Super Contango in Crude Oil
Super Contango in Crude Oil
Could IFRS 9 Fair Value Hedge Accounting be a helpful Tool?
Our previous issue of the Corporate Treasury Newsletter ("Fair Value Hedge Accounting – Business as usual?", issue 104 of September 2020) took a more in-depth look at the main changes in hedge accounting under IFRS 9 and the related implications for fair value hedge accounting. In this article, we want to go into more detail on the importance of the designation options for fair value hedges under IFRS 9 for commodities, particularly in light of a crisis-related increase in price volatility on the commodity markets, thus making this theory more “tangible".
Increasing price volatility in commodities
As already discussed in our April 2020 newsletter, the Covid-19 pandemic has caused considerable fluctuations in market prices recently, fueling unprecedented price movements on the commodity markets ("super contango in crude oil"). At the peak of the price developments, a negative spot price of minus USD 37.63 per barrel was estimated for WTI crude oil, while the future price for the month of December 2020 fell from just under USD 60 to USD 27 per barrel. This made for interesting trading activities on the markets, in more ways than just from a financial perspective.
Fig. 1: Price development for Brent crude oil and the EUR/USD exchange rate from September 2019 to September 2020
Such unpredictable market movements not only present treasurers with challenges when making strategic decisions (e.g. adjusting the procurement strategy), but also cause significant accounting issues for financial instruments under IFRS 9.
Fair value hedge accounting and volatilities from inventory valuation
Price volatility on the commodity markets creates both opportunities and risks when trading or procuring commodities.
For companies in industries that are commodity-intensive or in commodity trading that according to IAS 2 are defined as "broker-traders" and that measure their inventories at fair value, price volatility causes the consolidated net income to become highly volatile. These volatilities arise from the fact that both inventories and derivative financial instruments (e.g. futures, forward contracts) must be recognized at fair value. Inventories are measured at spot prices, whereas the fair value of derivative financial instruments is determined by the respective forward rate. Even if a company procured its inventory at a "moderate" price, the market situation in the wake of Covid led to massive value changes due to the sharp drop in spot prices in the inventory. As a result of the "broker-trader" rule, the inventory valuation resulted in a significant expense entry in the income statement.
Given the large differences between the spot and forward rates, the desired compensatory effect of existing financial hedging with futures or forward contracts mitigated volatility on the income statement only so much.
This begs the question of whether companies subject to the "broker-trader" rule could have mitigated their income statement volatility better by using fair value hedge accounting.
Employing fair value hedge accounting with a spot designation and simultaneously applying the cost-of-hedging approach means that the value changes of the spot component of the hedged item and the hedging instrument offset each other (ceteris paribus) for the duration of the inventory hedge. In contrast, changes in the forward component are recognized in Other Comprehensive Income II under the cost of hedging approach and reclassified to the income statement over the duration of the hedging relationship (so-called cost-of-hedging approach; see IFRS 9.B6.5.29 et seq.) This leads to a "smoothing" of the income statement over the term of the hedge, particularly for long-term hedging relationships, while significant changes in the forward component's value are not directly reflected in the income statement. This has proven to increase the predictability of the company's earnings per reporting period.
Conceptually, the cost-of-hedging approach is often attributed to cash-flow hedge accounting only. However, IFRS 9 also provides for the general application to fair value hedges, thus offering commodity-consuming companies a further alternative to the "broker-trader" rule. Its application should however be reviewed on a case-by-case basis.
Source: KPMG Corporate Treasuy News, Edition 105, October 2020
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