A mark-to-market u-turn

A reversion to the old, non-mark-to-market regime for accounting for energy trading contracts is changing the energy supply business, reports Catherine Lacoursière

Accounting regulators in the US have given the energy industry an early Christmas present – a new ruling that eliminates mark-to-market (MtM) accounting for non-derivatives contracts, called EITF 02-3. For fiscal reporting after December 15, energy firms will fall in line with the rest of the corporate US and only be allowed to mark-to-market energy trading contracts that meet the generally accepted definition of a derivative.

Since 1998, the energy industry has had its own accounting rule for energy trading contracts, the controversial Financial Accounting Standards Board’s Emerging Issues Task Force (EITF) 98-10. Yet throughout its four-year life, the rule – which allowed energy firms to mark-to-market certain physically settled contracts such as tolling agreements, transportation and storage contracts, as well as financially settled ones – was hotly debated.

Its late-October repeal is equally controversial. The demise of 98-10 will not only affect how supply contracts are reported on financial statements but, in many cases, the underlying businesses as well.

Financial impact
The impact on financial statements is easily measured. If a firm has a lot of physically settled MtM accounting exposure on its books, the ruling could weigh down hard on the company’s net worth. The energy industry will no longer be able to mark energy contracts to market unless they qualify as a derivative under FAS 133, the US accounting rule governing the reporting of gains and losses related to derivatives contracts. Yet many energy firms have included MtM gains on physically settled contracts in their profits.

What’s more, under EITF 98-10, companies marked-to-market forecasts of profits and losses (P&L) reflecting multi-year energy contracts at the time the contracts were entered into. These unrealised, non-cash gains made up a large part of earnings for some firms. This practice is now shunned by many and widely blamed for leading to over-inflated earnings figures. As of December, energy companies are required to reverse out those P&L booked on contracts that do not meet the definition of a derivative under FAS 133. Broker-dealers also fall under the purview of the new ruling.

These contracts will now be reported under accrual accounting. “Companies will be unrolling some of the MtM earnings that have been booked over the past couple of years and, instead of booking earnings at the time of initiating a contract, they will not book earnings until products are actually delivered and cash comes in the door,” says Michael Heim, a securities analyst at full-service brokerage AG Edwards.

From December 15, 2002, companies will have to reverse out earnings that they have booked on derivative and non-derivative contracts that do not fall under the purview of FAS 133. The consensus was reached on October 25. So any contracts written after October 25 must apply FAS 133.

For energy firms with large non-derivative MtM exposure, the reversals may be substantial. Yet Heim says he does not expect to see a huge impact on stocks, unless there are credit rating implications for a company. At least one rating agency, Standard & Poor’s, says it does not predict a significant impact on ratings (see also S&P’s view on page 40). In the current environment, the market is often more focused on cash and liquidity position than earnings. Heim adds that analysts will be taking into consideration when the cash will be recognised. Hence, longer-terms deals – such as tolling arrangements (see box) – could be viewed less favourably.

Trading exit strategy
Meanwhile, energy firms wasted no time responding to analyst queries during third-quarter earnings announcements about how they would react to the accounting changes. Analysts expect many energy companies to be taking non-cash charges over the next few quarters, reflecting losses on their trading books.

Houston-based El Paso Energy has announced that it will take a $400–$600 million after-tax charge in the fourth quarter of 2002 to reflect losses associated with EITF 02-3 – the new ruling – and will exit the energy trading business. El Paso has also formed a new subsidiary, Travis Energy, with the aim of moving the credit and balance sheet of the trading portfolio off the parent company’s books.

Corporate America has been spinning off companies for years, often loading unwanted debt onto the new entity. Yet John Olson, an analyst at Houston-based financial services firm Sanders Morris Harris, says Travis Energy is the first subsidiary set up by an energy firm for the purpose of unloading a trading book. He expects many energy firms to follow El Paso’s lead.

Travis Energy will inherit $963 million in trading book margin that it will need to recover over the next two-and-a-half to three years. The company will be capitalised with a 50% interest from two of its properties (Citrus Corp and Great Lakes Gas Transmission), a $600 million credit line and cashflow from the liquidation of its trading portfolio.

Physical effects
Harder to measure than the direct effect on the balance sheet will be the impact of the accounting change on the underlying businesses of transporting, storing and supplying energy.

Suzanne Kupiec, partner and head of the energy trading and risk management practice at consultants Ernst & Young, says lessening the energy industry’s reliance on MtM accounting may result in financial reporting that does not reflect the economics of the business. She views FAS 133 as a more accurate hedge accounting strategy for static hedges than for the dynamic hedges more prevalent in the energy industry.

Under FAS 133, a derivative is a contract based on an underlying asset, index or other investment. The derivative is required to meet an 80/20 rule to comply with hedge accounting. That is, if a hedge is 80% effective, it is considered eligible for hedge accounting.

“Some of these contracts will no longer be fair value, but the economic hedges have to be fair value because they are derivatives,” says Kupiec. “You’ll see profit and loss on the derivative hedging the risk, but you won’t necessarily see profit or loss on the risk being hedged.

“The ability to avoid distorted financial statements will reside with the company’s ability to design effective hedge strategies that meet some of the most stringent requirements of FAS 133 for hedge accounting,” she adds.

For example, under former MtM rules, an energy firm contracting for natural gas storage services for the winter season would have to record energy trades on financial statements that reflect the fair value of the storage services together with that of the derivatives instruments providing an economic hedge for the storage services contracts.

“The resulting P&L was a good reflection of what the trading company was going to have – x dollars for storage costs versus the fair value of the storage contract, inclusive of economic hedges,” says Kupiec.

Possible scenarios
She says the repeal of EITF 98-10 will result in one of two scenarios, depending on whether accounting is driving business decisions or business decisions are driving accounting. First, she says, the fair value of the derivative may be “hung up” in other comprehensive income (OCI), with little clarity as to the value of the storage arrangement or what is being hedged. Under FAS 133, cashflow hedges require that the difference between the fair value and carrying value of a derivative be reported in OCI. “Energy trading contracts that don’t qualify as derivatives are not required to be reported anywhere in the financial statements, so you will not see the net economic results or failure of all trading strategies,” says Kupiec.

Alternatively, an energy firm could structure a fair-value hedge that would more closely approximate MTM accounting. However, having the fair value of the storage and derivatives contract on the balance sheet is limited by the extent to which the contracts offset each other and are subject to the 80/20 rule.

In the long term, energy firms may well tailor contractual terms to meet the definition of a derivative under FAS 133 and then apply MtM accounting. Kupiec says some of her clients have considered similar action.

Specifically, she says a company may change its trading strategies for storage to meet the aims of the FAS 133 hedge that the company structured, as opposed to optimising the strategy in response to market conditions. For example, a firm may reject or withdraw inventory when it is not optimum to do so in order to meet requirements to apply hedge accounting.

Nevertheless, some consider MtM to be the cause of the problems. Certainly, EITF 98-10 was as maligned for leading to financial reporting distortions as it was praised for providing tailored rules for accounting for energy contracts.

“To roll big portfolio valuation adjustments through the books at the end of every quarter is absolutely meaningless,” says Sanders Morris’s Olson. Olson, who feels MtM created meaningless comparisons and opportunities for gaming the system, has predicted for some time that stocks will start to recover on EITF 98-10’s repeal. He says it makes more sense for trading book values and maturities to be placed in the footnotes rather than on the balance sheet itself.

Certainly, accountants will be working overtime responding to, and complying with, the return of the old accounting regime for energy trading contracts. Yet the accounting pain may be well worth it if it rekindles the interest and investment of a market skittish with regard to MtM accounting practices.

Tolling: a likely casualty of the accounting changes

A business area that analysts expect to be hard hit by the repeal of EITF 98-10 is tolling. In the physical energy world, tolling involves one party supplying a fuel input to a generator, which accepts a fee to generate electricity and return the energy output to the fuel supplier. Both parties often buy financial derivatives, such as spread options, to hedge the risk of price changes in respect of both the input fuel and the electricity output. Tolling contracts often have long maturities due to the tendency of independent power developers (IPPs) to secure long-term contracts. IPPs are more easily able to obtain financing if they have long-term power supply contracts and, thus, revenue streams in place. Consequently, those active in tolling arrangements may have more significant longer-dated margin exposures and thus longer-dated exposure to MTM accounting. Since there is currently little liquidity in the market, few parties willing to assume the long-dated risk and new adjustments now required under accrual accounting, some energy firms no longer see it as economical to carry the long-term contracts.