This excerpt taken from the MRO 10-K filed Mar 10, 2005.
Estimated Fair Value of Derivative Contracts
We record all derivative instruments at fair value. Derivative instruments are used to manage risk throughout our different businesses. These risks relate to commodities, interest rates and our exposure to foreign currency fluctuations. We use derivative instruments that are exchange traded and non-exchange traded. Non-exchange traded instruments are referred to as over-the-counter ("OTC") instruments.
For commodities, the fair value of exchange traded instruments is based on existing market quotes. Fair value for OTC instruments such as options and swap agreements is developed through the use of option-pricing models or third party market quotes. Forward contracts are valued based on quotes from the counterparties of the forward contracts.
We also have two long-term contracts for the sale of natural gas in the United Kingdom ("U.K."). These contracts expire in September 2009. These contracts were entered into in the early 1990s in support of our investments in the East Brae field and the SAGE pipeline. Contract prices are linked to a basket of energy and other indices. The contract price is reset annually in October based on the previous twelve-month changes in the basket of indices. Consequently, the prices under these contracts do not track forward gas prices.
These U.K. gas contracts are accounted for as derivative instruments. The fair value of these contracts is determined by applying the difference between the contract price and the U.K. forward gas strip price to the expected sales volumes for the next eighteen months under these contracts. Adjustments to the fair value of these contracts result in noncash charges or credits to income from operations. The difference between the contract price and the U.K. forward gas strip price may fluctuate widely from time to time and may significantly affect income from operations.
The noncash change in fair value recognized in earnings was a loss of $99 million in 2004, a loss of $66 million in 2003 and a gain of $18 million in 2002. These effects are primarily due to the U.K. 18-month forward gas price curve strengthening 36 and 26 percent during 2004 and 2003 and weakening 12 percent during 2002.
For additional information on market risk sensitivity, see "Item 7A. Quantitative and Qualitative Disclosures About Market Risk" on page 50.