Will financial system regulatory reforms make energy price hedging costly – or impossible?
That was the question experts grappled with – and disagreed over – at the National Association of Regulatory Utility Commissioners (NARUC) meeting in Washington, DC this week.
The Commodity Futures Trading Commission (CFTC) is developing dozens of rules, as ordered by the Dodd-Frank financial reform bill, to try to prevent the kinds of trading abuses that led to collapse in derivatives markets in 2008. While the collapse came in the mortgage market, it opened questions about all derivatives markets.
Among those reforms are restrictions on swaps dealers, which may affect institutions like investment banks that often write derivatives contracts that hedge electric utilities, oil and gas producers, and fuel distributors against big price swings. For a fee, the dealers either take on the price swing risk or find another investor willing to do so.
Swaps dealers will be subject to substantial new regulations and, under a provision called the Volcker Rule, prohibited from proprietary trading. There are charges that, before the 2008 collapse, some banking entities were trading against clients’ interests to make profits for their own trading. Major investment banks have made billions from derivatives since the market emerged last decade, and they’re fighting many aspects of the proposed rules.
CFTC Commissioner Scott O’Malia said he fears the definition the CFTC majority is considering of swap dealers remains “too broad” and the exemptions for trading by “end users” of energy too narrow. Since dealers lay off their risks from contracts with other trading, he said the rule could “dry up liquidity” for the energy markets.
He called the pending rules “a 300-pound Rube Goldberg.”
The Energy Industry Responds
Richard McMahon of the Edison Electric Institute said utilities support the goals of Dodd-Frank, to lower systemic risk, but thought Congress made clear its intent to exempt users of physical energy like utilities and energy producers. He said the proposed rules appear to make parties apply for individual exemptions, trade by trade, which he called “extremely bulky and burdensome.”
Jeff Kittrell, General Manager of International Market & Commodity Risk at Anadarko, said his company fears the pending rules will increase market volatility, decrease trading opportunities, and thereby lower the amount of money available for new exploration and production.
But Mark Cooper, with the Institute for Energy & the Environment, said it was the entry of derivatives trading that introduced high volatility into the energy business. Years ago, he said, utilities signed 20 year supply contracts – now, they’re lucky to get a contract for three years. “The volatility of the last 10 years swamps the past,” he said.
The purpose of derivatives markets is supposed to be smoothing out the ups and downs of physical markets, Cooper said, but instead commodity derivatives have become “an asset class” drawing investment from hedge funds and “dentists from Long Island.” The derivatives market grew far larger than the physical markets underlying them, and led to speculation that pushed energy prices way out of whack with supply and demand fundamentals, he said.
“For 50 years, prudential regulation worked well,” Cooper told NARUC, but state regulators are increasingly accepting contracts indexed to trading markets over which they have no influence. “Back to the future!” he urged.
The States Weigh In
Commissioner Ken Anderson of the Texas Public Utility Commission said his state, which has deregulated much of the electricity industry, encourages hedging and has seen its consumer prices, under retail competition, go down. Cooper said that was mainly due to the massive shale discoveries driving down natural gas prices. “The fundamentals are working for you,” he said.
O’Malia told the conference, “We are trying to figure out what makes sense. We don’t want to add to costs” or reduce options for energy companies.
Nancy King, Managing Director at Morgan Stanley, said, “There are misperceptions that (Dodd-Frank) is just a bank problem.”
She said that the issues are complex and “people affected need to speak up” and let the CFTC know how pending rules will affect their businesses. “We understand the need” for reform, she said, but the CFTC is considering so many new rules at once, regulators may not see how they affect the overall market.
Photo Caption: Commodity Futures Trading Commissioner Chairman Gary Gensler (C) speaks during a joint hearing before the Capital Markets and Government Sponsored Enterprises Subcommittee and Financial Institutions and Consumer Credit Subcommittee of the House Financial Services Committee January 18, 2012 on Capitol Hill in Washington, DC.