Welcome to Wall Street's briar patch

Gordon Allott, BroadPeak Partners Inc., New York, NY

Producers who trade should be wary about drawing any conclusions that their regulatory world will remain unchanged. Despite the energy industry's resilience and ability to weather massive shocks like Enron and SEM Group, energy companies are now subject to the Wall Street Accountability Act.

On July 21, 2010, Congress enacted the Wall Street Transparency and Accountability Act or "Dodd-Frank" to reign in runaway derivative trading. The Commodity Futures Trading Commission (CFTC) has been hard at work developing the rules under this Act that will ultimately go into effect on July 14, 2011. This article is an attempt to outline how Dodd-Frank and CFTC rules will most likely unfold for producers and provide a key framework for how Dodd-Frank works.

Prior to Dodd-Frank, commodity transactions were governed primarily by the Commodity Futures Modernization Act (CFMA). The CFMA left commodity transactions largely outside the reach of the CFTC, and as a result left energy companies with minimal regulatory obligations. Dodd-Frank effectively replaces the CFMA and, in short, makes it illegal for producers to execute trades outside the forthcoming CFTC rules.

So what does Dodd-Frank mean to a producer? It means that every trade is now likely under the jurisdiction of the CFTC and should be evaluated to determine if it has Dodd-Frank regulatory obligations.

As a rule, if the CFTC deems a particular transaction a swap, it must be cleared. That is, unless there is an applicable exception. It is worth mentioning that the CFTC uses the term "swap" very liberally. Generally, in our industry we think of swaps as a financial product that exchanges fixed for floating prices, and floating for fixed prices. But the CFTC takes a much wider view of swaps to include just about any transaction that has a price or event contingency. For example, the CFTC considers a natural gas option a "swap" as well as any other future transaction with financial settlement. In general, the CFTC considers a "swap" as any product that is:

1. contingent on an economic or other event;
2. financially settled (as opposed to physically settled); or,
3. a physical trade that does not meet the requisite level of intent to take delivery.

Using this definition many energy products including swaps, basis swaps, options, swing contracts, and others fall under the clearing requirement. So as a rule, many products which producers have become accustomed to trading are now technically required to be cleared. That is, unless there is an exemption.

The foremost exemption is an express determination that a particular product falls outside the clearing requirement. The CFTC has the ability to leave out certain products based on its interpretation of Dodd-Frank. For example, a product might meet the definition of a swap, but if there is no clearing organization for the product then it is likely to be exempted.

There has been a lot of press recently regarding the CFTC's proposed exemption of forward contracts. These are cash contracts for physical delivery that the CFTC largely considers merchandising transactions as opposed to swaps. But there is a catch. The CFTC only exempts forward transactions that are intended to be physically settled. Take for example, a producer that has gas exposure in the Barnett. To hedge its exposure, the producer executes physical forward sales at Henry Hub. If the producer does not have transportation agreements and scheduling capabilities necessary to actually move the gas from the Barnett, it is doubtful that the producer can prove the requisite "intent" to deliver the product. This is tricky, because many producers use physical forwards as a part of their business. Under Dodd-Frank, if the producer cannot actually deliver the product, it is considered a swap and must be cleared.

Oil and gas associations like the IPAA lobbied hard to carve a regulated safe-harbor for un-cleared swaps by creating an "End User Exemption." It's important to be clear on the narrow scope of this distinction. The end-use exemption is not an exemption from Dodd-Frank; it is only an exemption to clearing.

To the extent that a company is using "swaps" for bona-fide commercial hedging purposes, those hedges will not be required to be cleared. Bona-fide hedging is considered hedging of native physical commodity risk or other risk intrinsic to the business. The result of the exemption is that producers' trades are still absolutely regulated, but if they are bona-fide hedges, the producer may file paperwork to exempt the trade from the clearing requirement.

The paperwork for the exemption includes a statement to the CFTC as to how the producer meets its financial obligations for non-cleared swaps. It is currently unclear whether a producer must make this statement every time it enters a swap or whether it can do so on a semi-regular basis. This was brought up in the rulemaking process and we expect some clarity with final rules.

An ECP is an "Eligible Contract Party." An ECP is an entity that has assets of $10 million or greater. Most producers that engage in trading will fall into this regulated category. To the extent that a producer does not meet this threshold it must only use cleared transactions. What is important to recognize is that when it comes to trading Dodd-Frank's "swaps," there is no such thing as an unregulated designation.

First and foremost, producers should recognize the scope of "swaps" under Dodd-Frank is expansive. Congress conveyed a great deal of authority to the CFTC to regulate trades, which is quite different than the previous regulatory regime. Producers should recognize they are becoming a part of a regulated category and that any trade they enter into may have Dodd-Frank implications.

Producers are going to see the greatest amount of change with their trading counterparties. Marketers, regional banks, and large financial institutions are the primary providers of hedges to producers. Under proposed regulations, there is some probability that these companies will fall into highly regulated categories such as "Major Swaps Participants" or "Swaps Dealers." As such, there are stringent regulatory requirements, particularly with regard to collateralization of transactions.

Producers will no doubt feel a trickle-down effect as their counterparties pass on more rigorous margin and collateral requirements. In a nutshell, everyone under Dodd-Frank is going to pay out more in margin, including producers. This is going to require more robust margin management and collateral capabilities to support market transactions.

The end-use exemption requires producers to make an earnest statement as to how that producer manages its own counterparty exposure. Should the CFTC find that a producer does not have sufficient operations to manage OTC credit exposure, there is a risk that the exemption will be disallowed. In short, we are advising producers to establish at least minimal credit monitoring and collateral management programs to support the End-User statement.

Should producers avoid all the hassle and just clear their OTC swaps? It could be the right solution, but participating in a cleared market comes with it new challenges. These include working with an FCM (Futures Commission Merchant), understanding exchange collateral calculations, and capture of exchange and clearing fees. Not to mention a defined program for determining daily transaction values and settlement support.

BroadPeak's Market Services Group has been working with a number of producers to help them improve their internal mark to market, credit management and exchange programs. Our experience is that some producers are planning to simply steer clear of the financial markets by selling everything at the wellhead. This, in our opinion, is unfortunate as it directly affects debt advance rates and eliminates many of the very useful risk mitigation tools. The ability to internally manage and value positions has always been an area from which we feel producers can benefit significantly.

More Oil & Gas Financial Journal Current Issue Articles
More Oil & Gas Financial Journal Archives Issue Articles
View Oil and Gas Articles on PennEnergy.com