Risk management is an important part of any business, especially in the oil and gas industry. Because oil and gas is a commodity, one significant risk that oil and gas producers have to deal with is the risk related to the price of that product. There are many strategies that producers use to deal with this risk. One strategy is to enter into agreements called derivative instruments or hedge agreements. These agreements might be a swap agreement, where the producer pays or receives amounts based on the difference between the “hedged” price and a market price from NYMEX or another index. Another strategy is to enter into what’s called a costless collar arrangement, where call and put options are used to create a net-zero effect on commodity price and reduce downside risk.
Regardless of how a company chooses to deal with the risk of price fluctuation, any time derivative instruments or hedging agreements are present the next question becomes, “How do I account for these?”.
How Do I Account for Hedging Agreements?
Accounting standards require that if these arrangements are designated as “hedges” by an entity, and function as such, they are recognized on the balance sheet at fair value, but any unrealized gains or losses associated with the arrangements are deferred through accumulated other comprehensive income on the financial statements.
As an example, think of a hedging swap agreement. Every month, the hedge agreement price is compared to an index price, and the difference is paid to or paid by the company, depending on where the agreement price fell in relation to the index price for that month. However, the agreement can run from one to two or even three years. Thus, until the agreement is finished, there’s always what’s called an “unrealized” portion that might be based on futures prices, again from an index like NYMEX. As each month is “realized,” the gain or loss hits the bottom line through the income statement, but what remains going forward still has value. Current futures prices might dictate that the Company has an asset and an unrealized gain through other comprehensive income if their hedge price is better than the futures prices. Conversely, if the company’s hedge price is less than the futures prices, a liability will be recorded as well as an unrealized loss through other comprehensive income. The objective is to reduce earnings volatility by more closely matching gains or losses from a derivative with the underlying item being hedged (usually production revenue in this case).
As if This Weren’t Complex Enough…
An entity can elect NOT to designate its derivative instruments as hedges. If this occurs, the fair value is still recorded on the balance sheet, and the realized gain is still recorded on the income statement, but the unrealized gain is now also recorded as a current period gain or loss rather than being deferred through other comprehensive income. In this instance, the gains or losses from the derivative are recorded in the current period regardless of when the gains or losses on the underlying item being hedged are realized.
As you can see, hedging transactions and derivative agreements can create complex accounting and disclosure requirements. However, these arrangements can effectively mitigate risks related to commodity price and thus can potentially be an essential component of GAAP financial statements for oil and gas producers.
Wrapping up our series on GAAP for the oil and gas industry, our last blog will discuss financial statement disclosures commonly seen in the oil and gas industry and what they might mean for your company’s financial statements.
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Hall, Kistler & Company has been helping producers in the oil and gas industry since we opened our doors in 1941. We know what it takes to produce proper GAAP financial statements for oil and gas companies and can provide guidance along the way. Let us help when you are coming off of the sidelines and BACK INTO THE GAME.