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  • soscorp soscorp Oct 2, 2008 11:05 AM Flag

    3rd Quarter GAAP Earnings Per Share

    Are the markt to market GAAP gains from taxable or are they reported as adjustment to basis?

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    • Mark to market gains and losses do not affect tax basis nor do they affect taxable income until the position is settled, usually at maturity. If the settlement is a payment from the producer to the counterparty, that is often recorded as a cost of sale (via reduction of gross revenues) -- and the converse occurs if the settlement is a payment to the producer from the counterparty.

      The tax treatment is a little bit analogous to unrealized gains and losses on a stock investment. You recognize a gain or loss for tax purposes when you sell or close the position. So it is with hedges.

      Generally, a mark to market loss is covered by the sale of the underlying commodity at market price, so the company realizes the hedge price (in a swap) -- to simplify, e.g., if the swap is $8/mcf and market is $11/mcf, there is a GAAP hedge loss of $3/mcf that is hedged. But the company sells its product at market ($11), takes that $11 and uses it to pay the swap settlement ($11 - $8 = $3 to counterparty) and keeps $8/mcf to pay its bills. At that point is has realized a hedge loss of $3/mcf, but has cash flow of $8/mcf. If there had been no hedge, the producer would have kept the full $11. The hedge loss is realized but is offset by the NG sale at market price. So the producer is deprived of $3/mcf, but its operations are covered.

      If the hedge is an asset (that is, the swap price is greater than market), the results are the reverse. Using a swap price of $8 and NG market of $6, there is a GAAP mark to market gain of $2/mcf. When the position is closed, the company sells NG at market, $6, and receives a payment of $2/mcf from the counterparty (swap price of $8 minus the market of $6). The company now gets $6 from selling the NG plus $2 from the counterparty, a total of $8/mcf -- the same net cash flow as when the market price is $11. Hedges smooth out the cash flow.

      Note that hedges are actually not usually in Mcf but in BTUs since gas is priced on BTU content. 1 cf = approx 1030 BTU, so 1 Mcf = 1.03 MMBTU. If you look at hedge positions in a 10Q or 10K, you will see the NG hedges in BTU volumes.

      • 1 Reply to badbernanke
      • One further note -- hedge gains and losses for LINE and other MLPs are ordinary income/expense, not capital gain or loss. The realized settlement gain or loss increases (in a gain) or decreases (in a loss) the ordinary income reported to investors on the K-1.

        It is possible (depending on all the circumstances) that LINE will have an additional loss of $68 million due to the LEH hedge termination in 2008, but the amount and timing depends on tax rules applicable to such an event and how to value the potential recovery.

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