A natural gas capacity contract provides the purchaser with use of a portion of a natural gas pipeline. Derivative accounting typically does not apply to this type of contract because the criterion of net settlement is not met. However, the parties should evaluate whether this type of contract is a derivative in its entirety in accordance with the criteria in ASC 815-10-15-83. Figure UP 5-8 summarizes key considerations in assessing whether a typical arrangement for the purchase or sale of natural gas capacity is a derivative in its entirety.

Figure UP 5-8
Does a natural gas capacity contract meet the definition of a derivative?

In general, we would not expect a contract for natural gas capacity to be accounted for as a derivative because it fails the net settlement criterion.

Factors to consider in assessing whether a natural gas capacity contract has the characteristic of net settlement are discussed in the following paragraphs. See UP 3.2.3 for further information on overall application of the net settlement criterion.

When evaluating whether the net settlement criterion is met, a reporting entity should first consider whether the contract terms explicitly or implicitly provide for net settlement of the entire contract. Natural gas capacity agreements typically require the capacity owner to provide natural gas capacity (i.e., physical delivery is required). Further, although pricing of a natural gas capacity agreement may be based on locational price differences, the agreement itself does not typically permit net settlement. However, the type of contract and its terms should be reviewed for any implicit net settlement terms or liquidating damage provisions, which may imply the contract could be net settled.

In this form of net settlement, one of the parties is required to deliver an asset, but there is an established market mechanism that facilitates net settlement outside the contract. ASC 815-10-15-110 through 15-116 provide guidance on indicators to consider in assessing whether an established market mechanism exists. A key aspect of a market mechanism is that one of the parties to the agreement can be fully relieved of its rights and obligations under the contract.

Because it is the capacity agreement being assessed, the evaluation is based on whether there are buyers standing ready to relieve the reporting entity of all of its rights and obligations for the natural gas capacity contract itself. The Federal Energy Regulatory Commission (FERC) provides market pricing for short-term capacity agreements (less than one year). Therefore, short- and long-term natural gas capacity agreements have different characteristics and may have different markets. We understand that there may be some bilateral activity in certain locations within North America, with trading of capacity among market participants to manage excess capacity and meet obligations on a short-term basis for near term delivery, but often not for the full term of a contract. In addition, pipeline companies maintain electronic bulletin boards that provide some information; however, these postings include all transactions, including pre-arranged deals that may be tariff-based. The FERC guidelines regulating transactions on these bulletin boards should be considered in assessing whether net settlement under a market mechanism exists. Although we understand that there is some activity in the market, it does not appear that there is sufficient liquidity to support the conclusion that a market mechanism exists for natural gas capacity for most contracts. The key factor in this evaluation is whether there are quoted market prices and buyers standing ready to transact for the entire contract (i.e., for the full volume and term of the contract).

Whether there is an active spot market for the particular asset being sold under the contract is the key factor in assessing whether an asset is readily convertible to cash. Current market conditions should always be considered in this analysis. To be deemed an active spot market, a market must have transactions with sufficient frequency and volume to provide pricing information on an ongoing basis. In addition, quoted prices from that market must be readily available on an ongoing basis. See UP 3.2.3.3 for further information on the determination of whether a market is active.

Because it is the capacity agreement being assessed, the evaluation is based on whether the natural gas capacity itself is readily convertible to cash. The fact that the capacity facilitates the movement of natural gas, which is readily convertible to cash, has no bearing on this evaluation. Although we understand that there is some trading of natural gas capacity, based on the current structure of the markets, we are not aware of any active spot markets for capacity in the United States.

We are not aware of a market mechanism or active spot market for natural gas capacity contracts in the US and thus we believe that derivative accounting is generally not applicable to these contracts. However, a reporting entity should evaluate all facts and circumstances in concluding on the appropriate accounting for a specific natural gas capacity contract. In addition, a reporting entity should monitor its conclusion each reporting period because markets may evolve, potentially rendering this type of contract a derivative. Reporting entities also should evaluate the contract to determine if there are any embedded derivatives that require separation from the host contract (assuming the contract does not meet the definition of a derivative in its entirety). See UP 3.4 for information on evaluating embedded derivatives.

Reporting entities may also consider conditionally designating natural gas capacity contracts under the normal purchases and normal sales scope exception if physical delivery is probable throughout the life of the contract and the other criteria for application of this exception are met (ASC 815-10-15-22 through 15-51 as applicable). If a conditionally designated normal purchases and normal sales contract meets the definition of a derivative at a later date, it would be accounted for as a normal purchases and normal sales contract from the time the contract becomes a derivative. Absent such a designation, the reporting entity would be required to initially fair value the contract when it meets the definition of a derivative.

See UP 3.3.1 for further information on the normal purchases and normal sales scope exception.

Generally, no. A natural gas capacity contract allows the buyer to capture a spread between two locations. A reporting entity can use a natural gas capacity contract to move natural gas through the pipelines and capture a pricing spread between two locations. However, the reporting entity must trade the natural gas capacity contract together with natural gas inventory or market purchases to capture the basis differences. Absent a capacity market, the natural gas capacity contract itself does not settle based on natural gas locational price differences. Thus, such contracts are not derivatives unless they meet the net settlement criterion as discussed above.