FASB Definition of a Derivative Determination of an Underlying When a Commodity Contract Includes a Fixed Element and a Variable Element

FASB: Definition of a Derivative: Determination of an Underlying When a Commodity Contract Includes a Fixed Element and a Variable Element

Derivatives Implementation Group

Statement 133 Implementation Issue No. A11

Title: Definition of a Derivative: Determination of an Underlying When a Commodity Contract Includes a Fixed Element and a Variable Element
Paragraph references: 7, 29(g)(2), 57
Date cleared by Board: June 28, 2000
(Revised September 25, 2000)

QUESTIONS

  1. Is a commodity contract between two parties to transact a fixed quantity at a specified future date at a fixed price (such as the commodity's forward price at the inception of the contract) a derivative, assuming that the characteristics of notional amount, underlying, and no initial net investment are present and the commodity to be delivered is readily convertible to cash pursuant to paragraph 9(c)?
  2. Is a commodity contract between two parties to transact a fixed quantity at a specified future date at whatever the prevailing market price might be at that future date a derivative, assuming that the characteristics of notional amount, underlying, and no initial net investment are present and the commodity to be delivered is readily convertible to cash pursuant to paragraph 9(c)?
  3. Commodity contracts commonly have features of both fixed-price contracts and floating-price contracts, such as an agreement to purchase a commodity in the future at the prevailing market index price at that future date plus or minus a fixed "basis differential" set at the inception of the contract. Assume that the characteristics of notional amount, underlying, and no initial net investment are present and the commodity to be delivered is readily convertible to cash pursuant to paragraph 9(c).
    1. Is this type of mixed-attribute contract a derivative?
    2. If this type of mixed-attribute contract is a derivative, can it be designated as the sole hedging instrument in a cash flow hedge of the anticipated purchase or sale of the commodity?

BACKGROUND

An example of a commodity contract containing features of both fixed-price contracts and floating-price contracts is a transaction between a buyer and seller of crude oil. The buyer is a refinery that seeks to use the crude oil in the production of unleaded gasoline. The buyer agrees in January to buy 1,000,000 barrels of a specific type of crude oil in July from the seller at the July 1 West Texas Intermediate (WTI) index price plus $1.00 per barrel. The contract appears to be primarily a floating price contract, but includes a fixed margin above that price. (If the buyer or the seller no longer wants exposure to fluctuations in WTI between January and July, it will separately use the futures market to "fix" the WTI portion of the contract.)

The fixed $1.00 differential is commonly referred to as the "basis" differential, but it reflects multiple factors, such as timing, quality, and location. If not fixed, the basis differential can be very volatile, because it captures the passage of time (a financing element), changes in relative value of different qualities (or grades) of crude to each other (light v. heavy, sweet v. sour), and changes in the attractiveness of locations from the central pricing hub (Cushing, Oklahoma) relative to each other factor. Supply and demand is a critical factor in influencing the changes in basis due to quality and location; for example, an increase in imports of light crude through the Gulf of Mexico corridor will tend to lower the basis differential for light crude (falling prices due to increased supply) and tend to direct domestic supplies of light crude to northern U.S. locations (because the foreign oil fills southern U.S. demand), lowering the basis differential for contracts calling for delivery at northern points (again due to increased supply in the North). The basis differential therefore is not a simple fixed "transport" charge, but rather a complex and volatile variable in itself. For this reason, energy traders may specialize solely in "trading basis" and seeking the most attractive differential at all times relative to WTI-fixing and unfixing basis by selling contracts back to counterparties or entering into offsetting contracts with third parties.

RESPONSE

Question 1

Yes, the fixed-price commodity contract is a derivative instrument because it meets all the criteria in paragraph 6, including having an underlying (namely, the price of the commodity), as required by paragraph 6(a)(1). The contract's fair value will change as the underlying changes because the contract price is not the prevailing market price at the future transaction date.

A party to this contract would need to determine if the "normal purchases and normal sales" exception in paragraph 10(b) applies to the contract.

Question 2

Yes, the variable-price commodity contract is a derivative instrument because it meets all the criteria in paragraph 6, including having an underlying (namely, the price of the commodity), as required by paragraph 6(a)(1). However, because the contract price is the prevailing market price at the future transaction date, the variable-price commodity contract would not be expected to have a fair value other than zero.

A party to this contract would need to determine if the "normal purchases and normal sales" exception in paragraph 10(b) applies to the contract.

Question 3A

Yes, the whole mixed-attribute contract is a derivative because the basis differential is a market variable in determining the final transaction price under the contract, and this variable has been fixed in the contract, producing an underlying. (If the differential was a market pricing convention that typically would not be expected to change, the contract would be a derivative with very minor, if any, fluctuations in fair value.) The fact that the base commodity price in the contract is a floating variable will help to mute the fluctuations in fair value of the contract as a whole, but there still will be potential changes in fair value of the overall contract because of the fixed-basis element.

A party to this contract would need to determine if the "normal purchases and normal sales" exception applies to the contract.

Question 3B

Typically not. Since that mixed-attribute contract has an underlying related solely to changes in the basis differential, that contract (as a derivative) would generally not be sufficiently effective if designated as the sole hedging instrument in a cash flow hedge of the anticipated purchase or sale of the commodity-a forecasted transaction whose variability in cash flows is based on changes in both the basis differential and the base commodity price.

Because its underlying relates solely to changes in the basis differential, the mixed-attribute contract would essentially be hedging only a portion of the variability in cash flows. The entity is not permitted to designate a cash flow hedging relationship as hedging only the change in cash flows attributable to changes in the basis differential. Paragraph 29(g)(2), as amended by FASB Statement No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, states that if the hedged transaction is the forecasted purchase or sale of a nonfinancial asset, the designated risk being hedged must be either foreign exchange risk (which does not apply in this example) or "the risk of changes in the cash flows relating to all changes in the purchase price or sales price of the asset reflecting its actual location if a physical asset (regardless of whether that price and the related cash flows are stated in the entity's functional currency or a foreign currency), not the risk of changes in the cash flows relating to the purchase or sale of a similar asset in a different location or of a major ingredient." That paragraph permits no other bifurcation of risk in designating the hedged risk. For an entity to be able to conclude that the hedging relationship proposed in Question 3B (in which the mixed-attribute contract (as a derivative) is the sole hedging instrument in a cash flow hedge of the anticipated purchase or sale of the commodity) is expected to be highly effective in achieving offsetting cash flows, the entity would need to consider the likelihood of changes in the base commodity price as remote or insignificant to the variability in hedged cash flows (for the total purchase or sales price).

However, the mixed-attribute contract may be combined with another derivative whose underlying is the base commodity price, with the combination of those derivatives designated as the hedging instrument in a cash flow hedge of the overall variability of cash flows for the anticipated purchase or sale of the commodity. Such a combination would address the risk of changes in both the basis differential and the base commodity price.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.