Understanding how the "normal purchase and sale exclusion" under FASB 133 affects earnings volatility.
Mike Walker is head of North American Strategic Consulting at Caminus, where he provides advice and insight to energy market participants and regulators on the development of traded markets in power gas and other energy commodities, and the effective management of risks in such markets. Prior to joining Caminus, Walker was with the Ernst & Young LLP and Cap Gemini Ernst & Young US LLC firm where he served as the operations director of the Magellan Center for Trading & Risk Management. Walker holds a Bachelor of Science and a Juris Doctor from the University of Kansas.
You are a utility service provider. You don't normally have to hedge your energy purchases. You simply obtain a mix of long-term, medium-term, and spot physical purchases, and pass the costs on to your customer through your rate recovery mechanism-such as a fuel adjustment clause or a rate filing. Now, however, you are going to start serving customers who can purchase energy outside of the traditional rate recovery mechanism. These so-called "deregulated customers" are not going to accept pass-through of annual energy cost increases-although they may accept pass-through of energy cost decreases.
Funny how fickle a customer can be. But the problem of customer retention and satisfaction can be compounded for management when shareholders object to increased volatility of corporate earnings. Greater earnings volatility usually translates into lower price/earnings (P/E) ratios and lower P/Es equal lower share prices.
The P/E ratio is the price of a stock divided by its earnings per share. The P/E ratio, also known as a multiple, gives investors an idea of how much they are paying for a company's earnings power. The higher the P/E, the more investors are paying, and therefore the more earnings growth they are expecting.
The earnings volatility arises from the Financial Accounting Standards Board (FASB) Rule 133. Rule 133 mandates that energy contracts (purchases and sales) that are derivative contracts must be reported on the balance sheet as an asset or liability at fair value. Changes in fair value are recognized in earnings unless specific conditions are met.