Minimum Volume Commitments
The new ASC 606 standard creates challenges for midstream operators—but solutions are available.
By Marc Gorewitz, Jennifer Tu and Sandy Dhariwal, in Midstream Business
Minimum volume commitment contracts (MVCs), often referred to as throughput agreements, are agreements under which a shipper or producer—a counterparty—undertakes to transport an agreed minimum volume of a commodity such as natural gas, NGL or crude oil through a third-party operator’s assets, such as pipelines or processing plants, over a specified period.
In the midstream industry, these contracts are typically utilized to enable the operator to recoup the costs of constructing infrastructure, such as a processing plant or pipeline lateral, for the benefit of the counterparty. Under these agreements a counterparty pays a shortfall or deficiency fee if the MVC is not met for a specified period—monthly, quarterly or annually.
Several challenges exist in tracking these volume commitments. Tracking of throughput agreements tends to be a manual and time-consuming process; invoice statements to producers are often challenged and it is difficult for the organization to track and have reporting insight with respect to the number of these agreements and the progress of each counterparty in fulfilling their obligations.
Companies face difficulties tracking these throughput agreements to determine if commitments are being met within the contractual time periods. At most companies, throughput agreements are tracked in spreadsheets, outside of commercial systems.
While commercial systems have the functionality to calculate the settlement for actual volumes transported, these systems are rarely capable of calculating whether a commitment has been met for a specified period.
These throughput agreements often have diverse structures that contribute to the complexity in tracking them. Some common features include:
Rollover/Excess volume carry-forward provisions—This is the ability of the counterparty to roll over volumes flowed in excess of the MVC in the current period and apply against the commitment level for subsequent periods (offset shortfalls in future periods). Excess volumes may either be carried forward until utilized or may expire if unused by a specified date. Rollover provisions may allow 100% of the excess volume or a specified percentage to apply to future MVCs.
Deficiency cap—Another common provision is a deficiency cap that essentially places a limit on the amount of the shortfall or deficiency that can be charged to the counterparty within the contractual period.
Makeup rights—This is the ability for the counterparty to make up shortfalls by flowing excess volumes in future periods. Often no deficiency fee is due until the makeup period has expired. This may also be structured as the potential for the refund of deficiency fees in future periods.
Third-party volumes—In certain agreements, in addition to counterparty volumes, third-party volumes on those same assets may be applied toward satisfying the volume commitment.
In addition to the above provisions, there are other factors that may impact deficiency calculations. An example would be adjustments for operational issues such as unplanned maintenance, weather or other force majeure events that prevent a counterparty from flowing the commodity and thus impact their ability to meet the commitment. Another example would be a prior period adjustment where it is subsequently determined that actual volume was higher or lower than the initially reported volume, which may result in the determination that a counterparty has actually satisfied a commitment for which it was previously thought a deficiency was due.
The adoption of the Financial Accounting Standards Board’s Accounting Standards Codification (ASC) 606, “Revenue from Contracts with Customers,” has added another layer of complexity to these calculations. ASC 606 is effective for public calendar year filers from Jan. 1, 2018, and for private calendar year filers from Jan. 1, 2019.
As part of their adoption of ASC 606, companies are required to disclose the future minimum fixed (unearned) revenues to which they are entitled over the remaining life of their contracts with customers.
Given the fact that these throughput contracts represent a counterparty’s fixed minimum obligation over multiple years, the future minimum revenues to be earned for these agreements and the expected timing of such recognition must be disclosed under ASC 606. The unearned future minimum revenues must be disclosed in the financial statements at each reporting date (quarterly for public companies and typically annually for private companies). Therefore, there is an ongoing requirement to adjust MVC calculations for actual volumes and other adjustments, such as fee escalations, in order to generate these disclosures.
A case study
At Opportune, we recently completed an enterprise-wide revenue recognition project for a large midstream client. As part of this project, Opportune designed a solution for consolidating the unearned revenue at a contract level across all business segments.
Several of the client’s business segments had MVCs that required disclosure under ASC 606. Opportune Process & Technology consultants worked in tandem with Opportune Complex Financial Reporting (CFR) consultants to deliver the solution.
The CFR resources analyzed the contracts to determine the fees that were subject to the ASC 606 disclosure requirements and assisted the client in drafting the technical accounting memos summarizing how revenue was to be recognized upon adoption of ASC 606.
The midstream client had a high number of throughput agreements spanning multiple assets, which contained several of the contract provisions referenced earlier.
Historically, all the MVCs had been manually tracked outside of the commercial application within separate Excel spreadsheets. While the Excel spreadsheets each utilized similar calculations to track the commitments, there were no common templates with the same formulas. Therefore, aggregation and review was difficult. Opportune’s CFR team worked with the client to develop a standardized set of Excel templates with a common set of inputs, calculations and consistent output formats.
A new set of calculations were added to the commitment templates to facilitate the calculation of the unearned revenue for the purposes of the new ASC 606 disclosures. There were a number of benefits coming out of the development of the standardized templates. They included:
- Greater spreadsheet integrity and reduced risk of errors;
- Ease of review for both accounting and external auditors with a robust audit trail back to contracts;
- Dual purpose—not only could the client calculate deficiency fees and progress against volume commitments, the client could also generate the metrics required for ASC 606 disclosure;
- Setup of tracking for new contracts was simplified; and
- Ease of training and ability to transfer responsibility for tracking different contracts because everyone is familiar with a common set of templates.
The Excel MVC templates are still subject to limitations of a manual process. The next evolution of this solution would be to automate the tracking and calculation of these volume commitments within an integrated application across the enterprise and facilitate the sharing of information with counterparties within a web-enabled mobile platform.
One such platform that would be a logical fit for this solution is the Salesforce development platform. Out of the box, Salesforce provides a cloud-based architecture that allows for sharing of data, both inside and outside an organization.
The solution envisioned would either import or interface actual volume data from within the source system(s) and support the calculations required to track actuals against a commitment level while factoring in contract provisions (rollovers, deficiency caps, etc.) and calculate any deficiencies.
Storing the data in a common repository would facilitate reporting of multiple volume commitments within one segment and across the enterprise. Built-in Salesforce analytics would provide a means to capture key metrics on these agreements.
Lastly, the operator of the asset would have the option of sharing the status of the MVCs with counterparties in near-real time using a secured portal, thus enabling the counterparty to increase or decrease volume flows to meet volume commitments before the commitment period ends.
Marc Gorewitz is a Director with Opportune LLP, Jennifer Tu is a director in Opportune’s Process & Technology practice and Sandy Dhariwal is a manager in Opportune’s Complex Financial Reporting practice.