BP Annual Report and Form 20-F 2011 - Company Reporting

Business reviewpart of a larger portfolio of similar transactions. Gains and losses arisingare recognized in the income statement from the time the derivativecommodity contract is entered into.IFRS requires that inventory held for trading be recorded at itsfair value using period end spot prices whereas any related derivativecommodity instruments are required to be recorded at values based onforward prices consistent with the contract maturity. Depending on marketconditions, these forward prices can be either higher or lower than spotprices resulting in measurement differences.BP enters into contracts for pipelines and storage capacity, oiland gas processing and liquefied natural gas (LNG) that, under IFRS, arerecorded on an accruals basis. These contracts are risk-managed using avariety of derivative instruments, which are fair valued under IFRS. Thisresults in measurement differences in relation to recognition of gains andlosses.The way that BP manages the economic exposures describedabove, and measures performance internally, differs from the way theseactivities are measured under IFRS. BP calculates this difference forconsolidated entities by comparing the IFRS result with management’sinternal measure of performance. Under management’s internal measureof performance the inventory, capacity, oil and gas processing and LNGcontracts in question are valued based on fair value using relevant forwardprices prevailing at the end of the period and the commodity contracts forbusiness requirements are accounted for on an accruals basis. We believethat disclosing management’s estimate of this difference provides usefulinformation for investors because it enables investors to see the economiceffect of these activities as a whole. The impacts of fair value accountingeffects, relative to management’s internal measure of performance and areconciliation to GAAP information is shown on page 58.Commodity trading contractsBP’s Exploration and Production and Refining and Marketing segmentsboth participate in regional and global commodity trading markets in orderto manage, transact and hedge the crude oil, refined products and naturalgas that the group either produces or consumes in its manufacturingoperations. These physical trading activities, together with associatedincremental trading opportunities, are discussed further in Exploration andProduction on pages 88-89 and in Refining and Marketing on page 98.The range of contracts the group enters into in its commodity tradingoperations is as follows.Gas and power OTC markets are highly developed in North America andthe UK, where the commodities can be bought and sold for delivery infuture periods. These contracts are negotiated between two parties topurchase and sell gas and power at a specified price, with delivery andsettlement at a future date. Typically, these contracts specify deliveryterms for the underlying commodity. Certain of these transactions are notsettled physically, which can be achieved by transacting offsetting saleor purchase contracts for the same location and delivery period that areoffset during the scheduling of delivery or dispatch. The contracts containstandard terms such as delivery point, pricing mechanism, settlementterms and specification of the commodity. Typically, volume and price arethe main variable terms.Swaps are often contractual obligations to exchange cash flowsbetween two parties: a typical swap transaction usually references afloating price and a fixed price with the net difference of the cash flowsbeing settled. Options give the holder the right, but not the obligation, tobuy or sell crude, oil products, natural gas or power at a specified price onor before a specific future date. Amounts under these derivative financialinstruments are settled at expiry. Typically, netting agreements are used tolimit credit exposure and support liquidity.Spot and term contractsSpot contracts are contracts to purchase or sell a commodity at the marketprice prevailing on or around the delivery date when title to the inventoryis taken. Term contracts are contracts to purchase or sell a commodity atregular intervals over an agreed term. Though spot and term contracts mayhave a standard form, there is no offsetting mechanism in place. Thesetransactions result in physical delivery with operational and price risk. Spotand term contracts typically relate to purchases of crude for a refinery,purchases of products for marketing, purchases of third-party naturalgas, sales of the group’s oil production, sales of the group’s oil productsand sales of the group’s gas production to third parties. For accountingpurposes, spot and term sales are included in sales and other operatingrevenues, when title passes. Similarly, spot and term purchases areincluded in purchases for accounting purposes.Business review: BP in more depthExchange-traded commodity derivativesThese contracts are typically in the form of futures and options traded ona recognized exchange, such as Nymex, SGX and ICE. Such contractsare traded in standard specifications for the main marker crude oils, suchas Brent and West Texas Intermediate, the main product grades, suchas gasoline and gasoil, and for natural gas and power. Gains and losses,otherwise referred to as variation margins, are settled on a daily basiswith the relevant exchange. These contracts are used for the trading andrisk management of crude oil, refined products, natural gas and power.Realized and unrealized gains and losses on exchange-traded commodityderivatives are included in sales and other operating revenues foraccounting purposes.Over-the-counter contractsThese contracts are typically in the form of forwards, swaps and options.Some of these contracts are traded bilaterally between counterparties;others may be cleared by a central clearing counterparty. These contractscan be used both for trading and risk management activities. Realized andunrealized gains and losses on OTC contracts are included in sales andother operating revenues for accounting purposes.The main grades of crude oil bought and sold forward usingstandard contracts are West Texas Intermediate and a standard NorthSea crude blend (Brent, Forties and Oseberg or BFO). Although thecontracts specify physical delivery terms for each crude blend, a significantnumber are not settled physically. The contracts typically contain standarddelivery, pricing and settlement terms. Additionally, the BFO contractspecifies a standard volume and tolerance given that the physically settledtransactions are delivered by cargo.BP Annual Report and Form 20-F 2011 111