NGW, a consumer gas provider, estimates a rather cold winter. As a result it decides to enter into a futures contract on the NYMEX for natural gas on November 2, 2016. The trading unit is 10,000 million British thermal units (MMBtu). The three-month futures contract rate is $7.00 per MMBtu, so each contract will cost NGW $70,000. In addition, the exchange requires a $5,000 deposit on each contract. NGW enters into 20 such contracts.
REQUIRED
1. Why is this futures contract likely to be considered an effective hedge and therefore qualified for hedge accounting?
2. Why would this transaction be accounted for as a cash-flow hedge?
3. Assume that the December 31, 2016, futures contract rate is $6.75 for delivery on February 2, 2017, and the spot rate on February 2, 2017, is $6.85. Assume that NGW sells all of the gas on February 3, 2017, for $8.00 per MMBtu. Prepare all the necessary journal entries from November 2, 2016, through February 3, 2017, to account for this hedge situation.