Note 5 – 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 qualify as derivative instruments; however, because the contract price is the prevailing price at the future transaction date, the contract has no determinable fair value. The Swaps’ contract prices are determined at the beginning of each month to reflect that month’s published first of month index price and are recorded at fair value. Southwest does not utilize derivative financial instruments for speculative purposes, nor does it have trading operations.

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 25% in the Arizona and California jurisdictions) of its natural gas supply portfolios. The maturities of the Swaps highly correlate to forecasted purchases of natural gas, during time frames ranging from October 31, 2018 through October 31, 2019. Under such contracts, Southwest pays the counterparty 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):



	September 30, 2018	December 31, 2017
Contract notional amounts	14,157	10,929

The following table sets forth the gains and (losses) recognized on the Swaps (derivatives) for the three-, nine-, and twelve-month periods ended September 30, 2018 and 2017 and their location in the Condensed Consolidated Statements of Income for both the Company and Southwest:

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



(Thousands of dollars)
		Three Months Ended								Nine Months Ended								Twelve Months Ended
	Location of Gain or (Loss) Recognized in Income on Derivative	September 30,								September 30,								September 30,
Instrument		2018				2017				2018				2017				2018				2017
Swaps	Net cost of gas sold	$	511			$	(546	)		$	(3,815	)		$	(6,851	)		$	(8,536	)		$	(4,098	)
Swaps	Net cost of gas sold	(511		)	*	546			*	3,815			*	6,851			*	8,536			*	4,098			*
Total		$	—			$	—			$	—			$	—			$	—			$	—



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

No gains (losses) were recognized in net 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”), both of which were designated cash flow hedges, to partially hedge the risk of interest rate variability during the period leading up to the planned issuance of debt. The first FSIRS terminated in December 2010. The second FSIRS terminated in March 2012. Losses on both FSIRS are being amortized over ten-year periods from Accumulated other comprehensive income (loss) into interest expense.

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

Fair values of derivatives not designated as hedging instruments:



September 30, 2018		Asset		Liability
Instrument	Balance Sheet Location	Derivatives		Derivatives			Net Total
Swaps	Deferred charges and other assets	$	24	$	—		$	24
Swaps	Other current liabilities	1,038		(5,735		)	(4,697		)
Swaps	Other deferred credits and other long-term liabilities	57		(188		)	(131		)
Total		$	1,119	$	(5,923	)	$	(4,804	)

December 31, 2017		Asset		Liability
Instrument	Balance Sheet Location	Derivatives		Derivatives			Net Total
Swaps	Other current liabilities	$	11	$	(4,468	)	$	(4,457	)
Swaps	Other deferred credits and other long-term liabilities	19		(1,342		)	(1,323		)
Total		$	30	$	(5,810	)	$	(5,780	)

The estimated fair values of the natural gas derivatives were determined using future natural gas index prices (as more fully described below). Master netting arrangements exist with each counterparty that provide for the net settlement (in the settlement month) of all contracts through a single payment. As applicable, management has elected to reflect the net amounts in its balance sheets. There was 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, unrealized gains and losses in fair value of the Swaps are recorded as a regulatory asset and/or liability. When the Swaps mature, any prior positions held are reversed and the settled position is recorded as an increase or decrease of purchased gas under the related purchase gas adjustment (“PGA”) mechanism in determining the 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.



	Three Months Ended		Nine Months Ended		Twelve Months Ended
(Thousands of dollars)	September 30, 2018		September 30, 2018		September 30, 2018
Paid to counterparties	$	866	$	4,797	$	6,343
Received from counterparties	$	—	$	6	$	6

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



September 30, 2018
Instrument	Balance Sheet Location	Net Total
Swaps	Other deferred credits and other long-term liabilities	$	(24	)
Swaps	Prepaids and other current assets	4,697
Swaps	Deferred charges and other assets	131

December 31, 2017
Instrument	Balance Sheet Location	Net Total
Swaps	Prepaids and other current assets	$	4,457
Swaps	Deferred charges and other assets	1,323

Fair Value Measurements. The estimated fair values of Southwest’s Swaps were determined at September 30, 2018 and December 31, 2017 using futures settlement prices, published by the CME Group, for the delivery of natural gas at Henry Hub adjusted by the price of future settlement bases, 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 measurement.

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 financial assets and liabilities that were accounted for at fair value by both the Company and Southwest:

Level 2 - Significant other observable inputs



(Thousands of dollars)	September 30, 2018			December 31, 2017
Assets at fair value:
Deferred charges and other assets - Swaps	$	24		$	—
Liabilities at fair value:
Other current liabilities - Swaps	(4,697		)	(4,457		)
Other deferred credits and other long-term liabilities - Swaps	(131		)	(1,323		)
Net Assets (Liabilities)	$	(4,804	)	$	(5,780	)

No financial assets or liabilities associated with the Swaps, which were 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.

With regard to the fair values of assets associated with pension and postretirement benefit plans, asset values were last updated as required as of December 2017. Refer to Note 11 – Pension and Other Post Retirement Benefits in the 2017 Annual Report to Shareholders, which is incorporated by reference into the 2017 Form 10-K.