EXECUTIVE EDUCATION SERIES: Hedging with Commodities

Presented by: Shareholders Tim Woods and

Mike Loritz

August 1, 2013

MHM’s Derivatives Assistance Group

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Before We Get Started…

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This webinar is eligible for CPE credit. To receive credit, you will need to answer periodic polling questions throughout the webinar.

External participants will receive their CPE certificate via email immediately following the webinar.

CPE Credit

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Today’s Presenters

Mike Loritz, CPA Shareholder 913.234.1226 | mloritz@cbiz.com Mike has 17 years of experience in public accounting with diversified financial companies and other service based companies, including banking, broker/dealer, investment companies, and other diversified companies ranging from audits of public entities in the Fortune 100 to small private entities. He is a member of MHM's Professional Standards Group, providing accounting knowledge leadership in the areas of derivative financial instruments, investment securities, share-based compensation, fair value, revenue recognition and others.

Tim Woods, CPA Shareholder 720.200.7043 | twoods@cbiz.com A member of MHM’s Professional Standards Group, Tim is a subject matter expert for derivatives and hedge accounting. He also has extensive experience in leasing transactions, fair value, stock-based compensation, and complex debt and equity transactions. Tim has worked in public accounting, consulting, and private industry for the past 20 years, focusing on outsourced CFO consulting and financial statement audits for small and mid size privately held companies. He has extensive experience in accounting for business combinations and variable interest entities, as well as with issues in leasing, revenue recognition, and foreign exchange.

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The information in this Executive Education Series

course is a brief summary and may not include all the details relevant to your situation.

Please contact your MHM service provider to further

discuss the impact on your financial statements.

Disclaimer

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Today’s Agenda

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Commodities and Hedge Accounting

Valuation Issues

Cash Flow Hedging

COMMODITIES & HEDGE ACCOUNTING

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Why are Derivatives Used?

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Risk Management Derivatives are used by many

companies to manage the risk of changing market conditions on assets/liabilities or variable cash flows on operations.

Hedge accounting can apply Arbitrage

Lock in riskless profits (excluding counterparty credit risk)

Generally the use by large banks (interest rate) and commodity traders

Speculation Trading derivative products in order to

take a position in the market (betting on future

movements)

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Risk Management — Commodities Companies utilize derivatives to offset (HEDGE) risks that are inherent

in their business models Examples include:

Futures/Forward contracts to lock in sales prices for commodities being sold (hedging the volatility in sales prices); e.g. grains held by a broker.

Futures/Forward contracts to lock in purchase prices for commodities to be used (hedging the volatility in inputs); e.g. diesel fuel futures for transportation company.

Futures/Forward contracts used to offset the changes in fair value of the commodity inventory held by a broker.

Upon entering into these derivative contracts, the company is satisfied with the price that it will receive upon settlement of the derivative. Ideally any gain or loss on the derivative contract is offset by the loss or gain from the item being hedged. The company has received the market rate on the date into which the derivative contract was entered.

Why are Derivatives Used?

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Common Types of Derivatives

Option-Based Interest rate cap or floor

Put or call option Currency

Forward Agreements Forward Rate

Foreign exchange Commodity

Future Agreements Equity

Currency Commodity

Swaps Interest rate

Currency Commodity

Credit Default

Forward Based

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Futures/Forward Contracts – Hedge the forecasted purchase or sale of a commodity (agricultural, metals, energy)

Can be straight forward (one – one relationship)

Series of forecasted purchases Single commodity over a specific period Multiple commodities over specific periods Multiple commodities over specific period to

multiple locations

Option Contracts – Hedge increase in price of the commodity over a certain threshold

Futures/Forwards/Options – Hedge the change in fair value of inventory

Types of Commodity Hedges

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Derivatives that are accounted as freestanding are recorded at fair value at each reporting date with the change recorded in earnings.

Derivatives that are accounted for as hedging instruments are also recorded at fair value; however, the accounting for the impact to earnings is based upon the type of hedge that has been implemented.

Regardless of whether hedge accounting is utilized, ALL derivatives are recorded on the balance sheet at their estimated fair value.

What is Hedge Accounting?

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Fair value hedge - Economic purpose is to enter into a derivative instrument whose changes in fair value directly offset the changes in fair value of the hedged item (i.e. item has fixed cash flows - inventory).

Foreign currency hedge - If the hedged item is denominated in a foreign currency, then an entity may designate the hedge as either of the above or a net investment hedge.

What is Hedging?

Cash flow hedge - Economic purpose is to enter into a derivative instrument whose gains and losses on settlement directly offset the losses and gains incurred upon settlement of the transaction being hedged. (i.e. forward purchase/sale)

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Contains explicit guidance regarding the application of hedge accounting models, including documentation and effectiveness assessment requirements. One of the fundamental requirements of ASC 815 is that formal documentation be prepared at inception of a hedging relationship.

Stresses the need for the documentation to be prepared contemporaneously with the designation of the hedging relationship.

ASC 815

ASC 815

Hedging is a Privilege, Not a Right!

Formal Documentation Under ASC 815 Hedge Documentation

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You can replace this text with

your own text. Keep the text

short and simple

You can replace this text with

your own text. Keep the text

short and simple

Hedging relationship

Documentation must include:

Hedge Documentation

• Identification of the hedging instrument • Identification of the hedged item or forecasted

transaction(s) • Identification of how the hedging instrument’s

effectiveness in offsetting the exposure to changes in the hedged item’s fair value (fair value hedge) or the hedged transaction’s variability in cash flows (cash flow hedge) attributable to the hedged risk will be assessed.

• How ineffectiveness will be measured

Entity’s risk management objective and strategy for

undertaking the hedge

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Sample Company XX (Company) budgets the purchase of natural gas for use in its operations over the future 12 month period. The Company would like to protect against rising energy prices related to natural gas, thus the overall profitability and operating cash flows are exposed to the variability in the market price. As a result, the Company intends to enter into derivative contracts as a hedge of the exposure to changes in cash flows associated with the forecasted purchase of natural gas.

Cash Flow Example

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Risk Management Objective The Company’s cash flows and ultimately profitability are exposed to changes in the market price of natural gas as the Company has limited ability to pass along the costs to its users. Exposure to the variability in natural gas prices is limited to changes in spot prices at the respective delivery points (including location differential or citygates) as the Company has fixed delivery costs from the delivery points to its facilities. The Company may use futures/forward contracts with notional amounts and underlying indices that management believes will be highly effective at hedging that variability.

Cash Flow Example

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Hedged Item The Company has forecasted the purchase of 100,000 MMBtu on or near August 31, 2013, to be delivered to the Company’s single location. The Company designates a futures purchase contract for the purchase of 100,000 MMBtu, with a settlement date of August 31, 2013 as a hedge of the variability of cash flows associated with the forecasted purchase of 100,000 MMBtu on that date. Based on the Company’s internal evaluation, the purchase of the natural gas is assessed as probable of occurring as the Company intends to continue operations in the current state, which uses significantly more than the hedged forecasted transaction. Additionally, we have assessed the counterparty credit risk and determined that the likelihood the counterparty would default on any payments due under the contractual terms of the hedging instrument is not probable (ASC 815-20-35-15).

Cash Flow Example

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Hedging Instrument The hedging instrument is the NYMEX futures contracts for the purchase of 100,000 MMBtu on August 31, 2013 as based on delivery to Henry Hub. Note: In this example, the Company obtains its natural gas from the Mid-Continent Hub in Kansas. Thus, even if all other terms are exactly the same, the hedge will not be 100% effective since the actual acquisition of natural gas will be from the Mid-Continent Hub and the futures contract is based on the Henry Hub, resulting in a location differential.

Variability in the location differential will lead to ineffectiveness Since the Company has fixed delivery costs in this example, no

ineffectiveness will result (from the Mid-Continent Hub to their facility)

Cash Flow Example

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Effectiveness Assessment:

The Company will perform the initial and on-going effectiveness assessment through a regression analysis of the daily change in the actual futures contract and a perfectly effective hypothetical (PEH) futures contract designed to entirely offset the changes in cash flows of the forecasted acquisition of natural gas. The regression analysis will use a minimum of 30 daily data points (length of the hedging relationship) prior to the hedging relationship.

When correlating the actual futures contract to the perfectly effective hypothetical derivative instrument, the R2, or coefficient of determination, which is the R, or coefficient of correlation, squared, should be equal to or greater than 0.8 . The R2 factor should be greater than (0.8) and less than or equal to 1.25 in order to be considered highly effective.

Cash Flow Example

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Hedge Documentation

In measuring the effectiveness of a cash flow hedge, a

Company must measure the correlation of the expected

(hedged) result and the actual result (difference should be

minimal for an effective hedge).

In terms of a fair value hedge, the Company must measure

the correlation of the change in fair value of the hedged item

and the change in fair value of the derivative being utilized in

the hedge.

There are certain situations in which the Company can utilize

the critical terms match method, provided that the requisite criteria are met, and can

therefore presume that no-ineffectiveness exists.

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Ineffectiveness The Company will use the cumulative dollar-offset method to assess the ineffectiveness on a quarterly basis. The Company will compare the change in the value of the actual futures contract with the change in the fair value of the perfectly effective hypothetical contract (a contract assuming the same critical terms as the hedged item – including delivery at Mid-Continent).

The amount of ineffectiveness to be recorded equals the lesser of the cumulative change in the fair value of the actual futures contract or the cumulative change in the fair value of the perfectly effective hypothetical swap.

Cash Flow Example

VALUATION ISSUES

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Futures Contracts Futures contracts are actively traded instruments in

the marketplace on certain regulated exchanges.

Futures contracts allow the buyer (seller) to purchase (sell) a stated notional amount of a certain commodity, currency, financial instrument, etc… at a stated price over a designated period of time.

Futures contracts may be entered and exited at anytime during the life of the futures contract provided that the buyer (seller) is willing to accept a net settlement of the value of the futures contract, and not physical settlement (receipt of the actual underlying).

The prices of futures contracts are based on the current spot price and can be estimated from the spot price using the risk free rate, the dividend or stated interest rate on the underlying (if any), costs of storage, and convenience cost.

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Futures Contracts Therefore, using the following formulae, the value of a futures contract can be derived from the current spot price of the underlying and compared to the actual future price to identify any opportunities in the marketplace:

Futures prices with:T = Time to maturityS = Current Spot price of Underlyingr = risk free rate for TI = Known income provided by underlyingq = Known convenience income or yieldc = costs of carrying the commoditye = 2.71828^ = to the power of

F = Se^rT Provides no incomeF = (S - I)e^rT Provides income with present value = IF = Se^(r-q)T Provides yield = to q%F = Se^(r+c)T Cost to maintain = c%

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Futures Contracts

EXAMPLE – value of futures contract

Futures prices with: VARIABLES FOR CONTRACTT = Time to maturity 1S = Current Spot price of Underlying $1,578.00 GOLD - 1 ozr = risk free rate for T 0.13%I = Known income provided by underlying 0q = Known convenience income or yield 0c = costs of carrying the commodity 0e = 2.71828 2.71828^ = to the power of

ACTUAL per CME $1,588.00F = Se^rT Provides no income $1,580.05 = 1580*(2.71828)^(.0013*1)F = (S - I)e^rT Provides income with present value = IF = Se^(r-q)T Provides yield = to q%F = Se^(r+c)T Cost to maintain (storage) = c%

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Forward Contracts

Therefore, although forward contracts may impose explicit times for settlement (e.g. at the maturity of the contract), the formula for calculating the value of a forward contract is the same as the formula for calculating the value of a futures contract, except for

one difference – CREDIT RISK

Given that futures contracts are traded on organized exchanges, the requirement for initial and maintenance margin limits the

credit risk associated with these contracts and, as such, credit risk is generally not

considered in the valuation of futures contracts.

However, assuming that a forward contract meets the definition of a derivative, and if

the underlying is consistent with the underlying of an actively traded futures

contract, it is likely that this is the case, the holder of the forward contract must take

into account the credit risk of the counterparty, when determining the value of the forward contract. That is, the CVA must be added to r when discounting the

value of the contract.

NOTE: you must take into account the presence of credit enhancements when

valuing the contract. e.g. collateral, letters of credit, guarantees, master netting

arrangements, etc…

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Options on Futures and Forward Contracts Options on Futures and Forward contracts have the same properties as options on any

financial asset (e.g. stocks) and can, provided that the options are European, that is, they can only be exercised at maturity of the contract (or at a certain date) be valued using the Black Scholes Option Pricing Model (or a derivation thereof, the Black model).

Therefore, a European call and put option can be valued using the following formulae:

Black Scholes Option Pricing Model for Futures Contracts:EXAMPLE:

c = e^-rT[F*N(d1) - K*N(d2)] call = $1.05p = e^-rT[K*N(-d2) - F*N(-d1)] put = $3.35

whereN(d) N(-d)

d1 =[ln(F/K) + σ^2*T/2] / σ*SQRT(T) 0.072169 N(d1) = 0.528766 0.471234d2 =[ln(F/K) - σ^2*T/2] / σ*SQRT(T) = d1 - σ*SQRT(T) -0.07217 N(d2) = 0.471234 0.528766

EXAMPLE: PUT - CALL PARITY, requires that:European call and put option on an oil futures contract c + Ke^-rT = p + Fe^-rtT = 0.333333 Time to expirationF = 60 Current Futures price We can use put-call parity to findK = 60 Exercise price mispriced options in the market.r = 0.09 Risk free rateσ = 0.25 Volatility of Oil Futures Contracte = 2.71828

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Options on Futures and Forward Contracts

We can also calculate the values of options on futures contracts using lattice based models (binomial and trinomial models) and simulation.

However, this is beyond the scope of this webinar.

CASH FLOW HEDGING EXAMPLE

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Cash Flow Hedging Example In this example we have a company that uses corn bushels as an input in their manufacturing process.

On 11/1/12, the Company purchased 5 March 2013 futures contracts for delivery on March 15, 2013, delivery of 25,000 bushels of corn. Accordingly, the Company will settle the futures contract on March 15, 2013, and will accept delivery of the 25,000 bushels of corn on March 15, 2013.

The Company has properly documented this transaction as a cash flow hedge on 11/1/12.

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On 11/1/12, the Company must estimate the cost today of the 25,000 bushels of corn to be delivered on March 15, 2013.

Accordingly, the Company has estimated the following cost:

Base corn price – $6.59 per bushel Basis – $(.07) per bushel*** Total estimated corn price – $6.52 per bushel

*** - ASC 815 requires that basis is included in the estimated cost of corn and that the change thereof is included in the effectiveness testing. As the futures contract cannot hedge basis, this is potentially a source of ineffectiveness, if the basis changes over the term of the hedge.

Understanding the concept of basis is a key element in developing a sound hedging strategy. Basis refers to the relationship between the cash price in a local market and the futures market price for a commodity. A more formal definition of basis is the difference between the cash price and the futures price, for the time, place and quality where delivery actually occurs.

Cash Flow Hedging Example

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Cash Flow Hedging Example Therefore, given that the Company has estimated that the corn to be purchased on March 15, 2013, will cost $6.52 per bushel or $163,000. The purpose of the 5 futures contracts is to offset the changes in the cost from the estimated $163,000.

Our example will demonstrate the calculations that are needed to assess the effectiveness of the cash flow hedge and the calculation of ineffectiveness, and the resulting impact on the Company’s financial statements.

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Cash Flow Hedging Example

HEDGED ITEM HEDGING INSTRUMENTDATE TOTAL TOTAL OPEN

HEDGE CORN EST. EST. EST. EST. CONTRACTENTERED BUSHELS COST BASIS COST $ COST CONTRACTS BUSHELS PRICE

11/1/2012 25000 $6.59 ($0.07) $6.52 $163,000 5 25000 6.59

12/31/2012 25000 7 -0.1 $6.90 $172,500 5 25000 7

CHANGE $9,500 $10,250Percent offset 107.89%

Amount to be deferred in AOCI is the lesser of the cumlative change in the hedged item or hedging instrumentAccordingly, the amount to be deferred in AOCI is $9,500

Entries are: DR CRDerivatives - commodity contracts, at fair value $10,250AOCI $9,500Unrealized gain on derivatives -commodity contracts $750

In order to assess hedge effectiveness, the Company will perform a regression analysis of the changes in the hedging instrumeand the changes in the hedged item - in the case above, the hedging instrument offset the hedged item by 107.89%.

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Cash Flow Hedging Example

HEDGED ITEM HEDGING INSTRUMENTDATE TOTAL TOTAL OPEN

HEDGE CORN EST. EST. EST. ACTUAL CONTRACTENTERED BUSHELS COST BASIS COST $ COST CONTRACTS BUSHELS PRICE

11/1/2012 25000 $6.59 ($0.07) $6.52 $163,000 5 25000 6.59

3/15/2013 25000 6 -0.15 $5.85 $146,250 5 25000 6

CHANGE ($16,750) -$14,750Percent offset 88.06%

Amount to be deferred in AOCI is the lesser of the cumlative change in the hedged item or hedging instrumentAccordingly, the amount to be deferred in AOCI is ($14,750)

Entries are: DR CR BALANCESDerivatives - commodity contracts, at fair value ($24,250) -$14,750AOCI $24,250 $14,750

Amount in AOCI will be reclassied to earnings (COGS) upon the hedged item (corn bushels) impacting earnings (sale of invento

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CASH FLOW HEDGING - EXAMPLE

EXAMPLE OF REGRESSION ANALYSIS

In the preceding example, the ending result was as follows (if we add 11 additional data points), the regression analysis would CHANGE CHANGE

IN HEDGED IN HEDGING SUMMARY OUTPUT# ITEM INSTRUMENT

1 $16,750 $14,750 Regression Statistics2 $25,000 $22,500 Multiple R 0.9945609083 ($15,000) ($16,000) R Square 0.98915144 ($22,575) ($21,500) Adjusted R Square 0.988066545 $16,000 $16,500 Standard Error 2480.0045876 ($50,000) ($60,000) Observations 127 $7,500 $7,2008 $500 $350 X Variable 1 0.9053086679 $16,500 $13,900

10 ($28,000) ($35,000)11 $12,500 $12,50012 $5,000 $5,500

CONCLUSION: Given the results of the regression analysis, an R2 of 98.92%, the Company's hedging programappears to be highly effective at offsetting the changes in the hedged item (commodity price risk) and the use ofcash flow hedge accounting continues to be proper.

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Questions?

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Today’s Presenters

Mike Loritz, CPA Shareholder 913.234.1226 | mloritz@cbiz.com Mike has 17 years of experience in public accounting with diversified financial companies and other service based companies, including banking, broker/dealer, investment companies, and other diversified companies ranging from audits of public entities in the Fortune 100 to small private entities. He is a member of MHM's Professional Standards Group, providing accounting knowledge leadership in the areas of derivative financial instruments, investment securities, share-based compensation, fair value, revenue recognition and others.

Tim Woods, CPA Shareholder 720.200.7043 | twoods@cbiz.com A member of MHM’s Professional Standards Group, Tim is a subject matter expert for derivatives and hedge accounting. He also has extensive experience in leasing transactions, fair value, stock-based compensation, and complex debt and equity transactions. Tim has worked in public accounting, consulting, and private industry for the past 20 years, focusing on outsourced CFO consulting and financial statement audits for small and mid size privately held companies. He has extensive experience in accounting for business combinations and variable interest entities, as well as with issues in leasing, revenue recognition, and foreign exchange.

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