Structured Transaction White Paper

Embedded Derivatives in Structured Transaction Energy Contracts

Phillip Green, Senior Business Analyst, Consultant
Derivatives 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.

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 margin

Re-sell natural gas at 100% of price in market.

Obligated to purchase from Aramaco at 98% of average price realized

Right to sell in market at 100%
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.

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 gas

Notional 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 Testing
Energy Trading Risk Management
Derivatives Trading Desk©®™