Energy Hedging in a "Reformed" Environment

While we tend to avoid spending much time addressing political issues, in recent weeks we've received numerous inquires from clients and others regarding the potential impact of the the Dodd-Frank bill as it relates to the hedging activities of oil & gas producers, large energy consuming companies, fuel & natural gas marketers, refiners, etc. 

In short, until the legislation is signed, sealed and delivered, it's impossible to say.  We've had dozens of discussions with clients, folks on both sides of the aisle in Washington, various industry trade associations, attorneys, academics, etc. and everyone seems to have a different opinion of the "end-user" exemption, should said exemption be included in a final bill.  It's also worth noting that the legislation as a whole is still in limbo due to a potential lack of "yay" votes in the Senate.

Having said that, we thought we would pass along a few interesting takes on the subject and the potential impacts of the proposed legislation as it relates to energy hedging. 

Earlier this week, Thompson & Knight published their views on the subject, with a focus on how the proposed legislation could impact oil & gas producers who hedge via OTC (over-the-counter) derivatives, in a note to clients titled, "Oil and Gas Hedging: How will it change?".  In summary, their opinion, as we interpret it, is that oil and gas producers should still be able to engage in hedging "as usual" with a few, potential changes:

• Banks will most likely be forced to conduct commodity, including oil and gas, trading through affiliated entities rather than the bank itself.
• Interest rate and foreign exchange hedges will most likely receive an exemption from the bill and as such, banks will continue to be able to trade OTC interest rate and foreign exchange derivatives as they do today.  One unintended consequence of this framework is that producers will, most likely, no longer have the ability to net their commodity, interest rate and FX positions.
• New and/or additional ISDAs will be required.
• Oil & gas producers will probably retain the ability to utilize assets as collateral for hedging.
• Hedging "costs" will increase as bank affiliated commodity trading entities will be required to maintain higher capital levels.  In addition, these new entities may be required to clear their trades, which means they will need to post cash collateral, the cost of which will be passed on to their customers.

If you're interested in reading the full version of the "alert" it is available on the Thompson & Knight website.

On Tuesday, Alistair Barr at Marketwatch.com, authored an article titled, "Derivatives group sees $1 trillion regulatory impact."  Among other things, the article states:

The International Swaps and Derivatives Association said Tuesday that the bill could lead to a requirement to post collateral for all over-the-counter derivatives that are not cleared, including those involving an end-user.

An earlier version of the legislation exempted corporate end-users from margin requirements on such transactions, but this is no longer in the bill, ISDA said.

Sen. Saxby Chambliss, a Georgia Republican, attempted to amend the bill on Tuesday to restore the end-user exemption, but failed because the Democratic leaders didn't want to open up the entire bill to fresh amendments...

If ISDAs view is indeed correct and the bill becomes law, hedging will definitely become more challenging for many market participants.  Having said that, if clearing is mandated, we have already identified more than a few "loopholes" that will provide many producers, consumers and marketers with legitimate options to circumvent mandated clearing requirements.

For an entirely different angle on the subject, it's worth spending a few minutes on Dr. Craig Pirrong's (Professor of Finance and Energy Markets Director of the Global Energy Management Institute at the Bauer College of Business, University of Houston) blog.  Craig is a derivatives guru and has written numerous, thought provoking posts (not to mention numerous academic papers on derivatives) on the proposed legislation as it relates to mandated clearing of commodity derivatives.  Of particular interest is Craig's view that a mandate which requires OTC commodity derivatives to be cleared via CCP's, such as CME Group, won't necessarily eliminate, minimize or mitigate systemic risk, as it is intended to do.  In fact, he makes numerous, strong arguments that mandated clearing requirements could actually increase systemic risk. 

In a nutshell, until the proposed legislation becomes law, we won't know how the Frank-Dodd bill will ultimately impact energy producers, refiners, marketers and consumers.  Stay tuned...