Quarterly report pursuant to Section 13 or 15(d)

DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES

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DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
 9 Months Ended
Sep. 30, 2012
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
NOTE 3 - DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES
The following table presents the fair value of our derivative instruments and the classification of each in the Statements of Unaudited Condensed Consolidated Financial Position as of September 30, 2012 and December 31, 2011:
 
(In Millions)
 
Derivative Assets
 
Derivative Liabilities
 
September 30, 2012
 
December 31, 2011
 
September 30, 2012
 
December 31, 2011
Derivative
Instrument
Balance Sheet Location
 
Fair
Value
 
Balance
Sheet
Location
 
Fair
Value
 
Balance Sheet
Location
 
Fair
Value
 
Balance Sheet
Location
 
Fair
Value
Derivatives designated as hedging instruments under ASC 815:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign Exchange Contracts
Derivative assets
 
$
22.4

 
Derivative assets
 
$
5.2

 
Other current liabilities
 
$
1.3

 
Other current liabilities
 
$
3.5

Total derivatives designated as hedging instruments under ASC 815
 
 
$
22.4

 
 
 
$
5.2

 
 
 
$
1.3

 
 
 
$
3.5

Derivatives not designated as hedging instruments under ASC 815:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Foreign Exchange Contracts
 
 
$
—

 
Derivative assets
 
$
2.8

 
 
 
$
—

 
 
 
$
—

Foreign Exchange Contracts
Assets held for sale
 
1.1

 
 
 
—

 
 
 
—

 
 
 
—

Customer Supply Agreements
Derivative assets
 
54.5

 
Derivative assets
 
72.9

 
 
 
—

 
 
 
—

Provisional Pricing Arrangements
Derivative assets
 
1.4

 
Derivative assets
 
1.2

 
Other current liabilities
 
11.7

 
Other current liabilities
 
19.5

 
 
 
—

 
Accounts receivable
 
83.8

 
 
 
—

 
 
 
—

Total derivatives not designated as hedging instruments under ASC 815
 
 
$
57.0

 
 
 
$
160.7

 
 
 
$
11.7

 
 
 
$
19.5

Total derivatives
 
 
$
79.4

 
 
 
$
165.9

 
 
 
$
13.0

 
 
 
$
23.0


Derivatives Designated as Hedging Instruments
Cash Flow Hedges
Australian and Canadian Dollar Foreign Exchange Contracts
We are subject to changes in foreign currency exchange rates as a result of our operations in Australia and Canada. With respect to Australia, foreign exchange risk arises from our exposure to fluctuations in foreign currency exchange rates because the functional currency of our Asia Pacific operations is the Australian dollar. Our Asia Pacific operations receive funds in U.S. currency for their iron ore and coal sales. The functional currency of our Canadian operations is the U.S. dollar; however, the production costs for these operations primarily are incurred in the Canadian dollar.
We use foreign currency exchange contracts to hedge our foreign currency exposure for a portion of our U.S. dollar sales receipts in our Australian functional currency entities and our Canadian dollar operating costs. For our Australian operations, U.S. dollars are converted to Australian dollars at the currency exchange rate in effect during the period the transaction occurred. For our Canadian operations, U.S. dollars are converted to Canadian dollars at the exchange rate in effect for the period the operating costs are incurred. The primary objective for the use of these instruments is to reduce exposure to changes in Australian and U.S. currency exchange rates and U.S. and Canadian currency exchange rates, respectively, and to protect against undue adverse movement in these exchange rates. These instruments qualify for hedge accounting treatment, and are tested for effectiveness at inception and at least once each reporting period. If and when any of our hedge contracts are determined not to be highly effective as hedges, the underlying hedged transaction is no longer likely to occur, or the derivative is terminated, hedge accounting is discontinued.
As of September 30, 2012, we had outstanding Australian and Canadian foreign currency exchange contracts with notional amounts of $420.0 million and $645.7 million, respectively, in the form of forward contracts with varying maturity dates ranging from October 2012 to September 2013. This compares with outstanding Australian foreign currency exchange contracts with a notional amount of $400.0 million as of December 31, 2011. There were no outstanding Canadian foreign currency exchange contracts as of December 31, 2011, as we did not begin entering into Canadian foreign currency exchange contracts until January 2012.
Changes in fair value of highly effective hedges are recorded as a component of Accumulated other comprehensive loss in the Statements of Unaudited Condensed Consolidated Financial Position. Any ineffectiveness is recognized immediately in income and for the three and nine months ended September 30, 2012 and 2011, there was no material ineffectiveness recorded for these foreign exchange contracts. Amounts recorded as a component of Accumulated other comprehensive loss are reclassified into earnings in the same period the forecasted transaction affects earnings. Of the amounts remaining in Accumulated other comprehensive loss related to Australian hedge contracts and Canadian hedge contracts, we estimate that gains of $8.7 million and $6.2 million (net of tax), respectively, will be reclassified into earnings within the next 12 months.
The following summarizes the effect of our derivatives designated as hedging instruments, net of tax in Accumulated other comprehensive loss and the Statements of Unaudited Condensed Consolidated Operations for the three and nine months ended September 30, 2012 and 2011:

(In Millions)
Derivatives in Cash Flow
Amount of Gain (Loss)
Recognized in OCI on Derivative
 
Location of Gain
(Loss) Reclassified
from Accumulated OCI into Income
 
Amount of Gain
Reclassified
from Accumulated
OCI into Income
Hedging Relationships
(Effective Portion)
 
(Effective Portion)
 
(Effective Portion)
 
Three Months Ended
September 30,
 
 
 
Three Months Ended
September 30,
 
2012
 
2011
 
 
 
2012
 
2011
Australian Dollar Foreign
Exchange Contracts
(hedge designation)
$
1.4

 
$
(15.2
)
 
Product revenues
 
$
5.1

 
$
1.5

Canadian Dollar Foreign Exchange Contracts (hedge designation)
11.3

 
—

 
Cost of goods sold and operating expenses
 
1.3

 
—

Total
$
12.7

 
$
(15.2
)
 
 
 
$
6.4

 
$
1.5

 
Nine Months Ended
September 30,
 
 
 
Nine Months Ended
September 30,
 
2012
 
2011
 
 
 
2012
 
2011
Australian Dollar Foreign
Exchange Contracts
(hedge designation)
$
7.5

 
$
(10.3
)
 
Product revenues
 
$
7.8

 
$
2.5

Canadian Dollar Foreign Exchange Contracts (hedge designation)
6.2

 
—

 
Cost of goods sold and operating expenses
 
1.6

 
—

Australian Dollar Foreign
Exchange Contracts
(prior to de-designation)
—

 
—

 
Product revenues
 
—

 
0.7

Total
$
13.7

 
$
(10.3
)
 
 
 
$
9.4

 
$
3.2


Interest Rate Risk Management
Interest rate risk is managed using a portfolio of variable- and fixed-rate debt composed of short- and long-term instruments, such as U.S. treasury lock agreements and interest rate swaps. From time to time these instruments, which are derivative instruments, are entered into to facilitate the maintenance of the desired ratio of variable- and fixed-rate debt. These derivative instruments are designated and qualify as cash flow hedges. These instruments did not have a material impact on our financial statements as of and for the three and nine months ended September 30, 2012.
Derivatives Not Designated as Hedging Instruments
Australian Dollar Foreign Exchange Contracts
On July 10, 2012, we entered into a definitive share and asset sale agreement to sell our 45 percent economic interest in the Sonoma joint venture coal mine located in Queensland, Australia. The assets to be sold include our interests in the Sonoma mine along with our ownership of the affiliated wash plant. We hedged the Sonoma sale price on the open market by entering into foreign currency exchange forward contracts with a notional amount of AUD $141.0 million. The hedge contracts were considered economic hedges, which do not qualify for hedge accounting. The forward contracts have a maturity date of November 13, 2012. These instruments are prospectively marked to fair value each reporting period through Income (Loss) from Discontinued Operations on the Statements of Unaudited Condensed Consolidated Operations. For the three and nine months ended September 30, 2012, the change in fair value of these forward contracts resulted in net unrealized gains of $1.1 million based on the Australian to U.S. dollar spot rate of 1.04 at September 30, 2012. Current Assets held for sale of $1.1 million, representing the fair value of the contracts was recorded on September 30, 2012 in the Statements of Unaudited Condensed Consolidated Financial Position.
Canadian Dollar Foreign Exchange Contracts and Options
On January 11, 2011, we entered into a definitive agreement with Consolidated Thompson to acquire all of its common shares in an all-cash transaction, including net debt. We hedged a portion of the purchase price on the open market by entering into foreign currency exchange forward contracts and an option contract with a combined notional amount of C$4.7 billion. The hedge contracts were considered economic hedges, which do not qualify for hedge accounting. The forward contracts had various maturity dates and the option contract had a maturity date of April 14, 2011.
During the first half of 2011, swaps were executed in order to extend the maturity dates of certain of the forward contracts through the consummation of the Consolidated Thompson acquisition and the repayment of the Consolidated Thompson convertible debentures. These swaps and the maturity of the forward contracts resulted in net realized gains of $93.1 million recognized through Changes in fair value of foreign currency contracts, net in the Statements of Unaudited Condensed Consolidated Operations for the nine months ended September 30, 2011.
Customer Supply Agreements
Most of our U.S. Iron Ore long-term supply agreements are comprised of a base price with annual price adjustment factors, some of which are subject to annual price collars in order to limit the percentage increase or decrease in prices for our iron ore pellets during any given year. The price adjustment factors vary based on the agreement but typically include adjustments based upon changes in international pellet prices and changes in specified Producer Price indices including those for all commodities, industrial commodities, energy and steel. The adjustments generally operate in the same manner, with each factor typically comprising a portion of the price adjustment, although the weighting of each factor varies based upon the specific terms of each agreement. The price adjustment factors have been evaluated to determine if they contain embedded derivatives. The price adjustment factors share the same economic characteristics and risks as the host contract and are integral to the host contract as inflation adjustments; accordingly, they have not been separately valued as derivative instruments.
Certain supply agreements with one U.S. Iron Ore customer provide for supplemental revenue or refunds to the customer based on the customer’s average annual steel pricing at the time the product is consumed in the customer’s blast furnace. The supplemental pricing is characterized as a freestanding derivative and is required to be accounted for separately once the product is shipped. The derivative instrument, which is finalized based on a future price, is adjusted to fair value as a revenue adjustment each reporting period until the pellets are consumed and the amounts are settled. We recognized $49.8 million and $131.8 million, respectively, as Product revenues in the Statements of Unaudited Condensed Consolidated Operations for the three and nine months ended September 30, 2012, related to the supplemental payments. This compares with Product revenues of $53.8 million and $124.9 million, respectively, for the comparable periods in 2011. Derivative assets, representing the fair value of the pricing factors, were $54.5 million and $72.9 million, respectively, in the September 30, 2012 and December 31, 2011 Statements of Unaudited Condensed Consolidated Financial Position.
Provisional Pricing Arrangements
Certain of our U.S. Iron Ore, Eastern Canadian Iron Ore and Asia Pacific Iron Ore customer supply agreements specify provisional price calculations, where the pricing mechanisms generally are based on market pricing, with the final sales price to be based on market inputs at a specified point in time in the future, per the terms of the supply agreements. The difference between the provisionally agreed-upon price and the estimated final sales price is characterized as a derivative and is required to be accounted for separately once the revenue has been recognized. The derivative instrument is adjusted to fair value through Product revenues each reporting period based upon current market data and forward-looking estimates provided by management until the final sales price is determined. We have recorded $1.4 million as Derivative assets and $11.7 million as derivative liabilities included in Other current liabilities in the Statements of Unaudited Condensed Consolidated Financial Position at September 30, 2012 related to our estimate of final sales price with our U.S. Iron Ore and Eastern Canadian Iron Ore customers. These amounts represent the difference between the provisional price agreed upon with our customers based on the supply agreement terms and our estimate of the final sales price based on the price calculations established in the supply agreements. As a result, we recognized a net $10.3 million as a decrease in Product revenues in the Statements of Unaudited Condensed Consolidated Operations for the three and nine months ended September 30, 2012 related to these arrangements. At December 31, 2011, we did not have any derivative assets or liabilities recorded due to these arrangements.
In instances when we were still working to revise components of the pricing calculations referenced within our supply agreements to incorporate new market inputs to the pricing mechanisms, we record certain shipments made to customers based on an agreed-upon provisional price. The shipments were recorded based on the provisional price until settlement of the market inputs to the pricing mechanisms are finalized. The lack of agreed-upon market inputs results in these provisional prices being characterized as derivatives. The derivative instrument, which is settled and billed or credited once the determinations of the market inputs to the pricing mechanisms are finalized, is adjusted to fair value through Product revenues each reporting period based upon current market data and forward-looking estimates determined by management. During the third quarter, we reached final pricing settlements on the customer supply agreements in which components of the pricing calculations were still being revised. As such, at September 30, 2012, no shipments were recorded based upon this type of provisional pricing. For the three and nine months ended September 30, 2011, we recognized $193.0 million and $623.5 million, respectively, as an increase in Product revenues in the Statements of Unaudited Condensed Consolidated Operations under the pricing provisions for certain shipments to U.S. Iron Ore and Eastern Canadian Iron Ore customers as we were still in the process of revising the terms of the related customer supply agreements. At December 31, 2011, we recorded $1.2 million Derivative assets, $19.5 million derivative liabilities included in Other current liabilities and $83.8 million Accounts receivable in the Statements of Unaudited Condensed Consolidated Financial Position related to these types of provisional pricing arrangements with various U.S. Iron Ore and Eastern Canadian Iron Ore customers.
The following summarizes the effect of our derivatives that are not designated as hedging instruments in the Statements of Unaudited Condensed Consolidated Operations for the three and nine months ended September 30, 2012 and 2011:
 
 
 
 
(In Millions)
Derivatives Not Designated as Hedging Instruments
 
Location of Gain (Loss) Recognized in
Income on Derivative
 
Amount of Gain (Loss)
Recognized in
Income on Derivative
 
 
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
 
 
2012
 
2011
 
2012
 
2011
Foreign Exchange Contracts
 
Product revenues
 
$
—

 
$
—

 
$
—

 
$
1.0

Foreign Exchange Contracts
 
Other income (expense)
 
—

 
(6.2
)
 
0.3

 
100.5

Foreign Exchange Contracts
 
Income (Loss) from Discontinued Operations
 
1.1

 
—

 
1.1

 
—

Customer Supply Agreements
 
Product revenues
 
49.8

 
53.8

 
131.8

 
124.9

Provisional Pricing Arrangements
 
Product revenues
 
(10.3
)
 
193.0

 
(10.3
)
 
623.5

Total
 
 
 
$
40.6

 
$
240.6

 
$
122.9

 
$
849.9


Refer to NOTE 9 - FAIR VALUE OF FINANCIAL INSTRUMENTS for additional information.