchange contracts related to the third-party asset management of its gas portfolio, some of which are derivatives that do not qualify for hedge accounting or regulatory deferral, but are subject to NW Natural's regulatory sharing agreement. These derivatives are recognized in operating revenues, net of amounts shared with utility customers.

Notional Amounts

The following table presents the absolute notional amounts related to open positions on derivative instruments:



	September 30,				December 31,
In thousands	2018		2017		2017
Natural gas (in therms):
Financial	513,850		521,080		429,100
Physical	760,925		750,650		520,268
Foreign exchange	$	7,184	$	6,933	$	7,669

Purchased Gas Adjustment (PGA)

Derivatives entered into by the utility for the procurement or hedging of natural gas for future gas years generally receive regulatory deferral accounting treatment. In general, commodity hedging for the current gas year is completed prior to the start of the gas year, and hedge prices are reflected in weighted-average cost of gas in the PGA filing. Hedge contracts entered into after the start of the PGA period are subject to the PGA incentive sharing mechanism in Oregon. NW Natural entered the 2017-18 and 2016-17 gas year with forecasted sales volumes hedged at 49% and 48% in financial swap and option contracts, and 26% and 27% in physical gas supplies, respectively. Hedge contracts entered into prior to the PGA filing, in September 2017, were included in the PGA for the 2017-18 gas year. Hedge contracts entered into after the PGA filing, and related to subsequent gas years, may be included in future PGA filings and qualify for regulatory deferral.

Unrealized and Realized Gain/Loss

The following table reflects the income statement presentation for the unrealized gains and losses from derivative instruments:



	Three Months Ended September 30,
	2018						2017
In thousands	Natural gas commodity			Foreign exchange			Natural gas commodity			Foreign exchange
Benefit (expense) to cost of gas	$	4,473		$	210		$	(2,566	)	$	51
Operating revenues	(286		)	—			28			—
Amounts deferred to regulatory accounts on balance sheet	(4,285		)	(210		)	2,548			(51		)
Total gain (loss) in pre-tax earnings	$	(98	)	$	—		$	10		$	—



	Nine Months Ended September 30,
	2018					2017
In thousands	Natural gas commodity			Foreign exchange		Natural gas commodity			Foreign exchange
Benefit (expense) to cost of gas	$	1,384		$	—	$	(19,081	)	$	275
Operating revenues	(122		)	—		(1,249		)	—
Amounts deferred to regulatory accounts on balance sheet	(1,305		)	—		19,895			(275		)
Total gain (loss) in pre-tax earnings	$	(43	)	$	—	$	(435	)	$	—

UNREALIZED GAIN/LOSS. NW Natural's outstanding derivative instruments related to regulated utility operations are deferred in accordance with regulatory accounting standards. The cost of foreign currency forward and natural gas derivative contracts are recognized immediately in the cost of gas; however, costs above or below the amount embedded in the current year PGA are subject to a regulatory deferral tariff and therefore, are recorded as a regulatory asset or liability.

REALIZED GAIN/LOSS. NW Natural realized net losses of $1.9 million and $15.6 million for the three and nine months ended September 30, 2018, respectively, from the settlement of natural gas financial derivative contracts. Whereas, net gains of $1.0 million were realized for the three and nine months ended September 30, 2017. Realized gains and losses are recorded in cost of gas, deferred through regulatory accounts, and amortized through customer rates in the following year.

Credit Risk Management of Financial Derivatives Instruments

No collateral was posted with or by counterparties as of September 30, 2018 or 2017. NW Natural attempts to minimize the potential exposure to collateral calls by counterparties to manage liquidity risk. Counterparties generally allow a certain credit limit threshold before requiring us to post collateral against loss positions. Given NW Natural's counterparty credit limits and portfolio diversification, it was not subject to collateral calls in 2018 or 2017. The collateral call exposure is set forth under credit support agreements, which generally contain credit limits. NW Natural could also be subject to collateral call exposure where it has agreed to provide adequate assurance, which is not specific as to the amount of credit limit allowed, but could potentially require additional collateral in the event of a material adverse change.

Based upon current commodity financial swap and option contracts outstanding, which reflect unrealized losses of $9.7 million at September 30, 2018, we have estimated the level of collateral demands, with and without potential adequate assurance calls, using current gas prices and various credit downgrade rating scenarios for NW Natural as follows:



			Credit Rating Downgrade Scenarios
In thousands	(Current Ratings) A+/A3		BBB+/Baa1		BBB/Baa2		BBB-/Baa3			Speculative
With Adequate Assurance Calls	$	—	$	—	$	—	$	(2,587	)	$	(7,023	)
Without Adequate Assurance Calls	—		—		—		(2,587		)	(4,730		)

NW Natural's financial derivative instruments are subject to master netting arrangements; however, they are presented on a gross basis in the consolidated balance sheets. NW Natural and its counterparties have the ability to set-off obligations to each other under specified circumstances. Such circumstances may include a defaulting party, a credit change due to a merger affecting either party, or any other termination event.

If netted by counterparty, NW Natural's physical and financial derivative position would result in an asset of $1.9 million and a liability of $10.1 million as of September 30, 2018, an asset of $3.3 million and a liability of $12.6 million as of September 30, 2017, and an asset of $2.9 million and a liability of $23.3 million as of December 31, 2017.

NW Natural is exposed to derivative credit and liquidity risk primarily through securing fixed price natural gas commodity swaps to hedge the risk of price increases for natural gas purchases made on behalf of customers. See Note 13 in the 2017 Form 10-K for additional information.

Fair Value

In accordance with fair value accounting, NW Natural includes non-performance risk in calculating fair value adjustments. This includes a credit risk adjustment based on the credit spreads of NW Natural counterparties when in an unrealized gain position, or on NW Natural's own credit spread when in an unrealized loss position. The inputs in our valuation models include natural gas futures, volatility, credit default swap spreads and interest rates. Additionally, the assessment of non-performance risk is generally derived from the credit default swap market and from bond market credit spreads. The impact of the credit risk adjustments for all outstanding derivatives was immaterial to the fair value calculation at September 30, 2018. Using significant other observable or Level 2 inputs, the net fair value was a liability of $8.1 million, $9.3 million, and $20.3 million as of September 30, 2018 and 2017, and December 31, 2017, respectively. No Level 3 inputs were used in our derivative valuations, and there were no transfers between Level 1 or Level 2 during the nine months ended September 30, 2018 and 2017. See Note 2 in the 2017 Form 10-K.