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Structured Energy trading contract - FAS 133 accounting treatment -- Phillip Green

Structured Energy trading contract - FAS 133 accounting treatment -- Phillip Green



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Published by Philip Green
Structured Transaction White Paper
Embedded Derivatives in Structured Transaction Energy Contracts
Phillip Green, Senior Business Analyst, Consultant
Derivatives Trading Desk©®™
Structured Transaction White Paper
Embedded Derivatives in Structured Transaction Energy Contracts
Phillip Green, Senior Business Analyst, Consultant
Derivatives Trading Desk©®™

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Published by: Philip Green on Feb 16, 2009
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Structured Transaction White Paper 
Embedded Derivatives in Structured Transaction Energy ContractsPhillip Green, Senior Business Analyst, Consultant
 Derivatives Trading Desk©®™ 
Assessment of Structured Transaction for energy trading contracts. This analysis sets outto answer the following questions regarding a structured energy trading contract betweenan 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 accountingtreatment. The analysis will briefly discuss the economic projection
and todetermine if there is an
embedded derivative
hybrid derivative
inherent in the hostcontract:Is the forecast reliable?Is there a notional on the contract?Is there an embedded derivative in the host contract?
Economic projection forecast background
The forecast is based upon geological formations and gas and oil history of the area.Technology has been developed and is widely used to both quantify the amount of gaswithin the shales, and also the permeability of the shale. Companies like Schlumberger and Halliburton are pioneers in this field. Aramaco provides the forecasts to prospectivelease purchasers and use them as valuation of lease agreement terms.The forecast is a tool utilized by prospective gas well lease purchasers to assess potentialextraction capacities and inherent revenue from oil and natural gas extractions. Theselease purchase are normally one to ten years in tenor. Purchasers are either bullish or  bearish on their view of whether the wells or new drillings will actually deliver theextraction projections. They are willing to pay a premium for land leases with projected positive returns or history of successful transactions (piggy-backing); and seek to attaindiscounts with lease purchases deemed “wildcatting”, (an oil or natural-gas well drilledspeculatively in an area not known to be productive).Economic projection gas prices are based upon NYMEX strip prices (average of the dailysettlement price of the next 12 months futures contracts) and constant cost parameters.
1. Is the forecast reliable?
The economic projection forecasts are mainly used in the industry for the valuation of selling properties, i.e., land leases in reservoirs, oil and natural gas fields.
Economic project forecasts are reliable. In reviewing the forecast document, thedecline curve on the gross oil production is as expected. The decline falls off at anexpected 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 15years, conforming to characteristics of the Barnett Shale Reservoir in Texas. The declinecurves are extremely reasonable and credible, the production forecast falling off aggressively, showing a steadily declining production forecast.Energy giants such as Reliant, a Houston-based supplier of wholesale and retail naturalgas and electricity, have been using oil and gas production forecasts for years.
Economic projection forecasts are reliable. The forecasts are done by consultingfirms and geological surveyors utilizing highly sophisticated and advanced technologies.The forecasts are mostly accurate widely used in projections of gas production in oil andnatural 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 leasein Parker, Texas, with Aramaco as the operating company, and having a working interestin, 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 at100% in the market.Therefore, the notional = gross gas production purchased for re-sell minus margin.
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 fromAramaco)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 marginRe-sell natural gas at 100% of price in market.Obligated to purchase from Aramaco at 98% of average price realizedRight to sell in market at 100%
We can arrive at a notional calculation using the following attributes:
Underlier – Natural gas Notional amount,
(gross gas production purchased from Aramaco and delivered for re-sell = purchase price - margin)Delivery price,
(98 – 2%)Settlement date,
 – 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 embeddedderivatives.
Embedded Derivative assessment
Identifying and quantifying embedded derivatives is very complex. According to theFinancial Accounting Standards Board (FASB) and statement 133, the followingattributes, 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 onchanges 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 fromthe 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)

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