Because Congress won't let the absence of a problem stand in the way of grand solutions, the US oil and gas industry faces new threats to its ability to manage risk.
Responding to spectacular financial failures of 2008, Congress this summer passed, and President Barack Obama signed, a bill that will impose new limits and possibly large costs on tools producers use to protect themselves against harmful oil and gas price swings. A logical question to ask is how those tools contributed to the financial failures. They didn't. But the limits and costs are coming anyway.
In a report late last month, the law firm Mayer Brown explained how the Dodd-Frank Wall Street Reform and Consumer Protection Act will affect producers and other price hedgers such as transportation companies, utilities, and manufacturers. The firm reports that a section of the law entitled the Wall Street Transparency and Accountability Act of 2010:
• Eliminates the exemption from regulation under the Commodity Exchange Act for most over-the-counter (OTC) energy derivatives—those not traded on central exchanges.
• Adds regulations for OTC derivatives that at least will increase transaction costs.
• Might subject affected businesses to increased regulatory oversight, including minimum capital requirements and minimum initial and variation margin requirements.
Extent unclear
The extent of the changes won't be clear until the Commodity Futures Trading Commission and Securities and Exchange Commission refine definitions of important terms and clarify regulation of an exemption for nonfinancial hedgers, such as producers seeking to manage price risk. Even exempted producers will face increased reporting requirements and the need to avoid activity that would trigger regulation, Mayer Brown says.
An important goal will be avoiding classification as "a major swap participant." Swaps, which essentially exchange fixed for floating prices, usually involve financial institutions and occur off central exchanges. The new law defines "a major swap participant" as a business that maintains "a substantial position" in outstanding swaps other than positions held for hedging or mitigating commercial risk. "Large energy producing or consuming companies that are active in the OTC derivatives market will need to monitor their positions against the final rules promulgated by the CFTC that establish the parameters for a 'major swap participant' in order to ensure that they do not inadvertently fail to qualify for the 'end user exemption' under the act," Mayer Brown says.
A new and as yet uncertain regulatory hazard thus looms for oil and gas producers. It developed, notes the Centre for Global Energy Studies (CGES), out of concern for OTC derivatives that had nothing to do with oil, gas, or other commodities. The "main culprits" in the financial collapses of 2008 were instead credit default swaps. By March 2009, the market for credit default swaps had been tamed by the standardization of contracts and establishment of formal exchanges.
'Excessive speculation'
But that didn't stop Congress from attacking OTC commodity derivatives. "The irony of this move to curb the unstructured OTC market is that oil-related OTC paper played no part in the financial dramas that unfolded in 2008 and pushed the world to the brink of economic meltdown," CGES says in a comment published last month. The "avowed objective" of the new law—named for Rep. Chris Dodd (D-Conn.) and Sen. Barney Frank (D-Mass.), its main supporters—was to curb "excessive speculation." Yet most oil swaps represent hedging mechanisms offered to producers and consumers as a service by banks, which cushion their resulting exposure to price fluctuation on organized exchanges. "The OTC market is particular well suited to the needs of the oil business, with its great variety of crudes and products that are not amenable to standardization and thus involve unavoidable basis risk," the London study group says.
Repair of an unbroken mechanism thus threatens to create problems where none existed before. Oil and gas hedgers should be exempted categorically from the new controls. And voters need to score another blunder for the 111th Congress.
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