White Papers Managing Forward Curves in a Complex Market | Page 3
Managing Forward Curves in a Complex Market
A ComTech Advisory Whitepaper
FORWARD CURVES DEFINED
The term “forward curve” refers to a series of sequential prices either for future delivery of an asset or expected
future settlements of an index. Established futures markets, such as the NYMEX Henry Hub natural gas contract,
provide a series of future month contracts which are traded for fixed prices. These published future month prices
take on a curve shape when graphed, and are thus referred to as the “forward curve”.
A forward curve can be derived for any commodity
with a forward delivery market; however, the accuracy and completeness of that curve is going to depend on a number of factors, and primarily on the
liquidity of each forward period. Unfortunately, given
that most markets and/exchanges do not exhibit high liquidity in all future periods, it is generally best practice to derive the curve from many
sources of market data – including exchanges, broker marks, trader
indications and independent data publishers.
USES OF FORWARD CURVES
FINANCIAL STATEMENTS AND
FORWARD CURVES
The predominant use of forward curves is in the
preparation of corporate financial statements. Companies will use forward curves as key inputs to derivative valuation models in order to calculate the fair
value of commodity inventories or financial instruments that are carried on the balance sheet.
For US-based, public companies that operate
under the oversight of the Securities and Exchange
Commission (SEC), this valuation activity is governed by GAAP, and specifically ASC Topic 820
(formerly, SFAS-57). Amongst its requirements,
Topic 820 states that companies should use market-based price inputs and should disclose the reliability of those input s. Input reliability is classified
as either “level 1” (unadjusted quotes from active
markets), “level 2” (quotes from inactive markets or
markets for similar instruments), or “level 3” (price
inputs based on management assumptions). These
reliability level requirements often mean that companies must use the most active market quotes, even
in instances where those markets are quoted as strips as opposed to
individual months.
Accidentally using lower-level price inputs or misrepresenting the
reliability of price inputs may put the company at risk of re-statement
in future periods; and in the process, bring increased scrutiny of their
accounting and management practices by regulators and shareholders.
ASSET VALUATION
The second common use of forward curves is in asset valuation for either planning purposes or dynamic hedging. As these valuations are
not part of, or included, in the preparation of financial statement, companies may use something other than exchange-based curves. This is
especially helpful in cases where the operating characteristics of a particular asset are more granular than available market quotes; that is,
they operate in a market or region not directly traded or otherwise well
reflected by an exchange instrument. In this case, using derived curves
would provide the asset holder with a better estimate of the asset’s current and future value.
With an improved estimate of the asset’s value, the asset holder
would be in a better position to manage the asset’s net risk via production or fuels hedging, or operational adjustments to maximize value. However, again, it’s important to remember that such price curves
would not meet GAAP definitions for input price reliability.
© Commodity Technology Advisory LLC, 2015, All Rights Reserved.