Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to risks associated with commodity prices, interest rates and credit. Commodity price risk is defined as the potential loss that we may incur as a result of changes in the fair value of natural gas. Interest rate risk results from our portfolio of debt and equity instruments that we issue to provide financing and liquidity for our business. Credit risk results from the extension of credit throughout all aspects of our business but is particularly concentrated at Atlanta Gas Light in distribution operations and in wholesale services.
Our Risk Management Committee (RMC) is responsible for establishing the overall risk management policies and monitoring compliance with, and adherence to, the terms within these policies, including approval and authorization levels and delegation of these levels. Our RMC consists of members of senior management who monitor open commodity price risk positions and other types of risk, corporate exposures, credit exposures and overall results of our risk management activities. It is chaired by our chief risk officer, who is responsible for ensuring that appropriate reporting mechanisms exist for the RMC to perform its monitoring functions. Our risk management activities and related accounting treatments are described in further detail in Note 2, Financial Instruments and Risk Management.
Commodity Price Risk
Retail Energy Operations SouthStar's use of derivatives is governed by a risk management policy, approved and monitored by its Risk and Asset Management Committee, which prohibits the use of derivatives for speculative purposes.
Energy Marketing and Risk Management Activities SouthStar generates operating margin from the active management of storage positions through a variety of hedging transactions and derivative instruments aimed at managing exposures arising from changing commodity prices. SouthStar uses these hedging instruments to lock in economic margins (as spreads between wholesale and retail commodity prices widen between periods) and thereby minimize its exposure to declining operating margins.
We have designated a portion of SouthStar's derivative transactions as cash flow hedges in accordance with SFAS 133. We record derivative gains or losses arising from cash flow hedges in OCI and reclassify them into earnings in the same period as the underlying hedged item occurs and is recorded in earnings. We record any hedge ineffectiveness, defined as when the gains or losses on the hedging instrument do not offset and are greater than the losses or gains on the hedged item, in cost of gas in our consolidated statement of income in the period in which the ineffectiveness occurs. SouthStar currently has minimal hedge ineffectiveness. We have not designated the remainder of SouthStar's derivative instruments as hedges under SFAS 133 and, accordingly, we record changes in their fair value in earnings in the period of change.
SouthStar recorded a net unrealized loss related to changes in the fair value of derivative instruments utilized in its energy marketing and risk management activities of $7 million during 2007, $14 million of unrealized gains during 2006 and unrealized losses of $4 million during 2005. The following tables illustrate the change in the net fair value of the derivative instruments and energy-trading contracts during 2007, 2006 and 2005 and provide details of the net fair value of contracts outstanding as of December 31, 2007, 2006 and 2005.
The sources of SouthStar's net fair value at December 31, 2007, are as follows.
SouthStar routinely utilizes various types of financial and other instruments to mitigate certain commodity price and weather risks inherent in the natural gas industry. These instruments include a variety of exchange-traded and over-the-counter energy contracts, such as forward contracts, futures contracts, options contracts and swap agreements. The following table includes the fair values and average values of SouthStar's energy marketing and risk management assets and liabilities as of December 31, 2007 and 2006. SouthStar bases the average values on monthly averages for the 12 months ended December 31, 2007 and 2006.
Value-at-risk A 95% confidence interval is used to evaluate VaR exposure. A 95% confidence interval means there is a 5% confidence that the actual loss in portfolio value will be greater than the calculated VaR value over the holding period. We calculate VaR based on the variance-covariance technique. This technique requires several assumptions for the basis of the calculation, such as price distribution, price volatility, confidence interval and holding period. Our VaR may not be comparable to a similarly titled measure of another company because, although VaR is a common metric in the energy industry, there is no established industry standard for calculating VaR or for the assumptions underlying such calculations. SouthStar's portfolio of positions for 2007 and 2006, had annual average 1-day holding period VaRs of less than $100,000, and its high, low and period end 1-day holding period VaR were immaterial.
Wholesale Services Sequent routinely uses various types of financial and other instruments to mitigate certain commodity price risks inherent in the natural gas industry. These instruments include a variety of exchange-traded and over-the-counter energy contracts, such as forward contracts, futures contracts, options contracts and financial swap agreements.
Energy Marketing and Risk Management Activities We account for derivative transactions in connection with Sequent's energy marketing activities on a fair value basis in accordance with SFAS 133. We record derivative energy commodity contracts (including both physical transactions and financial instruments) at fair value, with unrealized gains or losses from changes in fair value reflected in our earnings in the period of change.
Sequent's energy-trading contracts are recorded on an accrual basis as required under the EITF 02-03 rescission of EITF 98-10, unless they are derivatives that must be recorded at fair value under SFAS 133.
Sequent recorded a net unrealized loss related to changes in the fair value of derivative instruments utilized in its energy marketing and risk management activities and contract settlement of $62 million during 2007, $132 million of unrealized gains during 2006 and unrealized losses of $30 million during 2005. The following tables illustrate the change in the net fair value of Sequent's derivative instruments and energy-trading contracts during 2007, 2006 and 2005 and provide details of the net fair value of contracts outstanding as of December 31, 2007, 2006 and 2005.
The sources of Sequent's net fair value at December 31, 2007, are as follows.
The following table includes the fair values and average values of Sequent's energy marketing and risk management assets and liabilities as of December 31, 2007 and 2006. Sequent bases the average values on monthly averages for the 12 months ended December 31, 2007 and 2006.
Value-at-risk Sequent employs a systematic approach to evaluating and managing the risks associated with contracts related to wholesale marketing and risk management, including VaR. Similar to SouthStar, Sequent uses a 1-day holding period and a 95% confidence interval to evaluate its VaR exposure.
Sequent's open exposure is managed in accordance with established policies that limit market risk and require daily reporting of potential financial exposure to senior management, including the chief risk officer. Because Sequent generally manages physical gas assets and economically protects its positions by hedging in the futures and over-the-counter markets, its open exposure is generally minimal, permitting Sequent to operate within relatively low VaR limits. Sequent employs daily risk testing, using both VaR and stress testing, to evaluate the risks of its open positions.
Sequent's management actively monitors open commodity positions and the resulting VaR. Sequent continues to maintain a relatively matched book, where its total buy volume is close to its sell volume, with minimal open commodity risk. Based on a 95% confidence interval and employing a 1-day holding period for all positions, Sequent's portfolio of positions for the 12 months ended December 31, 2007, 2006 and 2005 had the following 1-day holding period VaRs.
Interest Rate Risk
Interest rate fluctuations expose our variable-rate debt to changes in interest expense and cash flows. We manage interest expense using a combination of fixed-rate and variable-rate debt. Based on $840 million of variable-rate debt, which includes $579 million of our variable-rate short-term debt, $100 million of variable-rate senior notes and $161 million of variable-rate gas facility revenue bonds outstanding at December 31, 2007, a 100 basis point change in market interest rates from 5.56% to 6.56% would have resulted in an increase in pretax interest expense of $8 million on an annualized basis.
To facilitate the achievement of desired fixed-rate to variable-rate debt ratios, AGL Capital entered into interest rate swaps whereby it agreed to exchange, fixed rate debt for floating-rate debt. The swaps exchange at specified intervals, the difference between fixed and variable amounts calculated by reference to agreed-on notional principal amounts. These swaps are designated to hedge the fair values of $100 million of the $300 million senior notes due in 2011.
In August 2007, we executed a treasury-lock agreement covering a notional amount totaling $125 million to hedge the interest rate risk associated with our $125 million senior notes offering in December 2007. The 10-year treasury interest rate was locked in at a weighted average rate of 4.5%. The treasury-lock agreements settled and we paid $5 million in December 2007 in connection with our issuance of $125 million in senior notes. The $5 million is included within OCI (net of $2 million in income taxes) and will be amortized over the remaining life of the senior notes (through July 2016) as interest expense.
Distribution Operations Atlanta Gas Light has a concentration of credit risk as it bills only 12 Marketers in Georgia for its services. The credit risk exposure to Marketers varies with the time of the year, with exposure at its lowest in the nonpeak summer months and highest in the peak winter months. Marketers are responsible for the retail sale of natural gas to end-use customers in Georgia. These retail functions include customer service, billing, collections, and the purchase and sale of the natural gas commodity. The provisions of Atlanta Gas Light's tariff allow Atlanta Gas Light to obtain security support in an amount equal to a minimum of two times a Marketer's highest month's estimated bill from Atlanta Gas Light. For 2007, the four largest Marketers based on customer count, one of which was SouthStar, accounted for approximately 38% of our consolidated operating margin and 52% of distribution operations' operating margin.
Several factors are designed to mitigate our risks from the increased concentration of credit that has resulted from deregulation. In addition to the security support described above, Atlanta Gas Light bills intrastate delivery service to Marketers in advance rather than in arrears. We accept credit support in the form of cash deposits, letters of credit/surety bonds from acceptable issuers and corporate guarantees from investment-grade entities. The RMC reviews on a monthly basis the adequacy of credit support coverage, credit rating profiles of credit support providers and payment status of each Marketer. We believe that adequate policies and procedures have been put in place to properly quantify, manage and report on Atlanta Gas Light's credit risk exposure to Marketers.
Atlanta Gas Light also faces potential credit risk in connection with assignments of interstate pipeline transportation and storage capacity to Marketers. Although Atlanta Gas Light assigns this capacity to Marketers, in the event that a Marketer fails to pay the interstate pipelines for the capacity, the interstate pipelines would in all likelihood seek repayment from Atlanta Gas Light.
Retail Energy Operations SouthStar obtains credit scores for its firm residential and small commercial customers using a national credit reporting agency, enrolling only those customers that meet or exceed SouthStar's credit threshold.
SouthStar considers potential interruptible and large commercial customers based on a review of publicly available financial statements and review of commercially available credit reports. Prior to entering into a physical transaction, SouthStar also assigns physical wholesale counterparties an internal credit rating and credit limit based on the counterparties' Moody's, S&P and Fitch ratings, commercially available credit reports and audited financial statements.
Wholesale Services Sequent has established credit policies to determine and monitor the creditworthiness of counterparties, as well as the quality of pledged collateral. Sequent also utilizes master netting agreements whenever possible to mitigate exposure to counterparty credit risk. When Sequent is engaged in more than one outstanding derivative transaction with the same counterparty and it also has a legally enforceable netting agreement with that counterparty, the "net" mark-to-market exposure represents the netting of the positive and negative exposures with that counterparty and a reasonable measure of Sequent's credit risk. Sequent also uses other netting agreements with certain counterparties with whom it conducts significant transactions.
Master netting agreements enable Sequent to net certain assets and liabilities by counterparty. Sequent also nets across product lines and against cash collateral provided the master netting and cash collateral agreements include such provisions. Additionally, Sequent may require counterparties to pledge additional collateral when deemed necessary. Sequent conducts credit evaluations and obtains appropriate internal approvals for its counterparty's line of credit before any transaction with the counterparty is executed. In most cases, the counterparty must have a minimum long-term debt rating of Baa3 from Moody's and BBB- from S&P. Generally, Sequent requires credit enhancements by way of guaranty, cash deposit or letter of credit for transaction counterparties that do not meet the minimum ratings threshold.
Sequent, which provides services to retail marketers and utility and industrial customers, also has a concentration of credit risk as measured by its 30-day receivable exposure plus forward exposure. As of December 31, 2007, Sequent's top 20 counterparties represented approximately 53% of the total counterparty exposure of $366 million, derived by adding together the top 20 counterparties' exposures and dividing by the total of Sequent's counterparties' exposures.
As of December 31, 2007, Sequent's counterparties, or the counterparties' guarantors, had a weighted average S&P equivalent credit rating of A-, which is consistent with the prior year. The S&P equivalent credit rating is determined by a process of converting the lower of the S&P or Moody's ratings to an internal rating ranging from 9 to 1, with 9 being equivalent to AAA/Aaa by S&P and Moody's and 1 being D or Default by S&P and Moody's. A counterparty that does not have an external rating is assigned an internal rating based on the strength of the financial ratios of that counterparty. To arrive at the weighted average credit rating, each counterparty's assigned internal rating is multiplied by the counterparty's credit exposure and summed for all counterparties. That sum is divided by the aggregate total counterparties' exposures, and this numeric value is then converted to an S&P equivalent.
The following table shows Sequent's commodity receivable and payable positions as of December 31, 2007 and 2006.
Sequent has certain trade and credit contracts that have explicit minimum credit rating requirements. These credit rating requirements typically give counterparties the right to suspend or terminate credit if our credit ratings are downgraded to non-investment grade status. Under such circumstances, Sequent would need to post collateral to continue transacting business with some of its counterparties. Posting collateral would have a negative effect on our liquidity. If such collateral were not posted, Sequent's ability to continue transacting business with these counterparties would be impaired. If at December 31, 2007, Sequent's credit ratings had been downgraded to non-investment grade status, the required amounts to satisfy potential collateral demands under such agreements between Sequent and its counterparties would have totaled $26 million.