BP 2006 Annual Report Download - page 150

148
37 Derivative financial instruments (UK GAAP)
The following information for 2004 shows certain 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
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.
The group measures its market risk exposure, i.e. potential gain or loss in fair values, on its trading activity using value-at-risk techniques. These
techniques are based on a variance/covariance model or a Monte Carlo simulation and make a statistical assessment of the market risk arising from
possible future changes in market values over a 24-hour period. The calculation of the range of potential changes in fair value takes into account a
snapshot of the end-of-day exposures and the history of one-day price movements over the previous 12 months, together with the correlation of these
price movements. The potential movement in fair values is expressed to three standard deviations, which is equivalent to a 99.7% confidence level.
This means that, in broad terms, one would expect to see an increase or a decrease in fair values greater than the value at risk on only one occasion per
year if the portfolio were left unchanged.