Derivatives Implementation Group

Statement 133 Implementation Issue No. B11

QUESTION

Do the embedded derivative provisions of Statement 133 apply to volumetric production payments for which the quantity of the commodity that will be delivered is reliably determinable?

BACKGROUND

FASB Statement No. 19, Financial Accounting and Reporting by Oil and Gas Producing Companies, addresses the accounting for production payments. The term production payments encompasses different types of contracts that warrant different accounting. Statement 19 differentiates between production payments that contractually involve only cash flows, which are accounted for as borrowings (under paragraph 43(b) of that Statement), and those that involve delivery of a commodity (referred to as volumetric production payments), which are accounted for as the transfer of a mineral interest. Paragraph 47(a) of Statement 19 explicitly addresses the latter as follows:

   Some production payments differ from those described in paragraph 43(b) in that the seller's obligation is not expressed in monetary terms but as an obligation to deliver, free and clear of all expenses associated with operation of the property, a specified quantity of oil or gas to the purchaser out of a specified share of future production. Such a transaction is a sale of a mineral interest for which gain shall not be recognized because the seller has a substantial obligation for future performance. The seller shall account for the funds received as unearned revenue to be recognized as the oil or gas is delivered. The purchaser of such a production payment has acquired an interest in a mineral property that shall be recorded at cost and amortized by the unit-of-production method as delivery takes place. The related reserve estimates and production data shall be reported as those of the purchaser of the production payment and not of the seller (paragraphs 50 -56).

Some oil or gas volumetric production payments relate to the production of a single well and involve significant risk with respect to the receipt of the entire quantity specified in the contract. However, in recent years some contracts have essentially eliminated that risk by linking the deliveries under the volumetric production payments to the production from a group of producing wells or a small volume related to the expected production from a single producing well, thus making the quantity of the commodity that is delivered reliably determinable.

Statement 133 specifies criteria in paragraphs 12-15 for determining when an embedded derivative must be separated from a contract and accounted for as a derivative under that Statement.

RESPONSE

Yes. The embedded derivative provisions of Statement 133 do apply to the accounting by all parties for a volumetric production payment for which the quantity of the commodity that will be delivered is reliably determinable. That volumetric production payment is not itself a standalone derivative instrument because, like the contract in Statement 133 Implementation Issue No. A1, “Initial Net Investment,” it does not have the characteristic of a derivative discussed in paragraph 6(b) of Statement 133—that is, a smaller or no initial net investment. Although it is not derivative instrument, that volumetric production payment must be analyzed under paragraph 12 of Statement 133. That analysis would typically indicate that such a volumetric production payment effectively is a hybrid instrument composed of a host debt instrument embedded with a commodity forward. The embedded commodity forward meets the criterion in paragraph 12(a) of Statement 133 because commodity prices are not clearly and closely related to interest rates on the debt host contract. The criterion in paragraph 12(b) is met since a volumetric production payment is not remeasured at fair value under otherwise applicable generally accepted accounting principles with changes in fair value reported currently in earnings. Accordingly, if a separate instrument with the same terms as the commodity forward would be a derivative subject to the requirements of Statement 133, the embedded commodity forward would meet the criterion in paragraph 12(c) and must be accounted for separately. (Note that Statement 155 was issued in February 2006 and allows for a fair value election for hybrid financial instruments that otherwise would require bifurcation. However, Statement 155 does not apply to hybrid instruments that are not financial instruments, such as nonfinancial instruments that require volumetric production payments. Hybrid financial instruments that are elected to be accounted for in their entirety at fair value cannot be used as a hedging instrument in a Statement 133 hedging relationship.) However, the embedded commodity forward may nevertheless be eligible to qualify for the normal purchases and normal sales exception in paragraph 10(b) and, if so, would not be subject to the accounting requirements of Statement 133 for the party to whom it is a normal purchase or a normal sale. If it were a normal sale for the oil- or gas-producing company, the entire related volumetric production payment would be accounted for under Statement 19. If the embedded commodity forward does not qualify for the normal purchases and normal sales exception, it may qualify for designation as the hedging instrument in an “all-in-one” hedge, as discussed in Statement 133 Implementation Issue No. G2, “Hedged Transactions That Arise from Gross Settlement of a Derivative (‘All-in-One’ Hedges).”

If the quantity of the commodity that will be delivered under a volumetric production payment arrangement is not reliably determinable, the embedded commodity forward contracts in such volumetric production payment arrangements are considered not to contain a notional amount as that term is used in Statement 133. Such a circumstance can occur when the oil or gas volumetric production payments relate to the production of a single well (or relatively unproven properties) and the volume under the contract is relatively large, and thereby involve significant reserve risk with respect to the receipt of the entire quantity specified in the contract. If the embedded commodity forward is not subject to the requirements of Statement 133, the entire related volumetric production payment would be accounted for under Statement 19.

The above response has been authored by the FASB staff and represents the staff's views, although the Board has discussed the above response at a public meeting and chosen not to object to dissemination of that response. Official positions of the FASB are determined only after extensive due process and deliberation.