Note 4 – Derivatives and Fair Value Measurements

Derivatives. In managing its natural gas supply portfolios, Southwest has historically entered into fixed- and variable-price contracts, which qualify as derivatives. Additionally, Southwest utilizes fixed-for-floating swap contracts (“Swaps”) to supplement its fixed-price contracts. The fixed-price contracts, firm commitments to purchase a fixed amount of gas in the future at a fixed price, qualify for the normal purchases and normal sales exception that is allowed for contracts that are probable of delivery in the normal course of business, and are exempt from fair value reporting. The variable-price contracts have no significant market value. The Swaps are recorded at fair value.

As part of the June 2013 Nevada Annual Rate Adjustment and associated stipulation, the Company agreed to suspend further Swaps and fixed-price purchases pursuant to the Volatility Mitigation Program for its Nevada service territories. The decision will not impact previously executed purchase agreements. The Company, along with its regulators, will continue to evaluate this strategy in light of prevailing or anticipated changing market conditions.

The fixed-price contracts and Swaps are utilized by Southwest under its volatility mitigation programs to effectively fix the price on a portion (up to approximately 35%, depending on the jurisdiction) of its natural gas supply portfolios. The maturities of the Swaps highly correlate to forecasted purchases of natural gas, during time frames ranging from July 2014 through March 2016. Under such contracts, Southwest pays the counterparty at a fixed rate and receives from the counterparty a floating rate per MMBtu (“dekatherm”) of natural gas. Only the net differential is actually paid or received. The differential is calculated based on the notional amounts under the contracts, which are detailed in the table below (thousands of dekatherms):


	June 30, 2014		December 31, 2013
Contract notional amounts		7,658		13,571

Southwest does not utilize derivative financial instruments for speculative purposes, nor does it have trading operations.

The following table sets forth the gains and (losses) recognized on the Company’s Swaps (derivatives) for the three-, six-, and twelve-month periods ended June 30, 2014 and 2013 and their location in the Condensed Consolidated Statements of Income (thousands of dollars):

Gains (losses) recognized in income for derivatives not designated as hedging instruments:

(Thousands of dollars)


		Three Months Ended						Six Months Ended						Twelve Months Ended
Instrument	Location of Gain or (Loss) Recognized in Income on Derivative	June 30						June 30						June 30
Instrument		2014			2013			2014			2013			2014			2013
Swaps	Net cost of gas sold	$	(83	)	$	(7,669	)	$	5,907		$	(2,593	)	$	9,476		$	(2,885	)
Swaps	Net cost of gas sold		83	*		7,669	*		(5,907	)*		2,593	*		(9,476	)*		2,885	*

Total		$	—		$	—		$	—		$	—		$	—		$	—

*	Represents the impact of regulatory deferral accounting treatment under U.S. GAAP for rate-regulated entities.

No gains (losses) were recognized in income or other comprehensive income during the periods presented for derivatives designated as cash flow hedging instruments. Previously, Southwest entered into two forward-starting interest rate swaps (“FSIRS”) to hedge the risk of interest rate variability during the period leading up to the issuance of fixed-rate debt. At settlement of the first FSIRS in December 2010, Southwest paid an aggregate $11.7 million to the counterparties. The second FSIRS terminated in March 2012 at which time Southwest paid counterparties an aggregate $21.8 million. The losses on both FSIRS are being amortized over ten-year periods from Accumulated other comprehensive income (loss) and into interest expense.

The following table sets forth the fair values of the Company’s Swaps and their location in the Condensed Consolidated Balance Sheets (thousands of dollars):

Fair values of derivatives not designated as hedging instruments:


June 30, 2014		Asset Derivatives		Liability Derivatives			Net Total
Instrument	Balance Sheet Location	Asset Derivatives		Liability Derivatives			Net Total
Swaps	Deferred charges and other assets	$	483	$	—		$	483
Swaps	Prepaids and other current assets		1,884		(140	)		1,744

Total		$	2,367	$	(140	)	$	2,227


December 31, 2013		Asset Derivatives		Liability Derivatives			Net Total
Instrument	Balance Sheet Location	Asset Derivatives		Liability Derivatives			Net Total
Swaps	Deferred charges and other assets	$	257	$	(77	)	$	180
Swaps	Prepaids and other current assets		1,054		(253	)		801
Swaps	Other current liabilities		126		(282	)		(156	)
Swaps	Other deferred credits		7		(11	)		(4	)

Total		$	1,444	$	(623	)	$	821

The estimated fair values of the natural gas derivatives were determined using future natural gas index prices (as more fully described below). The Company has master netting arrangements with each counterparty that provide for the net settlement of all contracts through a single payment. As applicable, the Company has elected to reflect the net amounts in its balance sheets. The Company had no outstanding collateral associated with the Swaps during either period shown in the above table.

Pursuant to regulatory deferral accounting treatment for rate-regulated entities, Southwest records the unrealized gains and losses in fair value of the Swaps as a regulatory asset and/or liability. When the Swaps mature, Southwest reverses any prior positions held and records the settled position as an increase or decrease of purchased gas under the related purchased gas adjustment (“PGA”) mechanism in determining its deferred PGA balances. Neither changes in fair value, nor settled amounts, of Swaps have a direct effect on earnings or other comprehensive income.

The following table shows the amounts Southwest paid to and received from counterparties for settlements of matured Swaps.


(Thousands of dollars)	Three Months Ended June 30, 2014		Six Months Ended June 30, 2014		Twelve Months Ended June 30, 2014
Paid to counterparties	$	—	$	15	$	2,291

Received from counterparties	$	196	$	4,515	$	4,522

The following table details the regulatory assets/(liabilities) offsetting the derivatives at fair value in the Condensed Consolidated Balance Sheets (thousands of dollars).


June 30, 2014 Instrument	Balance Sheet Location	Net Total
Swaps	Other deferred credits	$	(483	)
Swaps	Other current liabilities		(1,744	)

December 31, 2013 Instrument	Balance Sheet Location	Net Total
Swaps	Other deferred credits	$	(180	)
Swaps	Other current liabilities		(801	)
Swaps	Prepaids and other current assets		156
Swaps	Deferred charges and other assets		4

Fair Value Measurements. The estimated fair values of Southwest’s Swaps were determined at June 30, 2014 and December 31, 2013 using New York Mercantile Exchange (“NYMEX”) futures settlement prices for delivery of natural gas at Henry Hub adjusted by the price of NYMEX ClearPort basis Swaps, which reflect the difference between the price of natural gas at a given delivery basin and the Henry Hub pricing points. These Level 2 inputs (inputs, other than quoted prices, for similar assets or liabilities) are observable in the marketplace throughout the full term of the Swaps, but have been credit-risk adjusted with no significant impact to the overall fair value measure.

The following table sets forth by level, within the three-level fair value hierarchy that ranks the inputs used to measure fair value by their reliability, the Company’s financial assets and liabilities recorded at fair value:

Level 2 - Significant other observable inputs


(Thousands of dollars)	June 30, 2014		December 31, 2013
Assets at fair value:
Prepaids and other current assets - Swaps	$	1,744	$	801
Deferred charges and other assets - Swaps		483		180

Liabilities at fair value:
Other current liabilities - Swaps		—		(156	)
Other deferred credits - Swaps		—		(4	)

Net Assets (Liabilities)	$	2,227	$	821

No financial assets or liabilities accounted for at fair value fell within Level 1 (quoted prices in active markets for identical financial assets) or Level 3 (significant unobservable inputs) of the fair value hierarchy.