Assessment of Structured Transaction for energy trading contracts. This analysis sets out to answer the following questions regarding a structured energy trading contract between an energy trading firm, the originator, and an operating company. The fictional company, let’s call it Aramaco, has concerns that the transaction may require FAS 133 accounting treatment. The analysis will briefly discuss the economic projection forecast and to determine if there is an embedded derivative or hybrid derivative inherent in the host contract.
2. Yes. Economic project forecasts are reliable. In reviewing the forecast document, the
decline curve on the gross oil production is as expected. The decline falls off at an
expected rate as the years go out, over fifty percent over the two-year period, from 350,
352 MMcf in year 2007 to 159,868 MMcf in year 2009; and levels out over the next 15
years, conforming to characteristics of the Barnett Shale Reservoir in Texas. The decline
curves are extremely reasonable and credible, the production forecast falling off
aggressively, showing a steadily declining production forecast.
Gas gross production forecast for 2007 is 350.352 (MMcf)
Gas price is 7.13 S/Mcf – based on NYMEX current strip prices (at the time of
forecast)
350,352 x 7.13 = 2498009.76 (price we will sell natural gas for in market)
2498009.76 x .98 = 2448049.5648 (differential price/margin price we purchase from
Aramaco)
2498009.76 – 2448059.5648 = 49960.1952 (approx. $50,000 total margin for 2007
based upon economic project forecast dated 11/9/2006). Asset?
Purchase natural gas with 2% built in margin
Re-sell natural gas at 100% of price in market.
Obligated to purchase from Aramaco at 98% of average price realized
Right to sell in market at 100%
Energy giants such as Reliant, a Houston-based supplier of wholesale and retail natural gas
and electricity, have been using oil and gas production forecasts for years.
Yes. Economic projection forecasts are reliable. The forecasts are done by consulting firms
and geological surveyors utilizing highly sophisticated and advanced technologies. The
forecasts are mostly accurate widely used in projections of gas production in oil and natural
gas wells. In Aramaco’s case, the reservoirs are Hidle-Deaver, in Johnson, Texas, the
Williamson Lease of the Tres Vistas Prospect in Fort Worth and the Williamson lease in
Parker, Texas, with Aramaco as the operating company, and having a working interest in, or
having the right to sell.
2. Can we derive a notional amount?
Energy trading company buys natural gas from Aramaco at 98% of cost and sells it at
100% in the market.
Therefore, the notional = gross gas production purchased for re-sell minus margin.
3. We can arrive at a notional calculation using the following attributes:
Underlier – Natural gas
Notional amount, n (gross gas production purchased from Aramaco and delivered for
re-sell = purchase price - margin)
Delivery price, k (98 – 2%)
Settlement date, s – when natural gas is delivered, sold in market
Is there an embedded derivative in the host contract?
A purchase and sale contract with executory treatment may contain embedded derivatives.
Embedded Derivative assessment
Identifying and quantifying embedded derivatives is very complex. According to the
Financial Accounting Standards Board (FASB) and statement 133, the following attributes,
inherent in the Aramaco transaction, may qualify as an embedded derivative to be separated
from the host contract and or meet the definition of a derivative:
There is no cost of carry. All imbalances fall on the Aramaco/Energy Transfer gathering
agreement, the host contract. Criteria met for definition of a derivative.
The Aramaco transaction is a purchase and sale contract with executory treatment.
Assess for embedded derivatives.
The contract is predominantly based on sales or service revenues of one of the parties.
Assess for embedded derivatives.
The embedded derivative causes modification to a contract’s cash flow, based on
changes in a specified variable. Assess for embedded derivatives.
There is a commodity-linked “tariff structure”. Assess for embedded derivative.
The contract allows us to recoup all fees associated in marketing the Aramaco gas.
Criteria met for derivative definition.
The pricing formula is an embedded derivative because it changes the price risk from
the gas price notional (gas gross x gas price minus margin) to the strip price, or spot
price (see notes).
The underlying is a variable, price or rate that is related to an asset or liability,
commodity price (price of natural gas, in this case)
Net settlement provision – there is an explicit or implicit net cash settlement provision