What Does Hedge or Mitigate Commercial Risk Mean?

Transcription

1 What Does Hedge or Mitigate Commercial Risk Mean? How Will Energy Producers and Consumers Prove They Are Commercial End Users Under the Dodd-Frank Act? February 24, 2012 Jeffrey J. Nichols Haynes and Boone, LLP Johnny Molina Ernst & Young LLP

2 What Does Hedge or Mitigate Commercial Risk Mean? How Will Energy Producers and Consumers Prove They Are Commercial End Users Under the Dodd-Frank Act? Summary The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or the Act ) attempts to sort through the energy trading and hedging market to protect commercial end users from new regulatory burdens intended for trading firms and financial institutions. The objective is to separate the large number of companies that use hedges like insurance to manage fluctuating prices on the one hand, from the small number of sophisticated energy traders and financial institutions, who would bear the brunt of the new regulation, on the other. An important criteria used by the statute and proposed regulations is whether hedges act to hedge or mitigate commercial risk. The statute and proposed rules have a number of tests and reporting requirements to determine whether hedges hedge or mitigate commercial risk, which rely on legal, accounting and financial concepts. This paper examines these concepts, and, in particular, studies the applicability of hedge accounting standards to the analysis. Using hedge accounting is not the only way to prove compliance with the hedge or mitigate commercial risk standard, but it may be the most objective standard to apply. The other standards are more subjective and need more substance to offer a viable alternative. But this analysis should not be conducted in a vacuum and consideration should be given to how potential commercial end users currently account for hedges. A study of the public filings of selected segments of energy producers and consumers shows that currently many of these companies do not account for hedges in a way that would enable them to qualify as commercial end users. The paper discusses alternative methods of proving hedge or mitigate commercial risk, and factors to consider for the process. Finally, the paper provides insight for future development of the regulations. Introduction The Dodd-Frank Act 1 is arguably the most significant financial legislation enacted since Depression-era reforms 75 years ago. It is 2,300 pages and covers the breadth of financial activity in the country. For energy producers and consumers, the most important aspect of the Act is new regulation of energy hedges. Before, energy hedges were frequently traded outside of exchanges ( over the counter or OTC ) and were exempt from regulation under the Commodity Exchange Act ( CEA ) 2, which regulated other commodity hedges. The Act makes energy hedges subject to regulation by the CEA, and generally requires that hedges be traded on an exchange and centrally cleared, but a major exception to clearing was created for hedges by certain entities, which are commonly referred to as Commercial End Users. Commercial End Users utilizing the exception to clearing must not be financial institutions, must use the hedges to hedge or mitigate commercial risk (referred to as HMCR ), and must fulfill certain reporting requirements. This paper will focus on the issues associated with the accounting and legal principles used to define HMCR. First is a description of why and how energy consumers and producers hedge in order to set the stage for the application of the HMCR analysis. Then, the statute and regulations are examined in detail with each test for HMCR described. Finally, the paper examines the hedge accounting test, and reports on a study of its use currently through a study of public filings by energy producers and consumers. 1 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law , 124 Stat (2010). The text of the Dodd- Frank Act may be accessed at OTCDERIVATIVES/ index.htm. 2 See Gramm-Leach-Bliley Act, Pub. L. No , 113 Stat (1999) (codified as amended in scattered sections of 12 U.S.C. and 15 U.S.C.). 1

3 Why Producers and Consumers Hedge Currently, most consumers and producers of energy use hedges like insurance, as a way to mitigate risk from price changes. Producers want to hedge against price drops, so they tend to swap floating prices for a fixed price. The effect is that they are paid from hedges when the price drops below the fixed price and will make payments when the price is above the fixed price. These payments run contrary to the ebb and flow of revenues from the sale of production, so that even when prices and revenues drop, producers can count on a minimum level of cash flows from their hedges. When prices and revenues are high, hedge payments are an expense that reduces profits. Energy consumers, by contrast, feel the impact of fluctuating energy prices in their costs. They would like to hedge against price increases, so that they are paid from hedges when the price rises above the fixed price and are willing to make payments when the price drops below the fixed price. There are many intermediaries between energy producers and consumers through the market, but ultimately producers and consumers are on opposite sides of energy price risk, which is transferred through these hedges. How Producers and Consumers Hedge Historically, energy producers and consumers have tended to hedge with their banks in OTC transactions, and the OTC market consists largely of transactions among banks and energy producers or consumers. This was confirmed recently when confidential data compiled by the CFTC was leaked by Senator Bernie Sanders to the Wall Street Journal, which reported that, on June 30, 2008, more than half of the OTC crude oil contracts were held by banks and four out of five crude oil contracts were held by either banks or energy producers and consumers. 3 By hedging with banks in OTC transactions, energy producers and consumers can use hard assets as collateral for debt financing as well as for hedges. If they were to use an exchange, they could not use hard assets to secure their hedges, but instead would be required to use liquid assets like cash or letters of credit, which could be a major drain on liquidity. The mechanics of posting initial margin collateral and then adding or subtracting variable margin collateral also requires management time and attention to administer. On the producer side, when price of the energy they produce increases, so do their hedge liabilities, which would draw away liquid assets for margin accounts at the same time that companies would like to deploy capital to increase production. For these reasons, energy producers and consumers would prefer to avoid using cleared exchanges. The Dodd Act threatens to change this by requiring that many of these OTC hedges be cleared or requiring that margin be held by one of the parties involved even if not cleared. However, as explained below, the final chapter on this subject has not yet been written. Dodd-Frank Act The commercial end user exception is a part of a very large law that was promulgated after several marathon negotiation sessions. In early summer 2010, the Conference Committee, a temporary panel of House of Representatives and Senate members, faced the challenging task of reconciling the version of the bill passed in December 2009 by the House with the Senate version passed in May The two versions differed in many ways, and each version contained lengthy and arcane provisions. During the process, numerous provisions were moved around and revised, and in the rush to complete the bill, there was a great deal of confusion as to what had been agreed to and what the final text actually meant. The Wall Street Journal describes the result as follows: In the early hours of Friday, June 25 [2010], Democrats altered a key provision to the derivatives section of the financial overhaul bill. It has a completely different meaning depending on who you ask. Some believe the language would require all people engaging in derivatives to post margin, or more costs to engage in a deal. Others believe it would apply only to big banks and major derivatives dealers. The difference could swing billions of dollars in one direction or another. 4 This issue is important to the commercial end user exception to clearing because a significant reason to avoid clearing is to avoid posting margin. If the Act requires margin for OTC transactions, then there would be little purpose for the commercial end user exception to clearing, and dedicating liquid assets to collateral accounts would impose significant costs. 3 Ianthe Jeanne Dugan & Liam Pleven, As Oil Spiked, Many Traded, Wall St. J., Aug. 18, 2011, html. The numbers of contracts grouped according to type of buyer were as follows: Banks: 5.6 million, Energy Companies: 2.7 million, Airlines: 204,705, Hedge Funds: 884,663, Others: 938, Damian Paletta, Dodd, Lincoln Try to Quell Derivatives Fury, Wall St. J. Wash. Wire Blog (July 1, 2010, 10:13 AM), washwire/2010/07/01/dodd-lincoln-try-to-quell-derivatives-fury/. 2

4 The concern grew to such a level that Senators Dodd and Lincoln published a letter dated June 30, 2010, addressed to their counterparts in the House of Representatives, in which they tried to clarify the meaning of the statute: The legislation does not authorize the regulators to impose margin on end users, those exempt entities that use swaps to hedge or mitigate commercial risk. If regulators raise the cost of end user transactions, they may create more risk. It is imperative that regulators do not unnecessarily divert working capital from our economy into margin accounts, in a way that would discourage hedging by end users or impair economic growth. 5 Note that the letter quotes the statute s phrase hedge or mitigate commercial risk, which underscores the policy objective of creating some kind of test to determine which hedges are more like insurance against price volatility and which hedges are more like speculative investing. If the Act and its final regulations give effect to this letter, the impact of qualifying as a commercial end user will manifest itself through lower margin requirements in addition to the exception to clearing. Hedge or Mitigate Commercial Risk Statutory Language The starting point for the exception to clearing ( End-User Exception ), and the hedge or mitigate commercial risk discussion is Section 723(a)(3) of the Act, which amends 7 U.S.C 2 by inserting the requirement to clear swaps as follows: (h) CLEARING REQUIREMENT. (1) IN GENERAL. (A) STANDARD FOR CLEARING. It shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a derivatives clearing organization that is registered under this Act or a derivatives clearing organization that is exempt from registration under this Act if the swap is required to be cleared. Later in the same Section 2(h), the Act provides an exception to the clearing mandate as follows: (7) The requirements of paragraph (1)(A) shall not apply to a swap if 1 of the counterparties to the swap (i) is not a financial entity; (ii) is using swaps to hedge or mitigate commercial risk; and (iii) notifies the Commission, in a manner set forth by the Commission, how it generally meets its financial obligations associated with entering into non-cleared swaps. Item (7)(i), financial entity, is defined in the Act as follows: (C) FINANCIAL ENTITY DEFINITION. (i) IN GENERAL. For the purposes of this paragraph, the term financial entity means (I) (II) (III) (IV) (V) (VI) (VII) a swap dealer; a security-based swap dealer; a major swap participant; a major security-based swap participant; a commodity pool; a private fund as defined in section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80-b-2(a)); an employee benefit plan as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002); (VIII) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of The entities described in this list are or will be subject to extensive regulation and would not have the expectation of availing themselves of the commercial end user exception when entering into swaps OTC. Item (7)(ii) is the introduction to the hedge or mitigate commercial risk concept. Item (7)(iii) creates compliance duties on the part of commercial end users. 5 Damian Paletta, Dodd, Lincoln Try to Quell Derivatives Fury, Wall St. J. Wash. Wire Blog (July 1, 2010, 10:13 AM), resources/documents/dodd-lincoln-letter pdf. 3

5 For most energy producers and consumers, item (7)(ii) will decide whether they will qualify as commercial end users, because they are not in danger of being financial institutions, and the compliance requirements will be able to be satisfied, although with some level of cost. The Act does not define hedge or mitigate or commercial risk. The phrase also appears in the Act in the definition of major swap participant but is not defined there either.6 Hedge or Mitigate Commercial Risk Notice of Proposed Rule Making Under the Act, the Commodities Futures Trading Commission ( CFTC ) has primary regulatory authority over commodity swaps. 7 The CFTC has published Notices of Proposed Rulemaking ( NOPR ) for public comment before adopting final rules. The final rules may be different from that published in the NOPR, but are likely to directionally be similar. There are two notices of proposed rulemaking that discuss HMCR at length. 8 One relates to the definition of Major Swap Participant ( MSP ), which turns on the dollar volume of hedges and excludes hedges that HMCR ( MSP NOPR ). 9 The other relates to the commercial end user exception to clearing ( Commercial End User NOPR ). 10 Both NOPRs state that the CFTC intends to interpret the HMCR concept consistently in its application of the MSP rule and the commercial end user rule. 11 Both NOPRs elaborate on what is meant by HMCR. The MSP NOPR is nearly identical to the Commercial End User NOPR, which defines HMCR as follows: (c) For purposes of section 2(a)(7)(A)(ii) of the CEA and Sec. 39.6(b)(4), a swap shall be deemed to be used to hedge or mitigate commercial risk when: (1) Such swap: (i) Is economically appropriate to the reduction of risks in the conduct and management of 6 A major swap participant means any person who is not a swap dealer, and (i) maintains a substantial position in swaps for any of the major swap categories as determined by the [Commodities Futures] Commission excluding [ ] positions held for hedging or mitigating commercial risk... Dodd-Frank Act at 1663 (to be codified at 7 U.S.C. 1). 7 Dodd-Frank Act, 124 Stat. at 1672 (to be codified at 7 U.S.C. 2) Fed. Reg. 80,747 (proposed Dec. 23, 2010) (to be codified 17 C.F.R. pt. 19); 75 Fed. Reg. 80,174 (proposed Dec. 21, 2010) (to be codified 17 C.F.R. pt. 240) Fed. Reg. 80,174 (proposed Dec. 21, 2010) (to be codified 17 C.F.R. pt. 240) Fed. Reg. 80,747 (proposed Dec. 23, 2010) (to be codified 17 C.F.R. pt. 39) Fed. Reg. 80,174, 80,194 (proposed Dec. 21, 2010) (to be codified 17 C.F.R. pt. 240). a commercial enterprise, where the risks arise from: (A) The potential change in the value of assets that a person owns, produces, manufactures, processes, or merchandises or reasonably anticipates owning, producing, manufacturing, processing, or merchandising in the ordinary course of business of the enterprise; (B) The potential change in the value of liabilities that a person has incurred or reasonably anticipates incurring in the ordinary course of business of the enterprise; (C) The potential change in the value of services that a person provides, purchases, or reasonably anticipates providing or purchasing in the ordinary course of business of the enterprise; (D) The potential change in the value of assets, services, inputs, products, or commodities that a person owns, produces, manufactures, processes, merchandises, leases, or sells, or reasonably anticipates owning, producing, manufacturing, processing, merchandising, leasing, or selling in the ordinary course of business of the enterprise; (E) Any potential change in value related to any of the foregoing arising from foreign exchange rate movements associated with such assets, liabilities, services, inputs, products, or commodities; or (F) Any fluctuation in interest, currency, or foreign exchange rate exposures arising from a person s current or anticipated assets or liabilities; or (ii) Qualifies as bona fide hedging for purposes of an exemption from position limits under the Act; or (iii) Qualifies for hedging treatment under Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133); and 4

6 (2) Such swap is: (i) Not used for a purpose that is in the nature of speculation, investing, or trading; or (ii) Not used to hedge or mitigate the risk of another swap or securities-based swap, unless that other swap itself is used to hedge or mitigate commercial risk as defined by this rule or the equivalent definitional rule governing security-based swaps promulgated by the Securities and Exchange Commission under the Securities Exchange Act of These factors might be categorized in terms of type of risk and extent of risk. Type: Commercial Risk A major issue to sort through is the type of risk that HMCR will include as a valid risk. Under the Act, the risk must be a commercial risk. Black s Law Dictionary defines commercial as something that relates to or is connected with trade and traffic or commerce in general [and] all aspects of buying and selling. 13 This definition is broad and would include most hedges. The Commercial End User NOPR and MSP NOPR above gives six dimensions of the type of risk, each of which connects the hedge to a change in value of some aspect of the company s business. This is more descriptive than Black s Law Dictionary, but seems to be nearly as broad. Most hedges could fit within one of the six circumstances. The commentary to the MSP NOPR describes commercial risk as being necessary to the conduct or management of a person s commercial activities and elaborates that the determinative factor should be whether the underlying activity to which the swap relates is commercial in nature. 14 A footnote to this commentary tries to describe it another way, as hedges that produce gains or losses which will be offset by losses or gains in the entity s commercial activities, and hence the risks posed by the swap or security based swap to counterparties or the industry generally will be mitigated. 15 Perhaps there could be an implied materiality to these factors. It would seem like the hedge should relate to the major, or at least one of the main, commercial activities of the potential commercial end user. There might be an issue of correlation as well because many hedges intended for this category would not be an exact offset for a particular type of risk, and some will correlate better than others will. For the word 12 Fed. Reg. 80,747 (proposed Dec. 23, 2010) (to be codified 17 C.F.R. pt. 39(c)). Author s note: an extraneous or was deleted from the end of Clause (B) above to correct a mistake in the original NOPR. 13 Black s Law Dictionary 304 (9th ed. 2009) Fed. Reg. 80,174, 80,194 (proposed Dec. 21, 2010) (to be codified 17 C.F.R. pt. 240). 15 Id. at footnote 126. commercial to have meaning, it must not be so broad that it includes everything. For example, if commercial activity were defined as any activity involved with making money, then all hedges could be seen as relating to commercial risk. On this issue, there will surely be more guidance. This issue is likely to create some uncertainty at first, as hedging parties try to determine the types of risk and the types of hedges permitted to hedge that risk, but after some time one would hope that different industries could feel comfortable that certain types of hedges will hedge risk that is commercial for that industry. At that point, companies may not need to reexamine this analysis until there is a change in the nature of their business or a change in their hedging strategy. It would be helpful for the CFTC to publish a list of some of the clear commercial risks for certain businesses, and some of the types of hedges that prima facie address those risks. Extent of Hedging Even if the risks that are being hedged are of the commercial type, there will be an ongoing issue of whether the terms of the hedges are within the economic band of HMCR or whether all or part of them have crossed into the zone of speculation. According to the Commercial End User NOPR, the hedges will be deemed to HMCR if they (a) are not held for a purpose that is in the nature of speculation, investing or trading ( Purpose Test ) and (b) are one of the following: (i) economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise ( Economically Appropriate Test ) or (ii) qualify as bona fide hedging for purposes of an exemption from position limits under the Commodity Exchange Act ( Bona Fide Hedging Test ) or (iii) qualify for hedging treatment under Financial Accounting Standards Board Accounting Standards Codification Topic 815, Derivatives and Hedging (formerly known as Statement No. 133) ( Hedge Accounting Test ). In summary, companies must pass the Purpose Test, plus one of the other three tests. Purpose Test The Purpose Test is whether the hedges are held for a purpose that is in the nature of speculation, investing or trading. It is not clear what this test adds that is not included in the other tests. For example, it would seem strange to think about a company proving that their hedges are economically appropriate under the Economically Appropriate Test or that they fulfill the requirements of hedge accounting under the Hedge Accounting Test, but then have their hedges still be deemed for a purpose that is in the nature of speculation, investing or trading. The word purpose suggests that there is an element of intent or motivation, but it would not be realistic to think that the CFTC will make any attempt to sort through motives in addition to the other tests. In the absence of a real understanding of what the purpose test means, it could become meaningless, with the implication that it is always satisfied if one of the other three tests are satisfied. 5

7 Economically Appropriate Test To satisfy this test, the hedges must be economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise where the risks relate to the change in value of products or services involved with the business. 16 There is very little guidance on what economically appropriate means. The MSP NOPR explains that the phrase is also used in the bona fide hedge exception to position limit rule, but that rule does not explain what economically appropriate means either. The MSP NOPR also states that the phrase is used by the SEC in the rules dealing with security-based swaps as follows: The SEC preliminarily plans to interpret the concept of economically appropriate based on whether a reasonably prudent person would consider the securitybased swap to be appropriate for managing the identified commercial risk. The SEC also preliminarily believes that for a security-based swap to be deemed economically appropriate in this context, it should not introduce any new material quantum of risks (i.e., it cannot reflect over-hedging that could reasonably have a speculative effect) and it should not introduce any basis risk or other new types of risk (other than the counterparty risk that is attendant to all security-based swaps) more than reasonably necessary to manage the identified risk. 17 Without more guidance, this test remains somewhat subjective. The phrase reasonably prudent suggests that the SEC and CFTC might compare a company s hedging program to a standard of care established by reference to similarly situated companies. This might be possible if similarly situated companies have disclosed their hedging programs through public filings or through filings with the CFTC. However, this type of analysis could be very complicated because energy risk management takes into account physical purchases or sales of assets directly or indirectly related to the hedges and would include projections. Due to its subjectivity and uncertainty, it is likely energy producers and consumers will prefer to use other tests to prove HMCR. Bona Fide Hedging Test The HMCR analysis incorporates concepts from the position limits rule in the CEA, which was revised by the Dodd-Frank Act. That rule refers to the term bona fide hedges. To qualify as a bona fide hedge, such a transaction must be among the enumerated types and must: i. represent a substitute for transactions made or to be made or positions taken or to be taken at a later time in a physical marketing channel, ii. be economically appropriate to the reduction of risks in the conduct and management of a commercial enterprise, iii. arise from the potential change in the value of assets, liabilities or services involved with a person, iv. if it is a swap of a swap, reduce the risks of another swap that otherwise complies, v. comply with other referenced sections dealing with establishing and liquidating hedges, enumerated hedge transactions, and pass-through swaps and offsets. 18 Note that items (ii) and (iii) of the Bona Fide Hedging Test are very similar to the Economically Appropriate Test. For that reason, item (ii) of this test may create the same uncertainty as the Economically Appropriate Test. Unfortunately, none of the tests so far can be seen as a safe harbor until more guidance is given on their application. The remaining test, the Hedge Accounting Test, is the only test that includes detailed criteria for application; therefore, it stands in stark contrast to the other tests. Hedge Accounting Tests Under the Dodd-Frank Act guidance, companies are allowed to use current accounting rules to demonstrate HMCR and determine eligibility for the End-User Exception. Transactions would presumably qualify as HMCR if they qualified for hedge accounting treatment under Financial Accounting Standards Board Accounting Standards Codification Topic 815 ( ASC 815 ), Derivatives and Hedging (formerly known as Statement No. 133). ASC 815 treats hedge accounting as a privilege that a company must qualify to use. The privilege is the ability for a company to recognize the effective portion s gains or losses from the derivative and the hedged item in earnings in the same period. Due to this special accounting treatment, hedge relationships must meet extensive documentation requirements. In addition, companies must assess hedge effectiveness and measure hedge ineffectiveness on a continuous basis Fed. Reg. 80,174, 80,214 (proposed Dec. 21, 2010) (to be codified 17 C.F.R. pt. 240) Fed. Reg. 80,174, 80,195 at footnote 129 (Dec. 21, 2010) (to be codified 17 C.F.R. pt. 240). 18 Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law , 124 Stat (2010), Section 737(c). 6

8 But what does the CFTC mean by qualify for hedging treatment under ASC 815? The requirements for assessing hedge effectiveness under ASC 815 are not as arduous as operationalizing and implementing an ASC compliant hedging program at a company. The application of hedge accounting requires certain regression analysis and effectiveness assessments in addition to stringent documentation requirements. Companies looking to implement a hedging program to apply hedge accounting would potentially require new accounting policies, procedures, technological improvements and additional technical resources. While the proposed end-user exception guidance is not specific as to the definition of qualify, at a minimum certain documentation and effectiveness testing at inception and on an ongoing basis would be required. In addition, there are a number of scope exceptions for instruments and transactions that would not qualify as hedged item in a hedging relationship and therefore not qualify for hedging treatment under ASC 815. While implementation of hedge accounting requires significant effort, ASC 815 acknowledges that certain derivatives may be used as economic hedges and other purposes related to the entity s risk management exposures but not qualify for special hedge accounting. For instance, ASC 815 requires a company to disclose separately these non-qualifying positions in the notes to the financial statements. Interestingly, these economic hedges as described in ASC 815 are similar to the instruments described in the Economically Appropriate Test above whose criteria are more subjective and judgmental when compared to the application of hedge accounting under the stringent rules of ASC 815. In regards to the End-User Exception, all of a company s commercial risk mitigation activities may not always qualify as hedges under US GAAP accounting rules. Furthermore, certain companies may determine that the effort to comply with the stringent requirements of ASC 815 is too burdensome. Other companies may only qualify or pursue hedge accounting for certain but not all transactions in their portfolio. While their current hedge documentation would support HMCR eligibility for the hedged transactions, the company would need to look to other HMCR criteria to ultimately qualify for the End-User Exception for their entire portfolio. In light of the qualifying hurdles in ASC 815, companies should consider their current application and experience with hedge accounting when pursuing the End- User Exception. Notwithstanding the above, current derivative accounting guidance as promulgated in ASC 815 is under review by the US GAAP accounting standard setter (the Financial Accounting Standards Board ( FASB )) as part of a larger project to simplify and improve transparency of all financial instrument accounting and reporting. As part of this comprehensive project, there have been a number of proposals and tentative decisions discussed by the FASB around hedge accounting. Many of these proposals have been aimed at making hedge accounting more accessible and easier for companies to qualify. For instance and under current guidance, one of the criteria for qualifying for hedging accounting is that the hedging relationship is highly effective (i.e., highly correlated hedging relationship) in achieving offsetting changes in fair value or cash flows during the period that the hedge is designated. The FASB s proposal makes it easier for companies to qualify and maintain hedge accounting by easing the requirements from highly effective to reasonably effective. While not defined by the FASB proposals, presumably reasonably effective would be a lower threshold. Under the new relaxed proposals, companies that currently do not use hedge accounting may be motivated to consider implementing hedge accounting as part of their risk management framework. Companies with commodity trading portfolios can divide their transactions into three (3) distinct groups; namely, transactions which: 1. Do not qualify for hedge accounting. 2. Qualify for hedge accounting. 3. Could potentially qualify for hedge accounting, but the Company decided not apply this accounting treatment. Do not qualify for hedge accounting Given the fact that certain transactions at a Company do not qualify for hedge accounting using ASC 815, these transactions will not qualify as HMCR using the ASC 815 method. ASC 815 is considered one of the most complex standards ever published by FASB. Due to the breadth and complexity of the guidance, companies often require extensive systems and technical resources to meet the requirements of ASC 815. In general these criteria include (but are not limited to) formal documentation of the companies hedging relationship, risk management strategy and objective, and ongoing effectiveness testing to determine if the hedging relationship is highly effective. Company specific circumstances often create challenges to meet these various hurdles. For instance, a certain natural gas producer, located in West Texas, hedges its natural gas inventory. To hedge the fair value exposure of its natural gas inventory, the company sells natural gas futures contracts, in an amount equal to the company s current inventory, on the New York Mercantile Exchange (NYMEX). The NYMEX futures prices are based on delivery of natural gas at the Henry Hub gas collection point in Louisiana. Although probably highly correlated, the price of company s natural gas inventory in West Texas and the price of the natural gas that is underlying the futures the company sold will differ as a result of regional factors (i.e., location, pipeline, or transportation cost, and supply and demand). ASC 815 does not permit the company to assess effectiveness based solely upon the change in the price of natural gas delivered to the Henry Hub. Rather, 7

9 it must consider the correlation of the change in the price of natural gas at the Henry Hub with the change in natural gas prices in West Texas. The difference between prices of natural gas at the Henry Hub and prices of natural gas at the West Texas location (the basis difference ) creates ineffectiveness that must be measured and reflected in earnings. If the change in the difference is significant during any period, it could result in the disqualification of the futures contract as an accounting hedge. As mentioned above, the FASB s proposed hedging guidance would more easily accommodate hedges that have these basis differences (different locations, different dates, etc.). In instances where a company fails to meet ASC 815 criteria or if the ASC 815 criteria ceases to be met during the lifetime of the transaction, the privilege to apply hedge accounting ceases and the company would recognize income or loss as it occurs without consideration of the change in value of the related exposure. Qualify for hedge accounting If a Company s transactions qualify for hedge accounting under ASC 815, they should consider applying the End-User Exception using the ASC 815 qualification. This would allow Companies to leverage their current hedge documentation to support the HMCR designation. Qualify for hedge accounting, but choose not to use Of the three distinct groups into which transactions fall, this scenario is the most interesting and provides the most fodder for discussion. This scenario applies to companies that have transactions that would qualify for hedge accounting, but the companies elect not to apply hedge accounting; however, these companies might now consider using the ASC 815 qualification in order to characterize these transactions as HMCR. Generally speaking, Companies may choose not to apply hedge accounting to its transactions for a variety of reasons, such as: Analysis Upon review of 10-K filings for 42 Utility companies, and 23 Independent Oil & Gas and Midstream companies, a view of the application of derivative and hedge accounting across the energy industry starts to come into focus. Specifically, 83% of the reviewed Utility companies were found to apply hedge accounting for some portion of their hedging activities, and conversely, 70% of reviewed Independent Oil & Gas and Midstream companies were found not to apply hedge accounting. From the perspective of the companies that do not apply hedge accounting, it is not immediately clear from their disclosures if some of these companies transactions qualify for hedge accounting, but the respective companies have elected not to apply it. Given the preponderance of Independent Oil & Gas and Midstream companies that do not apply hedge accounting it appears that this particular class of organizations could not readily rely on the ASC 815 method to qualify for the End-User Exception without performing hedge effectiveness assessment, at a minimum. The following two tables show the results of this 10-K analysis regarding whether or not Utility Companies, and Independent Oil & Gas and Midstream Companies make use of hedge accounting for certain transactions within their respective business organizations. Application of Hedge Accounting Independent Oil & Gas and Midstream Companies 30% 70% No. Yes. Independent Oil & Gas and Midstream Source: 10-K forms for the year ending 2010 filed by firms with SIC Code 1311 ( Crude Petroleum and Natural Gas ) with annual revenues of $1 billion or greater. 1. Companies find the reporting requirements associated with hedge accounting to be too burdensome to maintain. There may be certain components of a Company s portfolio that would qualify for hedge accounting treatment and the Company would realize some benefit; however, since the entire portfolio would not benefit, the Company may elect to forgo the hedge accounting benefit due to the perceived burdensome requirement with which it would then have to comply. 2. Risk of transactions falling out of hedge effectiveness due to various reasons, which could result in having to apply fair value accounting rules to the transaction; thereby, resulting in income statement volatility for the organization, and negating the benefit of using hedge accounting. Application of Hedge Accounting Utilities 83% 14% 3% No. No significant commodity derivatives. Yes. Utilities Source: 10-K forms for the year ending 2010 filed by firms with SIC Code 4911 ( Electric Services ), SIC Code 4931 ( Electric and Other Services Combined ), SIC Code 4932 ( Gas and Other Services Combined ), or SIC Code 4939 ( Combination Utilities NEC ) and with annual revenues of from $1 billion to $10 billion. 8

10 Conclusion After examining these tests, more questions than answers remain. If the final rules give detail and substance to the nonaccounting tests, it would appear that most independent oil and gas companies would prefer the non-accounting tests rather than incurring the expense of fulfilling the requirements of complying with hedge accounting, and risking that the basis differential between the hedged price and the sale price of their physical product grows too large to allow for hedge accounting. If, however, the non-accounting tests are viewed as subjective and uncertain, these companies will be incentivized to look closely at their hedging programs to see if it is possible to comply with hedge accounting, as well as what the cost will be. Utilities, by contrast, appear to have more options. Public filings show that many of these companies already use hedge accounting, which suggests they may be able to avoid the uncertainty of the application of the non-accounting tests and rely on their existing hedge accounting as a means to prove HMCR. It may be inferred then, that these rules will strike these different energy industries in different ways. One area of further inquiry might be to consider the factors why the different industries have taken a different approach to hedge accounting, and whether those factors would be relevant to the non-accounting tests as well. For example, it may be the case that the basis differential risk is lower for utilities than for oil and gas companies. If gas-fired power plants tend to price physical gas purchases and physical electricity sales according to indexes that tightly correlate with their financial hedges, then there would be low basis differential risk and therefore low risk of failing the hedge accounting analysis. Conversely, oil and gas companies may have less correlation between their physical transactions and the financial hedges. Using the example above, if a company sells physical natural gas in West Texas, but has Henry Hub financial hedges, the price difference between the two will fluctuate, and may change enough to mean that the hedge is no longer highly effective under the accounting rules. Would that lower level of correlation be a problem under the non-accounting tests? It seems that the correlation issue would be very relevant for considering whether the financial hedge is a substitute for a physical transaction under the Bona Fide Hedging Test, for example. If there is poor correlation, then it is not really a substitute, is it? Similarly, when considering whether the financial hedges are economically appropriate it would seem that a tight correlation suggests that they are more economically appropriate and a poor correlation would suggest that they are less economically appropriate. It is worth noting the practical implications of whether companies will use hedge accounting or non-accounting standards for this analysis. Regulators, primarily the CFTC, would take comfort in knowing that a third party accounting firm audited the application of a robust hedge accounting methodology to financial transactions, especially in contrast to the idea of trying to audit the hedge programs of commercial end users themselves. Financial institutions similarly will be faced with the task of monitoring their counterparty s compliance, and presumably would prefer independent attestation. If the reasonably effective concept described above has any potential to be a standard that independent oil and gas companies would follow (as opposed to the current highly effective standard that our survey shows 70% do not follow), while satisfying the desire of the regulators, and the regulated, to have a robust and objective methodology that gives more certainty to compliance, then perhaps it is worth exploring in more detail. There are large dollar amounts of hedges and financings that will be profoundly affected by the HMCR designation. This is a complicated area that mixes law, accounting and finance subjects. In the coming weeks and months, the regulations will be finalized. All the stakeholders involved, including the regulators, financial institutions and companies that produce or consume energy, will work towards preserving the commercial end user exception as a viable way to separate the companies that use hedges like insurance from the trading firms for which the bulk of the regulations are intended. It is also in everyone s interest to find a way of doing so with objective standards that give clarity and certainty of outcome. For more information, please contact: Jeff Nichols Haynes and Boone, LLP jeff.nichols@haynesboone.com Johnny Molina Ernst & Young LLP johnny.molina@ey.com 9