Groups work to limit potential adverse impacts of Dodd-Frank law

"It's hard to see the big picture. We're focusing on trees, but we don't know what forest we're in."
—Mark W. Menezes, partner, Hunton & Williams LLP

The new regulations are being developed at a crucial time. "Our economy has yet to recover. Now is when we need the private sector to invest in new projects and create jobs," explained Mark W. Menezes, a partner specializing in regulated markets and energy infrastructure at Hunton & Williams LLP in Washington, DC. "If new regulations make them move cash into a capital account, it is taken it out of commerce."

Oil and gas industry association officials, themselves dealing with potentially adverse and unintended consequences as the Dodd-Frank law is implemented, concurred with Menezes' assessment that a major problem with the commodities provisions is that CFTC doesn't have much time to get the job done. The Dodd-Frank law is scheduled to go into effect in mid-July. While CFTC has indicated informally that it is unlikely to meet that deadline, the agency continues to operate under a tight timeframe.

CFTC's challenges

The 2005 Energy Policy Act was the last time regulatory agencies had to develop and implement regulations from such sweeping legislation, Menezes explained. "That energy bill took three congresses to pass, so most of the affected regulators saw things coming," he told OGJ. "In this instance, there have been few cases since the CFTC was created where it has been forced not only to meet complex requirements, but also to increase its operations."

Demands for more stringent commodity regulations began as oil prices spiked in the first half of 2008, and then abruptly plunged by the end of the summer, he said. When the bottom fell out of financial markets that October, triggering a major economic recession, calls for reforms grew beyond energy commodities. Congress broadly responded with Dodd-Frank in slightly less than 2 years.

"It was unusual that Congress would expect the CFTC and SEC to write these rules," Menezes said, adding, "In hindsight, Congress may not have realized how complex these issues were."

Federal lawmakers did get the message as oil and gas producers and other end users of energy commodities spoke up, and the law exempts them from more stringent financial and reporting requirements aimed at swap dealers. They're still concerned that evolving regulations might unwittingly sweep them in, however.

So far, CFTC has issued rules in great deal on a variety of complex subjects, but in a way that's difficult to see how one rule affects another, Menezes added. "We've had rule after rule on everyday matters, but these companies don't know yet if they're covered," he said. "It's hard to see the big picture. We're focusing on trees, but we don't know what forest we're in."

The uncertain swap dealer definition is one of many implementation issues larger producers face, according to Jenny Fordham, vice-president for markets at the Natural Gas Supply Association. "We were somewhat caught in the net by actions targeting financial markets," she said. "Prices across the board increase as concerns with the banking industry emerged. The solution which came into vogue was to require every deal to be cleared, but that take into consideration what it would do to companies using physical assets to back their transactions and corporate capital programs."

'A lot of transparency'

Requiring all energy commodity transactions to be cleared through a regulated exchange is also a concern. "There's already a lot of transparency in the energy industry. It already was so far ahead of other industries that participants would not benefit from a clearing requirement, relative to the increased cost," said Susan W. Ginsberg, vice-president of regulatory affairs at the Independent Petroleum Association of America.

Many upstream independents hedge their production to manage their cash flow, Ginsberg noted. "Our members also do a lot of over-the-counter trading. They still clear many of their deals, but use a mixture to hedge and help manage cash flow," she said, noting that OTC trades can be based on a producer's credit rating, or the producer's counterparty might hold loans secured by the producer's reserves.

"If a business which puts 150% of its cash flow back into its operations has to divert a portion to a margin and clearing account, that's money that's not being used to find oil and gas," Ginsberg told OGJ. "End users should come out all right when the CFTC issues its rules. But it's being forced to do so much in such a short time that our members are concerned."

"We were somewhat caught in the net by actions targeting financial markets."
—Jenny Fordham, vice-president, markets, Natural Gas Supply Association

Keeping the end user exemption is crucial for producers that use commodity swaps, Fordham said. There also are some issues with the exemption itself, such as the CFTC's proposed requirement for a company getting its board's approval each time a trade occurs, effectively making it unworkable, she indicated. Another issue is a counterparty's verification of end user status, she said.

A new problem has recently emerged, the NGSA official said. While the law exempts options that are physically settled from designation as a swap, a commodity option and agricultural swaps notice of proposed rulemaking that the CFTC recently issued would sweep them in. "A lot of energy companies use options that are intended for physical delivery," she pointed out, adding, "A utility might use them with its supplier to get assurance of delivery to the city gate in a given period. Otherwise, the utility has to store more in its own system for emergencies. This could be a big issue for gas processors and municipal utilities if they use contracts with physical delivery options."

Market definitions

Still to be formulated are what constitutes the actual market, financial market, and cash market where there's no intent to take a physical delivery, she continued. "If the goal is to keep financial markets from interfering with physical markets, the position limits debate should focus on physically settled contracts," Fordham said. "As it's proposed, there's such a rigorous reporting obligation and narrow definition of a hedge in the bona fide hedge exemption that it's effectively gone."

CFTC's staff has started to move from some troublesome early positions, she indicated. It initially felt that anyone trading swaps qualified as a dealer requiring heavier regulation regardless of net. Another trend seems to be to require risk to be matched precisely in order to hedge, which is impossible in the energy business because a producer never knows what it's going to recover from the ground. This is sometimes referred to as a "tick-and-tie" requirement, which effectively would eliminate the ability to portfolio hedge, Fordham said.

"If a business which puts 150% of its cash flow back into its operations has to divert a portion to a margin and clearing account, that's money that's not being used to find oil and gas."
—Susan W. Ginsberg, vice-president, regulatory affairs, Independent Petroleum Association of America

The essential issues are the regulations' potential economic drain, the market's continued ability to function, and producers continuing to be able to enter into cost-effective hedging transactions, she told OGJ. "It's unfortunate, but my guess is that this uncertainty is being incorporated into companies' business plans," Fordham said.

"It was clear Congress wanted to regulate swap dealers, who provide liquidity and engage in speculation," Menezes said. But the law also identified a new group, major swap participants, he added. "For end users and major energy firms, the concern was not to be identified as either. They have physical assets and use hedges to protect against volatility," he said.

Speculators also have a clear role in markets because they add liquidity, Menezes said. "If end users suddenly became dealers, they might not want to be in that business. If they pull out, that will leave only the entities which Congress wanted to regulate," he said.

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