Quarterly report pursuant to Section 13 or 15(d)

Derivative Instruments

v3.20.2
Derivative Instruments
 6 Months Ended
Jun. 30, 2020
Derivative Instruments and Hedging Activities Disclosure [Abstract]  
Derivative Instruments DERIVATIVE INSTRUMENTS

We have entered into commodity derivatives consisting of natural gas supply contracts for the commissioning and operation of the Liquefaction Project (“Physical Liquefaction Supply Derivatives”) and associated economic hedges (collectively, the “Liquefaction Supply Derivatives”).

We recognize our derivative instruments as either assets or liabilities and measure those instruments at fair value. None of our derivative instruments are designated as cash flow or fair value hedging instruments, and changes in fair value are recorded within our Consolidated Statements of Income to the extent not utilized for the commissioning process.

The following table shows the fair value of our derivative instruments that are required to be measured at fair value on a recurring basis as of June 30, 2020 and December 31, 2019, which are classified as derivative assets, non-current derivative assets, derivative liabilities or non-current derivative liabilities in our Consolidated Balance Sheets (in millions).
 
Fair Value Measurements as of
 
June 30, 2020
 
December 31, 2019
 
Quoted Prices in Active Markets
(Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
 
Total
 
Quoted Prices in Active Markets
(Level 1)
 
Significant Other Observable Inputs
(Level 2)
 
Significant Unobservable Inputs
(Level 3)
 
Total
Liquefaction Supply Derivatives asset (liability)
$
3

 
$
(4
)
 
$
51

 
$
50

 
$
3

 
$
(3
)
 
$
24

 
$
24



We value our Liquefaction Supply Derivatives using a market-based approach incorporating present value techniques, as needed, using observable commodity price curves, when available, and other relevant data.

The fair value of our Physical Liquefaction Supply Derivatives is predominantly driven by observable and unobservable market commodity prices and, as applicable to our natural gas supply contracts, our assessment of the associated events deriving fair value, including evaluating whether the respective market is available as pipeline infrastructure is developed. The fair value of our Physical Liquefaction Supply Derivatives incorporates risk premiums related to the satisfaction of conditions precedent, such as completion and placement into service of relevant pipeline infrastructure to accommodate marketable physical gas flow.
As of June 30, 2020 and December 31, 2019, some of our Physical Liquefaction Supply Derivatives existed within markets for which the pipeline infrastructure was under development to accommodate marketable physical gas flow.

We include a portion of our Physical Liquefaction Supply Derivatives as Level 3 within the valuation hierarchy as the fair value is developed through the use of internal models which incorporate significant unobservable inputs. In instances where observable data is unavailable, consideration is given to the assumptions that market participants would use in valuing the asset or liability. This includes assumptions about market risks, such as future prices of energy units for unobservable periods, liquidity, volatility and contract duration.

The Level 3 fair value measurements of natural gas positions within our Physical Liquefaction Supply Derivatives could be materially impacted by a significant change in certain natural gas prices. The following table includes quantitative information for the unobservable inputs for our Level 3 Physical Liquefaction Supply Derivatives as of June 30, 2020:
 
 
Net Fair Value Asset
(in millions)
 
Valuation Approach
 
Significant Unobservable Input
 
Range of Significant Unobservable Inputs / Weighted Average (1)
Physical Liquefaction Supply Derivatives
 
$51
 
Market approach incorporating present value techniques
 
Henry Hub basis spread
 
$(0.350) - $0.172 / $0.008
 
(1)
Unobservable inputs were weighted by the relative fair value of the instruments.

Increases or decreases in basis, in isolation, would decrease or increase, respectively, the fair value of our Physical Liquefaction Supply Derivatives.

The following table shows the changes in the fair value of our Level 3 Physical Liquefaction Supply Derivatives during the three and six months ended June 30, 2020 and 2019 (in millions):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2020
 
2019
 
2020
 
2019
Balance, beginning of period
 
$
49

 
$
29

 
$
24

 
$
(25
)
Realized and mark-to-market gains:
 
 
 
 
 
 
 
 
Included in cost of sales
 
4

 
3

 
32

 
16

Purchases and settlements:
 
 
 
 
 
 
 
 
Purchases
 
(1
)
 
1

 
—

 
—

Settlements
 
(1
)
 
1

 
(6
)
 
43

Transfers out of Level 3 (1)
 
—

 
—

 
1

 
—

Balance, end of period
 
$
51

 
$
34

 
$
51

 
$
34

Change in unrealized gains relating to instruments still held at end of period
 
$
4

 
$
3

 
$
32

 
$
16


 
(1)
Transferred to Level 2 as a result of observable market for the underlying natural gas purchase agreements.

Derivative assets and liabilities arising from our derivative contracts with the same counterparty are reported on a net basis, as all counterparty derivative contracts provide for the unconditional right of set-off in the event of default. The use of derivative instruments exposes us to counterparty credit risk, or the risk that a counterparty will be unable to meet its commitments in instances when our derivative instruments are in an asset position. Additionally, counterparties are at risk that we will be unable to meet our commitments in instances where our derivative instruments are in a liability position. We incorporate both our own nonperformance risk and the respective counterparty’s nonperformance risk in fair value measurements. In adjusting the fair value of our derivative contracts for the effect of nonperformance risk, we have considered the impact of any applicable credit enhancements, such as collateral postings, set-off rights and guarantees.

Liquefaction Supply Derivatives

SPL has entered into primarily index-based physical natural gas supply contracts and associated economic hedges to purchase natural gas for the commissioning and operation of the Liquefaction Project. The remaining terms of the physical natural gas supply contracts range up to 9 years, some of which commence upon the satisfaction of certain events or states of affairs.

The notional natural gas position of our Liquefaction Supply Derivatives was approximately 4,808 TBtu and 3,663 TBtu as of June 30, 2020 and December 31, 2019, respectively, of which 91 TBtu and zero TBtu, respectively, were for a natural gas supply contract that SPL has with a related party.
 
The following table shows the fair value and location of our Liquefaction Supply Derivatives on our Consolidated Balance Sheets (in millions):
 
 
Fair Value Measurements as of (1)
Consolidated Balance Sheets Location
 
June 30, 2020
 
December 31, 2019
Derivative assets
 
$
20

 
$
17

Non-current derivative assets
 
37

 
32

Total derivative assets
 
57

 
49

 
 
 
 
 
Derivative liabilities
 
(6
)
 
(9
)
Non-current derivative liabilities
 
(1
)
 
(16
)
Total derivative liabilities
 
(7
)
 
(25
)
 
 
 
 
 
Derivative asset, net
 
$
50

 
$
24

 
(1)
Does not include collateral posted with counterparties by us of $2 million for such contracts, which are included in other current assets in our Consolidated Balance Sheets as of both June 30, 2020 and December 31, 2019. Includes a natural gas supply contract that SPL has with a related party, which had a fair value of zero as of June 30, 2020.

The following table shows the changes in the fair value, settlements and location of our Liquefaction Supply Derivatives recorded on our Consolidated Statements of Income during the three and six months ended June 30, 2020 and 2019 (in millions):
 
 Consolidated Statements of Income Location (1)
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2020
 
2019
 
2020
 
2019
Liquefaction Supply Derivatives gain (loss)
LNG revenues
 
$
(4
)
 
$
—

 
$
(4
)
 
$
1

Liquefaction Supply Derivatives gain
Cost of sales
 
12

 
7

 
33

 
83


 
(1)
Does not include the realized value associated with derivative instruments that settle through physical delivery. Fair value fluctuations associated with commodity derivative activities are classified and presented consistently with the item economically hedged and the nature and intent of the derivative instrument.

Consolidated Balance Sheets Presentation

Our derivative instruments are presented on a net basis on our Consolidated Balance Sheets as described above. The following table shows the fair value of our derivatives outstanding on a gross and net basis (in millions):
 
 
Gross Amounts Recognized
 
Gross Amounts Offset in the Consolidated Balance Sheets
 
Net Amounts Presented in the Consolidated Balance Sheets
Offsetting Derivative Assets (Liabilities)
 
 
 
As of June 30, 2020
 
 
 
 
 
 
Liquefaction Supply Derivatives
 
$
62

 
$
(5
)
 
$
57

Liquefaction Supply Derivatives
 
(10
)
 
3

 
(7
)
As of December 31, 2019
 
 
 
 
 
 
Liquefaction Supply Derivatives
 
$
51

 
$
(2
)
 
$
49

Liquefaction Supply Derivatives
 
(27
)
 
2

 
(25
)