Teaching Notes

This case is based on a hypothetical option on futures transaction entered into by a natural gas producer to hedge its exposure to commodity risk. The purpose of this case study is to expose the student to the competitive and innovative nature of the energy industry and to address the proper accounting methods for derivative instruments. This case also presents a detailed analysis of the risks involved and how to identify and quantify them. Upon completion of the case requirements, the student will be able to examine the effects of futures options and various option packages on the financial statements.

This case enables the student to evaluate and recommend a hedging strategy for a troubled company. The objectives of this case are met through a series of logical, thought-provoking questions. In examining the futures option and option packages, three alternatives are provided allowing the student to choose the most profitable strategy. These alternatives provide the student with a sensitivity analysis to measure the risks of each contract as the strike price of the option changes.

The case is appropriate for an advanced accounting course related to derivative transactions. It may serve as a useful tool to present the student with a comprehensive problem that is comprised of accounting and reporting for various types of financial instruments.

Solution #1

Strategic Uses of Options

Insurance against falling prices for an energy seller: a seller of energy can buy puts or floors as insurance protection against undesirably low energy sales. The put/floor buyer should have reasonable expectations that prices have the ability to rise. The put/floor allows the user to benefit from price increases while still protected against falling prices.

Insurance against rising prices for an energy user: a user of energy can buy calls or caps as insurance protection against undesirably high energy costs. A call/cap buyer should have reasonable expectations that prices have the ability to decline. The call/cap allows the user to benefit from price declines while still protected against rising prices.

See entire discussion on Futures Option in the Introduction.

Put Option on Futures: Purchasing a put gives you a specific locked-in price at which you have the right, but not the obligation, to sell a futures contract on a commodity that you expect to decrease in value. Consequently, if you look for the price of natural gas to decrease, you would buy a natural gas put option.

Buying (Long) a Put: A put buyer profits when prices fall with respect to the strike price. Above the strike price, the put has no exercise value, but the buyer has a sunk cost in the premium paid up front. (see graph)

February 1, 1997 - Burns Energy Associates should purchase a put option on July 1998 natural gas futures at a strike price of $1.170/MMBtu. The company expects prices to decline in the natural gas market.

June 31, 1998 - Prices have declined dramatically since then, and the option has now been exercised. The company sells natural gas futures at the February 1 strike price of $1.170/MMBtu when July futures are trading at $0.950/MMBtu.

The following calculations do not provide for the premium that must be paid up-front in order to enter into the contract. Premium computations will be demonstrated in later questions.

The company receives the difference as a result of the transaction:

$1.170/MMBtu X 4,000,000 MMBtu = f$4,680,000

$0.950/MMBtu X 4,000,000 MMBtu = ($3,800,000)

xx$ ,880,000

June 31, 1998 - Prices have declined dramatically since then, and the option has now been exercised. The company sells natural gas futures at the February 1 strike price of $1.120/MMBtu when July futures are trading at $0.940/MMBtu.

The company receives the difference as a result of the transaction:

$1.120/MMBtu X 4,000,000 MMBtu = f$4,480,000

$0.940/MMBtu X 4,000,000 MMBtu = ($3,760,000)

xx$ ,720,000

June 31, 1998 - Prices have declined dramatically since then, and the option has now been exercised. The company sells natural gas futures at the February 1 strike price of $1.240/MMBtu when July futures are trading at $1.025/MMBtu.

The company receives the difference as a result of the transaction:

$1.240/MMBtu X 4,000,000 MMBtu = f$4,960,000

$1.025/MMBtu X 4,000,000 MMBtu = ($4,100,000)

xx$ ,860,000

The calculations above demonstrate that the best option is the one that is exercised at the $1.170/MMBtu strike price. The company able to attain a greater profit potential ($880,000) with this strike in comparison to the other options. The premium that would be required at the start of the contract would be subtracted from the $880,000. For example, if the premium was calculated to cost Burns $15,000, the net profit would be $865,000.

Why invest in options on futures?

Mainly because they have a known and limited risk, options on futures have become an attractive investment for many firms seeking to profit from significant price movements in today's increasingly volatile and often uncertain investment environment. The holder of the option has the right, and not the obligation, to exercise the contract. Purchasing options on futures make it possible to realize a potentially substantial profit with a relatively small investment and with a known and limited risk. In order to purchase an option, the buyer must pay an up-front premium to the option writer at the inception of the contract. Under no circumstances can the loss exceed the cost of purchasing the option. Other advantages include:

• the leverage inherent in options
• the liquidity provided by established competitive option markets
• investment diversification
• the flexibility to follow the value of your investment on a day-to-day basis
• the staying power to weather temporary price setbacks without incurring additional risk or costs
• strict federal industry regulation to which options trading is subject
• freedom from the margin calls that many other investments are subject to, and
• the opportunity to realize profits during periods of declining prices as well as during periods of rising prices.

Two major advantages to using options instead of forward or futures contracts:

1. Options can be used to hedge cash flows that have a probability of occurring of less than 100 percent. If the cash flow does not materialize, the option can be left to expire.
2. If the price of the underlying exposed asset moves in favor of the option holder, the option need not be exercised.

Also, a uniform set of accounting standards has not been published to date regarding the accounting and disclosure of derivative instruments (excluding SFAS 52, 80, and 119). New hybrids of these contracts are entered into everyday by corporations, consequently, the FASB is experiencing difficulty formulating standards to cover all types of financial instruments. As a result, this situation of inadequate standards and limited disclosure requirements motivates companies to increase the number of transactions they enter into. As a result, this limited disclosure does not provide an adequate picture of the company's financial statements for its shareholders and investors.

Solution #2

A floor is a supply contract between a buyer and a seller of a commodity, whereby the seller is assured that he will receive at least some minimum price. The purpose for selling any option is to earn a premium. Energy companies can sell options against natural gas positions to either reduce fuel costs or increase sales realizations. A floor allows the seller of the commodity to receive at least a minimum set price should the prices move in an unfavorable direction.

Overview of the time value approach to premiums (this approach is used to simplify the calculation so that more time may be spent understanding the concepts):

Option premiums are comprised of two elements (Perry 43-44):

1. intrinsic value - the simple measure of how much an option is in-the-money, plus
2. time value - the more difficult measure of the value of the price insurance the option provides. The sophistication in option pricing models is directed at measuring the time value (the price of insurance) of the option.

Factors influencing time value (Arditti 67):

1. price curve - since options allow buyers to transact for possible forward delivery months, the level of forward prices is fundamental to establishing option value. The price curve provides those forward prices.
2. strike price - the level at which the strike price is set will determine the likelihood of the option going into-the-money. Out-of-the-money strikes will be cheaper than in-the-money strikes.
3. time to maturity - an option is a wasting asset. Each day the insurance (time) value of the option declines (all other pricing factors remaining unchanged). The pattern of decline is not constant. Time value decay accelerates at maturity is approached.

Calculations:

18-Month Floors Against the Permian Basin Index

1) Calculate the premiums to determine the per unit price of each floor:

A) Strike Price = 1.120; Floor Premium (Offer) = $3.390 MM

Time Value Approach (can be done using a financial calculator):

Compute PMT = $203,594

Total Premium Cost = $203,594

Premium Cost/MMBtu = $203,594/4,000,000/MMBtu* = 5.09¢/MMBtu

* information given in the case

B) Strike Price = 1.170; Floor Premium (Offer) = $5.340 MM

Time Value Approach (can be done using a financial calculator):

Compute PMT = $320,705

Total Premium Cost = $320,705

Premium Cost/MMBtu = $320,705/4,000,000 MMBtu = 8.02¢/MMBtu

C) Strike Price = 1.240; Floor Premium (Offer) = $7.098 MM

Time Value Approach (can be done using a financial calculator):

Compute PMT = $426,284

Total Premium Cost = $426,284

Premium Cost/MMBtu = $426,284/4,000,000 MMBtu = 10.7¢/MMBtu

 

2) Minimum Cost/MMBtu = Strike Price/MMBtu - Premium/MMBtu

* Burns earns 3¢ on the Permian Basin Index (information given in the case). If Burns has to pay a difference in basis on the index, then you would add the spread to the strike price since you would have to pay an additional 3¢ after the premium to enter into the contract.

3) Current Cost/MMBtu = Current Index Price/MMBtu - Premium/MMBtu

* Permian Basin index price at this time is 1.200 (information given in the case). In the third scenario, the index price is listed as 1.240 instead of 1.200. This occurs because the strike price is greater than the current index price, so your current cost calculation will start with your strike price.

The most profitable floor occurs at the 1.170 strike. The reason: this scenario provides the lowest current cost alternative that does not fall below the minimum $1.05/MMBtu all-inclusive set price as given in the case. Burns will have to pay a premium cost of $1.088/MMBtu right now (February 1, 1998) in order to lock-in the $1.058/MMBtu as the minimum amount it must receive in the future when it believes prices of natural gas are going to fall. This strategy is beneficial because the company cannot afford for prices to fall below $1.05/MMBtu; this measure is taken to manage and minimize risk of high loss in the future.

Solution #3

It is not appropriate for Burns to use caps as a risk management tool. A cap is a supply contract between a buyer and a seller, whereby the buyer is assured that he will not have to pay more than a given maximum risk. A purchased cap provides an energy user (not the producer as in this case) multi-period protection against increasing costs while still allowing the user to benefit from price declines. Caps are beneficial to the user (not the producer) against increases in the cost of purchasing (not selling) energy.

Solution #4

Potential option users often do not adopt option strategies because of the unwillingness to pay the up-front premium. Combined option structures that do not require a net premium are becoming more widely used as a risk management tool. One of the most common structures is the zero-premium (cost) collar. As a natural gas producer, Burns wants protection against falling prices in the market. Burns should buy a floor and sell a cap in order to create a zero-premium collar. Ordinarily, if Burns enters into a contract by purchasing a floor alone, the contract would require an up-front premium that Burns may not be able to pay. To offset the premium, Burns can also sell a cap. By setting the strike price appropriately, the premium earnings would equal the premium cost of the floor exactly. A collar has both a maximum price, a minimum price and a current price. An analysis of a collar should consider these three price parameters.

1) Calculate the premiums to determine the per unit price of each collar:

This zero-premium collar does not require an up-front premium to be paid. If the floor and the cap were not entered into simultaneously, a fee would have to be paid at the inception of each individual contract.

2) Minimum Cost/MMBtu = Floor Strike Price/MMBtu - Spread/MMBtu

3) Current Cost/MMBtu = Index Price/MMBtu - Spread/MMBtu

4) Maximum Cost/MMBtu = Cap Strike Price/MMBtu - Spread/MMBtu

The most profitable option for this company is Collar B. Collar C can be eliminated because the current cost/MMBtu is much higher than the current costs associated with Collars A and B. The goal is to find the collar that defines the highest amount that the company can potentially secure as the minimum cost that the producer will receive no matter what happens in the future. Burns does not want natural gas prices to fall below $1.05/MMBtu. With Collar B (as opposed to the $1.090/MMBtu with Collar A), Burns can lock-in to receive at least $1.140/MMBtu in the future when prices decline. Collar B provides for the maximum the buyer has to pay at $1.340/MMBtu. Selling the cap offsets the premium Burns had to pay at the inception of the floor option.

Solution #5

Risk is the exposure to the chance of injury or loss. Risks exist in today's natural gas market and they have an impact on every market participant's business regardless of their willingness and/or ability to recognize and deal with them.

Risks incurred by entering the financial transactions mentioned above for Burns Energy Associates are as follows:

1. Price Risk - Open price level exposure to changes in the natural gas market.
2. Basis Risk - Basis is the differential that exists at any time between the cash, or spot price of a given commodity and the price of the nearest futures contract for the same or a related commodity. Basis may reflect different time periods, product forms, qualities or locations. Basis risk is the uncertainty as to whether the cash futures spread will widen or narrow between the time a hedge position is implemented and liquidated.

Burns has contracted the Smithers Investment Group to develop a strategy to hedge against the possibility of a severe decline in the prices of natural gas in the market. Burns is hedging to protect themselves against price risk.

In the natural gas industry, transport (either physical or financial) of the commodity requires a company to understand and evaluate basis risk. Burns is a producer of natural gas and must take any differentials in the spot price of a given commodity and the price of the nearest futures contract for the same commodity. The uncertainty that surfaces from what Burns can sell gas for today versus the what Burns can sell gas for the same day two hours later is basis risk. Burns is also doing what it can to protect itself from basis risk exposure by locking-in a future price today through an options transaction.

Added information: Credit (Counterparty) risk is decreased significantly when dealing with options. Producers and consumers must pay an up-front premium when entering into an options transaction. Generally, this premium serves as a guarantee that the companies that enter into an option can afford to do so.

Why manage risk? Risk management reduces a company's exposure to injury or loss. Even if Burns decided not to manage risk or take the path of least resistance, this is an action that has future consequences to its business. A company is today's gas market is best served by understanding these consequences, both to itself and to the other market participants with which it does business, and managing its risks as economically as possible. Key concepts for Burns to keep in mind in understanding and managing risk:

1. Risk does not go away; it just gets shifted through various market mechanisms to those market participants more able or willing to bear it.
2. Mitigating risk and shifting it from one party to another has a cost associated with it. These costs born by the risk-avoiding party, can be direct fees such as market premiums or future opportunity costs.
3. There is a cost/benefit analysis that takes place which identifies when the cost of a particular risk-shifting mechanism is too high versus the benefit gained by shifting the risk to another party. Smithers needs to assist Burns in this area.

Asymmetrical risks - discussed previously in the introduction.

Solution #6

The requirements for an option to qualify as a hedge are similar to the determinants described in SFAS No. 80: Accounting for Futures Contracts (Perry 42). According to SFAS No. 80, two criteria must be met. First, "the item to be hedged exposes the enterprise to price risk." Here, risk refers to the sensitivity of a company's income for one or more future periods to changes in the market. Burns fulfills this requirement in that it wants to enter into these transactions to hedge against market prices declining in the future. Second, the contract must reduce that exposure to risk and must be designated as a hedge. The only difference is that risk assessments are made only on a transaction-by-transaction basis for an option. Also, this differs from foreign currency options and futures contracts used as hedges where the risk assessment is made on an enterprise level. The option contracts for Burns do attempt to reduce the exposure to risk and are designated as hedges in its books. Burns makes its risk assessments on an individual transaction basis as well. Under these terms, these transactions do qualify for hedge accounting. When determining the probability for high correlation (which is necessary to qualify for hedge accounting), the company should consider the correlation during relevant past periods and also the correlation that could be expected at higher or lower price levels. In this case, this is accomplished by utilizing the sensitivity analysis method for assessing risk.

Options can be used to hedge existing assets or liabilities, firm commitments, and anticipated transactions. For Burns, these options transactions qualify as cash flow hedges because they are hedges of a forecasted transaction. According to SFAS No. 80, "a contract may relate to transactions other than transactions involving existing assets or liabilities, or transactions necessitated by firm commitments. Entities often use cash flow hedges of forecasted transactions by using a derivative to "lock-in" or "fix" the price of the future transaction.

In accordance with the FASB Exposure Draft 162-B (Exposure Draft), the following criteria must be met in order for a hedge to qualify as a cash flow hedge:

1. Formal documentation of the hedging instrument, the specifically identified hedged forecasted transaction, and the nature of the risk being hedged should exist at the inception of the hedge.
2. The use of the derivative is consistent with the entity's established policy for risk management.
3. The derivative designated as the hedging instrument is not a written option.
4. The derivative is expected to have cumulative net cash flows that will offset substantially all of the changes in cash flows of the hedged transaction that are attributable to the risk being hedged.
5. The forecasted transaction is probable.
6. The forecasted exposure is a transaction--and external event involving an exchange with a third party.
7. The forecasted transaction is not the acquisition of an asset or the incurrence of a liability that will be measured at fair value subsequent to acquisition or incurrence with changes in fair value reported in earnings.
8. The hedge is not a fair value hedge.

In this case, these options transactions do satisfy the criteria above to be designated as a cash flow hedges.

Special note to qualification number four as listed in the Exposure Draft: "If a derivative designated as a hedge, such as a purchased option contract (as in this case), provides only one-sided protection against risk, the cumulative cash inflows from the derivative are expected to offset substantially the corresponding increased cash outflows (or reduced cash inflows) of the hedged transaction that are attributable to the risk being hedged." (See discussion on asymmetrical risks in the Introduction.)

Solution #7

According to the Exposure Draft, changes in the fair value of the derivative designated as a hedge of a forecasted transaction would be reported as a component of comprehensive income when the forecasted transaction was expected to occur. At that point, the cumulative gains or losses are recognized in earnings. In this case, the forecasted transaction is sales, the gains on the hedging instrument would be recognized in earnings when the sales are forecasted to occur. If the forecasted transaction is the receipt of cash from the sale, the hedging gains would be recognized in earnings when the cash was expected to be received. Also as with SFAS No. 80, the dollar amount of the item underlying the option (into which the option is exercisable) is not included in the company's balance sheet. For Burns, the items underlying the options are natural gas futures. This dollar amount would not be included in the company's balance sheet.

Accounting for Commodity-Based Contracts:

The Exposure Draft explains the following:

Contracts that permit settlement by delivery of a commodity, but that also can be settled for cash, should be included in the scope because those contracts often have characteristics similar to other derivatives, often are used interchangeably with other derivatives, and present risks similar to other derivatives. Previous statements excluded commodity-based contracts because those contracts required or permitted future of an item that is not a financial instrument.

Options on Futures Contracts fall into this category because these options give the holder the right to exercise them for futures contracts that allow for physical or financial delivery of commodities.

The Exposure Draft identifies four objectives in developing a hedge accounting approach for hedges of cash flow exposures:

1. Avoid the conceptual difficulty of deferring gains or losses on the derivative hedging instrument as assets or liabilities.
2. Assist financial statement users by making the deferred gains and losses visible.
3. Reflect the effectiveness of cash flow hedges.
4. Put some limitations on hedge accounting for cash flow hedges.

Deferring gains and losses on derivatives as a separate component of comprehensive income, rather than as a separate asset or liability, best meets the first two objectives. Recognizing deferred gains and losses in earnings on the projected date of the transaction best meets the last two objectives.

Journal Entries:

Accounting for the futures put option attached with a floor.

The underlying item of this contract is the natural gas futures. According to the Exposure Draft, this underlying item is not reflected on the balance sheet. Therefore, the first entry on the date of inception is a standard entry to record the premium as in the case of most options contracts.

Year-end adjustments are not necessary for options. In an options transaction, there is no amortization of the premium (FASB No. 80).

This loss recognition is deferred until the designated date of exercise. At the end of the year, the option is revalued using the method demonstrated in Solution 2 for the remaining six months to maturity. In the case of an unfavorable movement, losses on the purchased option are limited to the premium paid and generally does not offset gains on the hedged item. This is the case as described in the Exposure Draft for purchased options that may have gains to offset losses on the hedged item. Also, if this movement resulted in a loss, a debit to comprehensive income and a debit to the option would have been made. The Exposure Draft also states that "an entity report in other comprehensive income the changes in the fair value of a derivative that is designated as a cash flow hedge of a forecasted transaction and defer earnings recognition of the total amount of associated changes in fair value accumulated in other comprehensive income until the projected date of the forecasted transaction."

This entry records sales of the transaction that was forecasted. The futures position is not record on the books as directed by the Exposure Draft. The futures contract is not accounted for until the option is exercised into the futures position, thereby eliminating or ending the options contract. Once the futures contract is out of the underlying position of the option, it can be accounted for on the balance sheet.

The contract was exercised on this date, so the full amount must be recognized as a part of comprehensive income (Exposure Draft). This amount would be shown on the financial statements as a component of comprehensive income.

Solution #8

In accordance with the Exposure Draft, derivatives that are designated as cash flow hedges, the disclosure will include:

1. a description of the entity's risk management policy for such hedges, including a description of the forecasted transactions whose risks are hedged and the classes of derivatives used to hedge those risks,
2. the separate amounts for the reporting period of hedging gains and losses on the derivatives not recognized in earnings and a description of where those amounts and the related instruments are reported in the statement of comprehensive income and the statement of financial position,
3. the designated reporting periods in which the forecasted transactions are expected to occur and the deferred amounts to be recognized in earnings in those periods,
4. the amount of gains and losses on the derivatives recognized in earnings during the reporting period and a description of where those amounts are reported in the financial statements, and
5. the amount of hedging gains and losses included in other comprehensive income.

Burns Energy Associates should disclose its derivative transactions within the notes of its financial statements. By doing so, its shareholders and investors can obtain a more accurate picture of the company and its financial transactions.

Solution #9 - see Risk Analysis

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