BP 2005 Annual Report Download - page 83

37 Derivative financial instruments (UK GAAP)
The following information for 2004 and 2003 shows certain of the disclosures required by UK GAAP (FRS 13 ‘Derivatives and other Financial
Instruments: Disclosures’).
The group uses derivative financial instruments (derivatives) to manage certain exposures to fluctuations in foreign currency exchange rates and
interest rates and to manage some of its margin exposure from changes in oil, natural gas and power prices. Derivatives are also traded in
conjunction with these risk management activities.
The purpose for which a derivative contract is used is identified at inception. To qualify as a derivative for risk management, the contract must be
in accordance with established guidelines that ensure it is effective in achieving its objective. All contracts not identified at inception as being for
the purpose of risk management are designated as being held for trading purposes and accounted for using the fair value method, as are all oil
price derivatives.
The group accounts for derivatives using the following methods:
Fair value method Derivatives are carried on the balance sheet at fair value (‘marked to market’), with changes in that value recognized in earnings
of the period. This method is used for all derivatives that are held for trading purposes. Interest rate contracts traded by the group include futures,
swaps, options and swaptions. Foreign exchange contracts traded include forwards and options. Oil, natural gas and power price contracts traded
include swaps, options and futures.
Accrual method Amounts payable or receivable in respect of derivatives are recognized ratably in earnings over the period of the contracts. This
method is used for derivatives held to manage interest rate risk. These are principally swap agreements used to manage the balance between fixed
and floating interest rates on long-term finance debt. Other derivatives held for this purpose may include swaptions and futures contracts. Amounts
payable or receivable in respect of these derivatives are recognized as adjustments to interest expense over the period of the contracts. Changes in
the derivative’s fair value are not recognized.
Deferral method Gains and losses from derivatives are deferred and recognized in earnings or as adjustments to carrying amounts, as appropriate,
when the underlying debt matures or the hedged transaction occurs. This method is used for derivatives used to convert non-US dollar borrowings
into US dollars, to hedge significant non-US dollar firm commitments or anticipated transactions, and to manage some of the group’s exposure to
natural gas and power price fluctuations. Derivatives used to convert non-US dollar borrowings into US dollars include foreign currency swap
agreements and forward contracts. Gains and losses on these derivatives are deferred and recognized on maturity of the underlying debt, together
with the matching loss or gain on the debt. Derivatives used to hedge significant non-US dollar transactions include foreign currency forward
contracts and options and to hedge natural gas and power price exposures include swaps, futures and options. Gains and losses on these contracts
and option premiums paid are also deferred and recognized in the income statement or as adjustments to carrying amounts, as appropriate, when
the hedged transaction occurs.
Where derivatives used to manage interest rate risk or to convert non-US dollar debt or to hedge other anticipated cash flows are terminated
before the underlying debt matures or the hedged transaction occurs, the resulting gain or loss is recognized on a basis that matches the timing
and accounting treatment of the underlying debt or hedged transaction. When an anticipated transaction is no longer likely to occur or finance debt
is terminated before maturity, any deferred gain or loss that has arisen on the related derivative is recognized in the income statement, together
with any gain or loss on the terminated item.
RISK MANAGEMENT
Gains and losses on derivatives used for risk management purposes are deferred and recognized in earnings or as adjustments to carrying
amounts, as appropriate, when the underlying debt matures or the hedged transaction occurs. When an anticipated transaction is no longer likely
to occur or finance debt is terminated before maturity, any deferred gain or loss that has arisen on the related derivative is recognized in the income
statement, together with any gain or loss on the terminated item. Where such derivatives used for hedging purposes are terminated before the
underlying debt matures or the hedged transaction occurs, the resulting gain or loss is recognized on a basis that matches the timing and
accounting treatment of the underlying hedged item. The unrecognized and carried-forward gains and losses on derivatives used for hedging, and
the movements therein, are shown in the following table:
$ million
Unrecognized Carried forward in the balance sheet
Gains Losses Total Gains Losses Total
Gains and losses at 1 January 2004 331 (130) 201 1,003 (425) 578
of which accounted for in income in 2004 98 (28) 70 438 (75) 363
Gains and losses at 31 December 2004 487 (408) 79 1,063 (364) 699
of which expected to be recognized in income in 2005 259 (267) (8) 265 (77) 188
Gains and losses at 1 January 2003 526 (450) 76 352 (28) 324
of which accounted for in income in 2003 96 (51) 45 200 (14) 186
Gains and losses at 31 December 2003 331 (130) 201 1,003 (425) 578
of which expected to be recognized in income in 2004 98 (28) 70 438 (75) 363
TRADING ACTIVITIES
The group maintains active trading positions in a variety of derivatives. This activity is undertaken in conjunction with risk management activities.
Derivatives held for trading purposes are marked-to-market and any gain or loss recognized in the income statement. For traded derivatives, many
positions have been neutralized, with trading initiatives being concluded by taking opposite positions to fix a gain or loss, thereby achieving a zero
net market risk.
BP Annual Report and Accounts 2005 81