Structured Transaction White PaperEmbedded Derivatives in Structured Transaction Energy Contracts

Phillip Green, Senior Business Analyst, ConsultantDerivatives Trading Desk©®™

STRUCTURED TRANSACTION ENERGY TRADING CONTRACT

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:

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 gas within the shales, and also the permeability of the shale. Companies like Schlumberger and Halliburton are pioneers in this field. Aramaco provides the forecasts to prospective lease purchasers and use them as valuation of lease agreement terms.

The forecast is a tool utilized by prospective gas well lease purchasers to assess potential extraction capacities and inherent revenue from oil and natural gas extractions. These lease 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 the extraction 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 attain discounts with lease purchases deemed “wildcatting”, (an oil or natural-gas well drilled speculatively in an area not known to be productive).

Economic projection gas prices are based upon NYMEX strip prices (average of the daily settlement 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.

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.

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.

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 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%

Therefore, the notional = gross gas production purchased for re-sell minus margin.

We can arrive at a notional calculation using the following attributes:

Underlier – Natural gasNotional 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 in the purchase or sale contract.

No initial investment. No (or small) investment at inception. No initial net investment or a smaller investment than required to own the underlying. Criteria met for derivative definition. Contract agreement is riskless for Energy trading company.

The notional amount and underlying determine settlement amount.

The contract has a pricing formula other than the market price of the natural gas itself.

Notes:

Embedded derivative must be separated from the host contract, recorded at “fair value” and accounted for separately in the balance sheet (bifurcation)

Natural gas spot prices – pegged on Henry Hub, Louisiana (NYMEX Natural Gas Futures Near-Month Contract Settlement Price)

Henry Hub spot prices are reported in dollars per million Btu.

New York City Gate Spot

Natural Gas ($/MMbtu)

Natural Gas spot price – represents natural gas sales contracted for next day delivery and title transfer at the Henry Hub Gas Processing plant.

©2009 by Phillip Green,Senior Business Analyst, Consultant Derivatives and FAS 133 Hedge Effectiveness TestingEnergy Trading Risk ManagementDerivatives Trading Desk©®™