Commodity Price Risk Hedging: Lurking Risks You Should Know
The treasury department of an organization is often responsible for mitigating foreign currency, interest rate and commodity price risk. Most of the derivatives used to manage that risk are negotiated by Treasury … but this is not always the case for commodity risk management.
Frequently, purchasing departments or facilities departments are executing contracts the FASB wants treated as derivatives.
At many companies, commodity price risk is obvious and a key element of revenue and/or costs. For example, companies that are focused on buying and/or selling energy, agricultural goods or metals expect that the price of their goods will fluctuate, impacting margins and future cash flows. But other times, commodity risks are lurking in the background, and treasury may not be aware of them.
Take a typical manufacturing company that uses large amounts of energy (electricity or natural gas) as an input into production. The purchasing department generally acquires energy by paying the market rate as they go. Or, they might agree to purchase a certain amount of energy (or all of their energy needs at one plant) at a fixed price for a fixed time period. This way, they might achieve a lower average cost or at least have a good idea of what the cost of energy will be for the next one, two or three years. However, this method of fixed price contracts comes with some risks.
The Risk of Fixed Price Commodity Contracts
When a purchasing contract includes certain characteristics, it will meet the definition of a derivative under ASC 815. If the contract is deemed a derivative, then the contract must be placed on the balance sheet at fair value with an offsetting entry to P&L. This means that each period, changes in commodity prices will impact earnings, creating unwanted income volatility.
There are two risks here. First, if the purchasing group enters into a fixed price commodity contract that meets the definition of a derivative (and most do), but the company fails to identify it, then there is a control weakness. This is because all derivative instruments were not identified, and the risks increase as the financials are now incomplete, having failed to capture the balance sheet and income statement elements of the “derivative”. The second risk is that the contract is identified and accounted for correctly, but treasury, unaware of the transaction, was unable to mitigate the associated volatility risk in the income statement.
So, how do you know if a fixed price commodity contract will be deemed a derivative? Well, a contract meets the definition of a derivative under ASC 815 if it has all of the following characteristics:
- An Underlying Price
- A Specified Amount (or Minimum)
- Little or No Initial Net Investment
- Permits Net Settlement
Please note that items 1-3 look very much like any standard purchase order. A typical contract has a price and a quantity. They also do not usually cost anything to enter into (no large deposit or cash with order). What separates most contracts from becoming a derivative is the last requirement: Net Settlement. Net settlement is the ability to settle up in dollars any difference between the contracted price and the current price for all or any an unused portion of the contracted volume.
If a company decided it didn’t need all of its committed purchases of natural gas, there may be a liquid market to re-sell the entire contract volume or the unused portion by paying the counter-party the difference between today’s price and the fixed price. Net settlement can be an explicit clause in the contract or derive from the ability to readily sell any excess volume back into the market.
For example, there is a large and liquid natural gas market at Henry Hub in Louisiana and there are futures contracts trading natural gas indexed to that location. Therefore, any fixed price natural gas contract involving delivery at that location would meet the definition of net settlement, even if there wasn’t a specific net settlement clause in the contract.
Normal Purchase Normal Sale Scope Exception (NPNS)
Fear not! If you can identify a fixed price contract that meets the definition of a derivative, there is a way to prevent it from impacting your earnings if the goods are expected to be used as a standard part of the business. It’s called the Normal Purchase Normal Sale (NPNS) scope exception. Just like meeting the definition of a derivative, if it also meets the following criteria, it can be scoped out of derivative accounting by jumping through a couple of hoops.
To qualify for the exception, the contract must meet the following criteria:
- Normal Terms and Quantity – Is the commodity purchase contract for a normal quantity used in your business?
- Clearly and Closely Related Underlying – Are the contracted commodity price and price changes closely related to the commodity price in the marketplace? (e.g. natural gas contract price changes to your location are related to NYMEX natural gas prices)
- Probable Physical Settlement – Do you expect to take delivery of ALL of the commodity quantity purchased?
- Documentation – Have you prepared the contemporaneous documentation designating the contract as a Normal Purchase or a Normal Sale?
If the fixed price commodity contract meets all four criteria, then the contract will be considered a “Normal” purchase contract or a “Normal” sales contract and is exempt from the requirement to mark to market the contract. It’s a good idea to meet with the purchasing department at least semi-annually to cover any potentially risky contracts. Purchasing departments are not always aware of the accounting rules that must be followed, so there is a risk something could be missed.
Note: Simply documenting a contract as NPNS isn’t the end of it. There are actions that can taint the designation from an accounting perspective.
For example, if purchasing decides to sell any unused portion of the commodity back to the counter-party or into the larger market, then the contract would run afoul of the NPNS physical settlement requirement. Auditors may no longer trust the company to meet this requirement and may ask the company to treat all similar contracts as derivatives, impacting both balance sheet and P&L. Careful monitoring of fixed price contracts and compliance with NPNS requirements are key to keeping them off of your financial statements.
For more help with your commodity price risk hedging, click here.