market conditions or changes in the relationship of the price of NGLs and crude oil may cause our commodity
price sensitivities to vary significantly from these estimates.
The midstream natural gas industry is cyclical, with the operating results of companies in the industry
significantly affected by the prevailing price of NGLs, which in turn has been generally related to the price of
crude oil. Although the prevailing price of residue natural gas has less short-term significance to our operating
results than the price of NGLs, in the long-term the growth and sustainability of our business depends on
commodity prices being at levels sufficient to provide incentives and capital, for producers to increase natural
gas exploration and production. To minimize potential future commodity-based pricing and cash flow volatility,
we have entered into a series of derivative financial instruments. As a result of these transactions, we have
mitigated a portion of our expected natural gas, NGL and condensate commodity price risk relating to the
equity volumes associated with our gathering and processing activities through 2016.
Given the historical relationship between NGL prices and crude oil prices and the limited liquidity and
tenor of the NGL financial market, we have generally used crude oil derivative instruments to mitigate a portion
of NGL price risk. For the nearer tenor where there is greater liquidity in the NGL derivatives market, we have
periodically also utilized NGL derivatives. When the relationship of NGL prices to crude oil prices is at a
discount to historical ranges, we experience additional exposure as a result of the relationship where we utilize
crude oil swaps to mitigate NGL price exposure. When our crude oil swaps become short-term in nature, we
have periodically converted certain crude oil derivatives to NGL derivatives by entering into offsetting crude oil
swaps while adding NGL swaps.
Based on historical trends, we generally expect NGL prices to directionally follow changes in crude oil
prices over the long-term. However, the pricing relationship between NGLs and crude oil may vary, as we
believe crude oil prices will in large part be determined by the level of production from major crude oil
exporting countries and the demand generated by growth in the world economy, whereas NGL prices are more
correlated to supply and U.S. petrochemical demand. We believe that future natural gas prices will be
influenced by North American supply deliverability, the severity of winter and summer weather, the level of
North American production and drilling activity of exploration and production companies. Drilling activity can
be adversely affected as natural gas prices decrease. Energy market uncertainty could also further reduce North
American drilling activity. Limited access to capital could also decrease drilling. Lower drilling levels over a
sustained period would reduce natural gas volumes gathered and processed, but could increase commodity
prices, if supply were to fall relative to demand levels.
Other Asset-Based Activities
— Our operations of gathering, processing, and transporting natural gas, and
the accompanying operations of transporting, producing and marketing of NGLs create commodity price risk
due to market fluctuations in commodity prices, primarily with respect to the prices of NGLs, natural gas and
condensate. To the extent possible, we match the pricing of our supply portfolio to our sales portfolio in order
to lock in value and reduce our overall commodity price risk. We manage the commodity price risk of our
supply portfolio and sales portfolio with both physical and financial transactions. We occasionally will enter
into financial derivatives to lock in time spreads and price differentials across the Pelico system to maximize
the value of pipeline capacity.
Our wholesale propane logistics business is generally designed to establish stable margins by entering into
supply arrangements that specify prices based on established floating price indices and by entering into sales
agreements that provide for floating prices that are tied to our variable supply costs plus a margin.
Occasionally, we may enter into fixed price sales agreements in the event that a retail propane distributor
desires to purchase propane from us on a fixed price basis. We manage this risk with both physical and
financial transactions, sometimes using non-trading derivative instruments, which generally allow us to swap
our fixed price risk to market index prices that are matched to our market index supply costs. In addition, we
may on occasion use financial derivatives to manage the value of our propane inventories.
We manage our commodity derivative activities in accordance with our Risk Management Policy which
limits exposure to market risk and requires regular reporting to management of potential financial exposure.
Valuation
— Valuation of a contract’s fair value is validated by an internal group independent of the
marketing group. While common industry practices are used to develop valuation techniques, changes in
pricing methodologies or the underlying assumptions could result in significantly different fair values and
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