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, 2013
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, 2013 and December 31, 2012:
 
(In Millions)
 
Derivative Assets
 
Derivative Liabilities
 
September 30, 2013
 
December 31, 2012
 
September 30, 2013
 
December 31, 2012
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:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Interest-rate Swaps
Derivative assets
 
$
1.7

 
 
 
$
—

 
 
 
$
—

 
 
 
$
—

Foreign Exchange Contracts
Derivative assets
 
4.3

 
Derivative assets
 
16.2

 
Derivative liabilities
 
22.0

 
Derivative liabilities
 
1.9

Total derivatives designated as hedging instruments under ASC 815
 
 
$
6.0

 
 
 
$
16.2

 
 
 
$
22.0

 
 
 
$
1.9

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

 
 
 
$
—

 
Derivative liabilities
 
$
2.7

 
 
 
$
—

Customer Supply Agreements
Derivative assets
 
62.1

 
Derivative assets
 
58.9

 
 
 
—

 
 
 
—

Provisional Pricing Arrangements
Derivative assets
 
4.6

 
Derivative assets
 
3.5

 
Derivative liabilities
 
11.4

 
Derivative liabilities
 
11.3

Total derivatives not designated as hedging instruments under ASC 815
 
 
$
66.7

 
 
 
$
62.4

 
 
 
$
14.1

 
 
 
$
11.3

Total derivatives
 
 
$
72.7

 
 
 
$
78.6

 
 
 
$
36.1

 
 
 
$
13.2


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 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, 2013, we had outstanding Australian and Canadian foreign currency exchange contracts with notional amounts of $333.0 million and $453.5 million, respectively, in the form of forward contracts with varying maturity dates ranging from October 2013 to September 2014. This compares with outstanding Australian and Canadian foreign currency exchange contracts with a notional amount of $400.0 million and $630.4 million, respectively, as of December 31, 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, as of September 30, 2013 and 2012, 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 losses of $13.4 million and gains of $1.0 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 cash flow hedging instruments, net of tax in Accumulated other comprehensive loss in the Statements of Unaudited Condensed Consolidated Operations for the three and nine months ended September 30, 2013 and 2012:
 
(In Millions)
Derivatives in Cash Flow
Amount of Gain (Loss)
Recognized in OCI on Derivative
 
Location of Gain (Loss)
Reclassified
from Accumulated OCI into Earnings
 
Amount of Gain (Loss)
Reclassified
from Accumulated
OCI into Earnings
Hedging Relationships
(Effective Portion)
 
(Effective Portion)
 
(Effective Portion)
 
Three Months Ended
September 30,
 
 
 
Three Months Ended
September 30,
 
2013
 
2012
 
 
 
2013
 
2012
Australian Dollar Foreign
Exchange Contracts
(hedge designation)
$
2.9

 
$
1.4

 
Product revenues
 
$
(8.9
)
 
$
5.1

Canadian Dollar Foreign Exchange Contracts (hedge designation)
9.2

 
11.3

 
Cost of goods sold and operating expenses
 
(7.3
)
 
1.3

Total
$
12.1

 
$
12.7

 
 
 
$
(16.2
)
 
$
6.4

 
 
 
 
 
 
 
 
 
 
 
Nine Months Ended
September 30,
 
 
 
Nine Months Ended
September 30,
 
2013
 
2012
 
 
 
2013
 
2012
Australian Dollar Foreign
Exchange Contracts
(hedge designation)
$
(25.2
)
 
$
7.5

 
Product revenues
 
$
(4.5
)
 
$
7.8

Canadian Dollar Foreign Exchange Contracts (hedge designation)
(9.9
)
 
6.2

 
Cost of goods sold and operating expenses
 
(7.5
)
 
1.6

 
$
(35.1
)
 
$
13.7

 
 
 
$
(12.0
)
 
$
9.4


Fair Value Hedges
Interest Rate Hedges
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- to fixed-rate debt. These derivative instruments, with a notional amount of $250.0 million, are designated and qualify as fair value hedges as of September 30, 2013. These instruments did not have a material impact on our financial statements for the year ended December 31, 2012.
For derivative instruments that are designated and qualify as fair-value hedges, the gain or loss on the hedge instrument as well as the offsetting loss or gain on the hedged item attributable to the hedged risk are recognized in current net income. We include the gain or loss on the derivative instrument and the offsetting loss or gain on the hedged item in Other non-operating income (expense). The net gain or loss recognized in Other non-operating income (expense) for the three and nine months ended September 30, 2013 and 2012 were as follows:
(In Millions)
Derivatives in Fair Value Hedging Relationships
Location of Gain Recognized in
Income on Derivative
Net Gain Recognized in Income on Derivative
 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
 
2013
 
2012
 
2013
 
2012
Interest Rate Swaps
Other non-operating income (expense)
$
0.1

 
$
—

 
$
0.1

 
$
—


Derivatives Not Designated as Hedging Instruments
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 base price is the primary component of the purchase price for each contract. The inflation-indexed price adjustment factors are integral to the iron ore supply contracts and vary based on the agreement, but typically include adjustments based upon changes in the Platts 62 percent Fe market rate and/or international pellet prices and changes in specified Producers Price Indices, including those for all commodities, industrial commodities, energy and steel. The pricing 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. In most cases, these adjustment factors have not been finalized at the time our product is sold. In these cases, we historically have estimated the adjustment factors at each reporting period based upon the best third-party information available. The estimates are then adjusted to actual when the information has been finalized. 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 $53.9 million and $113.4 million as Product revenues in the Statements of Unaudited Condensed Consolidated Operations for the three and nine months ended September 30, 2013, respectively, related to the supplemental payments. This compares with Product revenues of $49.8 million and $131.8 million for the comparable respective periods in 2012. Derivative assets, representing the fair value of the pricing factors, were $62.1 million and $58.9 million in the September 30, 2013 and December 31, 2012 Statements of Unaudited Condensed Consolidated Financial Position, respectively.
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 revenue rate 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 revenue rate is characterized as a freestanding derivative and is required to be accounted for separately once the provisional 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 revenue rate is determined. At September 30, 2013 and December 31, 2012, we recorded $4.6 million and $3.5 million, respectively, as Derivative assets and $11.4 million and $11.3 million, respectively, as Derivative liabilities in the Statements of Unaudited Condensed Consolidated Financial Position related to our estimate of final revenue rate with our U.S. Iron Ore, Eastern Canadian Iron Ore and Asia Pacific Iron Ore customers at September 30, 2013 and related to our U.S. Iron Ore and Eastern Canadian Iron Ore customers at December 31, 2012. 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 revenue rate based on the price calculations established in the supply agreements. As a result, we recognized a net $24.3 million increase and a net $6.8 million decrease in Product revenues in the Statements of Unaudited Condensed Consolidated Operations for the three and nine months ended September 30, 2013, respectively, related to these arrangements. This compares with a net $8.1 million decrease and a net $10.3 million decrease in Product revenues for the comparable respective periods in 2012.
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, 2013 and 2012:
(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,
 
 
2013
 
2012
 
2013
 
2012
Foreign Exchange Contracts
Other income (expense)
$
—

 
$
—

 
$
—

 
$
0.3

Foreign Exchange Contracts
Income (Loss) from Discontinued Operations, net of tax
—

 
1.1

 
—

 
1.1

Commodity Contracts
Other non-operating income (expense)
(2.7
)
 
—

 
(2.7
)
 
—

Customer Supply Agreements
Product revenues
53.9

 
49.8

 
113.4

 
131.8

Provisional Pricing Arrangements
Product revenues
24.3

 
(10.3
)
 
(6.8
)
 
(10.3
)
Total
 
$
75.5

 
$
40.6

 
$
103.9

 
$
122.9


Refer to NOTE 8 - FAIR VALUE OF FINANCIAL INSTRUMENTS for additional information.