Although a virtual storage arrangement is not a lease and does not qualify as a derivative in its entirety, as outlined in Figure UP 5-5, it should be evaluated for potential embedded derivatives. In this type of arrangement, the shipper records a receivable from the transporter for the return of a specific quantity of natural gas on a specified future date. The value of the receivable will fluctuate with changes in the price of natural gas. This linkage to the price of natural gas represents an embedded derivative that should be separated from the host contract and accounted for at fair value in accordance with ASC 815-15-25-1.

Figure UP 5-6 outlines the analysis that would be performed on this embedded feature.

Figure UP 5-6
Does a virtual storage agreement contain an embedded derivative that requires separation?

This approach results in initial recognition of a receivable with an embedded derivative instrument linked to the price of natural gas. In accordance with ASC 815-15-30-2, the embedded derivative should be separated from its host contract at fair value at inception (i.e., generally at zero on day one for non-option derivatives, resulting in no day one gain or loss on the derivative). The remaining carrying value of the storage contract is assigned to the host contract. Further, although the discussion above is from the perspective of the shipper, the transporter would follow the same accounting model. See the response to Question UP 5-3 for information on whether the normal purchases and normal sales scope exception can be applied to the embedded derivative.

The model discussed above treats the injection of the natural gas as a prepayment of the future purchase of natural gas. Although this is the predominant model applied in practice, other models may be appropriate in given circumstances.

It depends. We believe an embedded derivative that has been separated from a host contract may be presented on a combined basis with the related host contract on the balance sheet because the combined presentation is reflective of the overall cash flows for that instrument (see FSP 19.3.3.1). Reporting entities should apply a consistent accounting policy to the presentation of similar contracts.

It depends. In considering income statement presentation for virtual storage transactions, reporting entities should assess whether net or gross presentation of natural gas purchases and sales is appropriate. In general, this determination will depend on the nature of the reporting entity’s virtual storage activities and its purpose for entering into virtual storage transactions. Transactions entered into for trading purposes as well as certain physically-settled nontrading activities should be presented net in the income statement. The determination of whether a derivative instrument held by a reporting entity is being held for trading purposes is a matter of judgment and will be based on the reporting entity’s intent and the specific facts and circumstances. See UP 3 for further information on evaluating whether gross or net income statement presentation of derivative-related trading activities is appropriate.

The following examples illustrate the journal entries for virtual storage.

EXAMPLE UP 5-3
Shipper’s accounting for a virtual natural gas storage agreement

Effective April 1, 20X1, Rosemary Electric & Gas Company, the shipper, enters into a natural gas storage agreement with Guava Gas Company, the transporter. There is no natural gas storage location specified. On May 1, 20X1, REG purchases 10,000 MMBtus of natural gas from the spot market and delivers it to (parks it with) GGC at the SoCal Border trading point (a market hub for natural gas located in California). REG is required to withdraw the natural gas on December 1, 20X1. REG pays a fee of $10,000 for natural gas injection and withdrawal (referred to herein as the virtual storage fee), equal to the spot-to-forward price difference at the date of injection. Spot and forward prices (forward price for delivery in December 20X1) of natural gas are as follows ($/MMBtu):

How should REG account for the virtual storage arrangement?

At the time of initial delivery of the natural gas, REG would record a receivable (valued based on the spot price of natural gas on the date of initial delivery to GGC plus the fee paid that represents the spot to forward difference) and an embedded derivative (valued at zero in this example). REG would record the following journal entries to account for this agreement (amounts in $000s).

A virtual storage arrangement results in significantly different financial reporting compared with injecting natural gas in physical storage. In this example, REG has a receivable during the “storage” period and ends the arrangement with inventory with a cost basis of $60,000, its “acquisition price” on December 1, 20X1. The virtual storage arrangement effectively results in REG marking its “inventory” to fair value during the “storage” period because it recognizes the fair value of the embedded derivative indexed to the price of natural gas. Therefore, REG would recognize the net gain on the change in value of the natural gas during the “storage" period, rather than only at the point when the natural gas is sold.

EXAMPLE UP 5-4
Transporter’s accounting for a virtual natural gas storage agreement

Effective April 1, 20X1, Rosemary Electric & Gas Company, the shipper, enters into a natural gas storage agreement with Guava Gas Company, the transporter. There is no natural gas storage location specified. On May 1, 20X1, REG purchases 10,000 MMBtus of natural gas from the spot market and delivers it to (parks it with) GGC at the SoCal Border trading point (a market hub for natural gas located in California). Assume GGC sells the natural gas into the spot market on the same day it is received.

REG is required to withdraw the natural gas on December 1, 20X1. REG pays a fee of $10,000 for natural gas injection and withdrawal (referred to herein as the virtual storage fee), equal to the spot-to-forward price difference at the date of injection. Spot and forward prices (forward price for delivery in December 20X1) of natural gas are as follows ($/MMBtu):

How should GGC, the transporter, account for the virtual storage arrangement?

GGC would record inventory and a liability to return the inventory when it receives the inventory from the shipper. The day 1 liability would be measured at the spot price of natural gas. GGC would also recognize an embedded derivative (at zero initially in this example) for the changes in market price of natural gas. GGC would record the following journal entries to account for this agreement and the related embedded derivative (amounts in $000s):

Virtual storage is presumed to be a trading activity and the purchases and sales of the underlying commodity are presented net in the income statement. See UP 3 for further discussion of the impact of derivatives being held for trading purposes on income statement presentation and see the response to Question UP 5-2 for further discussion of income statement presentation alternatives.

This example also assumes that GGC sells the natural gas inventory into the spot market on the day it was delivered from the shipper. However, GGC could have stored the natural gas inventory for its own operational purposes, which would have made it subject to valuation at lower of cost and net realizable value (see UP 11.2 for further information). In addition, GGC could have purchased the inventory for delivery to the shipper at a different point in time, to try to capture market movements. It is also likely that GGC would execute multiple purchases and sales of natural gas prior to the date it delivers natural gas. For simplicity, the example assumes that the natural gas was sold and purchased from the market on the same dates as the transactions with the shipper and ignores any additional trades.

It depends. ASC 815-10-15-22 defines normal purchases and normal sales.

In some cases, a shipper may use virtual storage in lieu of physical storage due to lack of physical storage availability or other operational considerations to help manage its fuel for generation or retail customer needs (buying natural gas for a lower price in one period for an assured source of supply in a higher price period).

Provided that the quantity delivered under the contract is consistent with the shipper’s future needs, it may be able to apply the normal purchases and normal sales scope exception if all of the criteria for application of this exception are met (see ASC 815-10-15-22 through 15-51 as applicable). However, the normal purchases and normal sales scope exception would not be applicable if this type of transaction results in purchases and sales in excess of the shipper’s actual operational needs, or is associated with a trading operation.

We generally would not expect the transporter to apply the normal purchases and normal sales scope exception because virtual storage arrangements are structured to allow the transporter to trade natural gas depending on price fluctuations, and such transactions are inherently trading activities.

Refer to UP 3.3.1 for further discussion of the accounting considerations related to the normal purchases and normal sales scope exception.

Yes, if all of the hedge accounting requirements in ASC 815 are met. ASC 815-20-25-45 permits an embedded derivative that is accounted for separately from its host contract to be designated as a hedging instrument. In this case, the embedded derivative that is separated from the host contract relates to the forecasted future delivery of natural gas. We believe that hedge accounting may be applied to this separated embedded derivative. The bifurcated embedded derivative may be designated an all-in-one hedge of the forecasted future purchase of natural gas to fulfill the withdrawal obligation and may be designated as such if it meets the criteria in ASC 815-20-25-21 and 25-22. To apply hedge accounting, the reporting entity will need to meet all of the documentation and other hedge accounting requirements. See DH 5 for further information on hedge accounting for commodities.