The decade long reformation of energy trading now looks to be only the opening act of a transformation that Dodd Frank regulation and a newly aggressive – and costly – approach by federal regulators is set to propel into its next stage.
Deregulation of energy markets, only partially finished by federal regulators before the collapse of Enron, which took the wind out of their sails just over ten years ago, has made for some unlikely bedfellows. It is hard to pity an energy trader, but feel at least for the complexity of operating a desk at someplace like JP Morgan or Noble, where only a matter of months ago paychecks, strategy and compliance originated at the Royal Bank of Scotland and within short institutional memory before that at Sempra Energy.
Alongside the “financialization” of broad swathes of the rest of the economy, with banks loosed to leverage newly available data and create financial products for a world aflood with cheap money of varying forms, financial institutions came to dominate the energy trading game. Financial players have always been key to capital-intensive energy markets, but for the past five years it has become increasingly difficult to tell a bank from an oil company.
While anecdotal examples like the storage of millions of barrels of oil on tankers rented by banks off the coast to take advantage of price spreads attract the most attention, the data collected by regulators like the Commodity Futures Trading Commission and the Federal Reserve underline the scale of the change. Traders without any correlating underlying physical position in oil have taken increasingly huge bets in the most-traded and liquid oil contracts, with debatable impacts on both pricing and longer-term investment decisions. For more analysis of this complicated subject, here is a good intro and much more information on the CFTC site here.
Now banks appear to be rethinking their energy strategy, at least in part because new regulations devised to make it difficult for them are starting to take effect. Whether this undermines the very innovation and entrepreneurialism that deregulation was intended to promote or whether it is a long-awaited rebalancing of the market back in favor of clearer supply-demand signals designed to serve customers is an open question, but a partial ‘de-financialization’ of energy has a ‘back to the future’ flavor that oil company shareholders, managers and regulators will want to handle cautiously.
As Wall Street firms like JP Morgan mull the disposal of their energy trading desks, it is the traditional oil and gas firms that may take their place, resuming a central role in energy trading. Recent analysis of the integrated oil majors in the wake of disappointing quarterly results by analysts at Sanford C. Bernstein argues that the firms could regain some buzz and higher valuations if they resume broader trading activity.
“Rising US oil output twinned with a shift in demand growth from the Western to the Eastern Hemisphere have change how oil flows around the world,” Liam Denning wrote in summarizing the research in the August 12 Wall Street Journal. “This creates trading-profit opportunities for firms with global oil production, refining and logistical infrastructure – and big balance sheets.”
Getting oil companies back to the heart of energy trading has its self-evident benefits. If the market is about serving customers and creating incentives for investment, no commercial entity is better placed to understand and address the gaps shown up by trading patterns than an oil company. Banks have other criteria to meet, and as trading strategies compete for capital the long-term future of the energy market is not necessarily their primary concern – that makes them excellent counter parties for risk management, but ineffective if they come to dominate trading.
But if the past decade of tinkering with energy markets has taught the sector anything, it is the importance of being on watch for unintended effects of regulation. It is analogous to remember car companies, which in the years before the financial crisis became more or less pyramid schemes, captive to and marginalized by their own lending arms so that innovation and responsiveness to the actual car market were ignored. Oil and gas firms, as the explosion in development and new field investment testifies, have managed to avoid this warping of their business model in recent years, and a return to a central role in trading comes with risks.
Oil firms need to be watchful of the trend to self-cannibalize by mortgaging their own long-term futures against the short-term nature of trading strategies. They will need to learn greater transparency, hardly an oil company sector specialty, and embrace once again the public turbulence that comes with price-setting power.
Oil and gas firms, for all their unpopularity in parts of the popular imagination, are credible and credit-worthy enterprises on the verge of another transformative chapter in energy trading dynamics, a chapter that threatens to undermine their independence even as it seems to grant them greater authority. Company management will, in the Sheryl Sandberg phrase, need to ‘lean in’ if they expect to lead, and actively manage their interests in the financial and regulatory markets of the world if they hope to avoid the regulatory capture and financial upheaval that has wracked Wall Street.
This commentary is by Peter Gardett, founding editor of Breaking Energy. All opinions and analysis are his own.
