Mitigating Risk

In 2009, the Obama administration launched several initiatives designed to restore a crumbling financial industry. Given the way the banking markets imploded beginning in late 2008, a degree of reform was needed. However, some of the proposed changes may negatively impact banks’ participation in energy trading, which could change available hedging options for oil and gas producers.

In 2000, only 17% of independent producers used swaps to manage financial risk, according to the latest Profile of Independent Producers survey by the Independent Petroleum Association of America. Today, that percentage has almost tripled.

In December the U.S. House of Representatives passed the Wall Street Reform and Consumer Protection Act (HR 4173), and the bill went to the Senate for review in January. HR 4173 authorizes the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to regulate over-the-counter (OTC) derivatives trading. It requires that substantially all deals in the OTC markets be regulated and cleared, and gives the CFTC power to set aggregate position limits on OTC swaps in energy trading. The House rejected a portion of the bill that would have given the SEC and the CFTC power to establish margins for transactions involving end-users. At press time, the CFTC was awaiting final comments from the public.

Oil and gas producers have since expressed concern that this proposed legislation would make legitimate hedging more expensive by forcing the OTC transactions to clear.

Mandatory clearing of OTC derivatives will add costs, says Matt McComiskey.

“Mandatory clearing of OTC derivatives will add costs,” says Matt McComiskey, senior vice president, Shell Energy North America (US) LP. “Furthermore, mandatory clearing will restrict the ability of hedging counterparties to use the credit available to them via bilateral financial trades, which are often secured by lines of credit or non-cash collateral.

“The added working capital required to meet variation margins that must be adjusted daily with the clearinghouses may also negatively impact the ability to manage risk, due to the real-time, in-hand cash requirements that accompany cleared transactions.”

In September 2009, the American Public Gas Association suggested including an exception within the bill, in which mandatory clearing would not apply if “one of the counterparties to the swap is a producer, processor, merchandiser, distributor or a manufacturer of, or user of, a commodity and enters the swap to reduce or manage risks in connection with the conduct or management of its commercial enterprise.” The final bill may include this provision, but there are no guarantees.

“Depending on the final form of the legislation, mandatory clearing may increase the capital required to execute OTC swaps, limit the number of counterparties that will enter into OTC swaps and reduce overall market liquidity,” McComiskey says.

Bill HR 4173 also aims to more clearly separate “speculative” traders from “regular” traders. Speculative trading involves buying futures and/or options in the hopes that commodity prices will change, and there is little interest in actually owning the products that trade. Regular trading is when companies hedge a portion of their product to lock in commodity prices. Traditionally, E&P companies use hedging as a tool to mitigate commodity-price risk, and it will probably continue to be a fundamental part of the energy business, McComiskey says.

“Producers must have access to effective ways to manage their risks. Some of the proposed regulatory changes may make hedging more complicated and costly, but it will be just as important.”

It is unclear whether banks’ involvement in oil and gas hedging makes their trades speculative or regular. Paul Volcker, former Federal Reserve chairman and head of the president’s economic advisory board, has publicly stated that federally insured banks shouldn’t be allowed to do speculative trading. McComiskey says, historically, speculation has been part of an overall market-participant balance, and a diverse group of market participants has been needed for a free market to work properly. Eliminating speculation may reduce market liquidity and have other unintended market consequences, he adds.

Another point of contention is how HR 4173 defines a “major swap participant.” The administration’s proposed definition includes anyone who is not a swap dealer, maintains a “substantial” net position in outstanding derivative contracts, and is not using the contracts to maintain an effective hedge under Generally Accepted Accounting Principles.

Under a broad interpretation of “major swap participant,” oil and gas producers could be prohibited from hedging with their banks and forced to trade directly with the exchanges, which would require producers to post cash collateral twice daily, based on the mark-to-market value of their hedges. Industry watchers are concerned that many producers would be unable to afford the exchange hedging requirements and wouldn’t hedge at all. This exposes producers to pricing uncertainty and the ensuing insecurity for E&P budgets.

"Proposed reforms have caused E&Ps to turn primarily to their banks for hedging needs," says Chris Croom, president of Asset Risk Management LLC.

As a result of financial-market uncertainty, producers’ choices for hedging resources are already changing. When credit was more readily available, E&P companies used their lending banks, banks outside their lending group and nonbank counterparties for hedging. But proposed reforms in the financial sector have caused E&Ps to turn primarily to their lending banks to facilitate hedging needs, according to Chris Croom, president of Asset Risk Management LLC, a Houston firm that advises E&P companies on maximizing hedging results.

If the constraints and costs on hedging make it more difficult for firms to hedge, it follows that some producers, especially smaller ones, may certainly opt to hedge less. The effectiveness of such a move depends on market fundamentals and how futures prices are tracking cash prices that market participants want to hedge, says Craig Pirrong, professor and director of the Global Energy Management Institute at the University of Houston.

Pirrong says, “The smaller the company, the more adversely it would be affected by the various changes. In particular, if you move to mandates in clearing, it will be more difficult for smaller firms to set up the cash management to go to future-style margining. Small- to medium-size firms already have reduced access to potential counterparties. Position limits or the clearing mandates make counterparties want to reduce their exposure to the market even more.”

Liquidity loss

If banks face new limits because of concerns about speculative trading, the loss of liquidity in the market could be a long-term situation, though it should mitigate over time, Pirrong says.

“If the banks are limited, some of the major oil companies could fill the gap by being swap dealers. But their ability to do that is limited by the bill provision that says if you hedge more than double the spec limit, you can’t get an exemption for being a swap dealer. Even if the banks stay in the hedging business, the position limits for swap dealers are likely to constrain the amount of business they’re going to be able to do. Hedge funds may step up, but this brings producers additional counterparty risk.”

“The smaller the company, the more adversely it would be affected by the various changes,” says Craig Pirrong, top, director of the Global Energy.

The combined impact of increasing the working capital required to engage in OTC-cleared transactions coupled with significant limitations on, or the outright elimination of, speculative trading may reduce market liquidity. McComiskey notes that “any loss of market liquidity, short or long term, will be disruptive. And disruption may lead to more volatility.”

Although part of the point of HR 4173 is to achieve greater transparency in trades and position reporting, Croom points out that the posting requirement is an inefficient use of capital. Under the proposed legislation, businesses would be forced by regulators to post capital and margin in order to hedge everyday business risks, creating access-to-capital problems for companies.

During the financial crisis, one of the major goals was for banks to increase lending activity to E&Ps; the proposed rules would push producers to use critical lending bandwidth to collateralize hedges with banks.

During the past three years, commodity pricing has been the main driver influencing hedging decisions, Croom says. By year-end 2009, producers were starting to see some of their previous higher-priced hedges roll off, and many needed to add new protection volumes. Since the summer of 2008, commodity-price points and the valuation of options have changed.

“In 2008 to mid-2009, a producer could place a wide collar, capturing good protection to the downside but also allowing for higher price participation to the upside,” Croom says. “But toward the end of 2009 through today, those same collars are much narrower as the option values practically look like fixed-price swaps.

“These lower-priced hedges have the potential to have a significant negative impact given a price recovery in 2011 and 2012, unless producers can actively manage those hedges in their favor to increase protection and upside-participation levels.”

Mike Corley, founder and president of EnRisk Partners LLC, expects to see the percentage of companies actively hedging increase, in spite of uncertainties in pending legislation.

Survey says

Houston-based EnRisk Partners LLC, an energy hedging, trading and risk-management advisory firm, recently surveyed 38 U.S., Canada and Australia-based producers about hedging activity in 2009. Of the participants, 41% hedged regularly while 29% didn’t hedge at all.

“The number of producers that are required to hedge by their lenders or investors is relatively low,” says Mike Corley, founder and president of EnRisk Partners.

“We’ve been talking to a lot of bankers, and based on our discussions, we think many of them that haven’t historically required or encouraged their customers to hedge are going to do so in the future.

Several bankers have said one of the reasons they don’t require it is because they don’t understand it well enough. The banks that have energy trading desks generally understand hedging, but smaller banks that don’t have a trading function in-house often haven’t had much exposure to hedging.”

Corley expects to see the percentage of companies actively hedging to increase, in spite of uncertainties in pending legislation. “No matter what happens with the government, producers will still need credit to hedge, and credit is still tight for many oil and gas companies right now. It’s a double-edged sword. They need credit to hedge which, in turn, ties up a portion of their overall credit line(s).

“This situation is definitely more difficult for smaller E&Ps, but there are some well-capitalized smaller trading and marketing companies that are offering producers hedging services. However, since the collapse of Enron and its merchant energy peers, there’s been a definite decline in the number of companies that offer hedging, outside of the major E&P lenders with in-house energy trading desks.”

Corley says a hedging option for smaller independents is to turn to a larger, nonbanking entity such as Shell, BP or Koch Supply & Trading. If they don’t have credit with one of these companies, many will accept a letter of credit from the producer’s bank. In this scenario, the trading company’s credit risk is most often with the bank, not the producer.

“When prices are high, many producers are willing to take on more risk to reap greater rewards. For several producers, it took some serious pain for them to take a step back and evaluate their hedging programs more seriously. In some cases, they would put on one-off positions when they thought prices were going to decline or they wanted to take advantage of very high prices.

“Now companies are creating stronger risk-management policies and hedging strategies that they will be able to stick with regardless of whether prices increase or decrease.”

There are several reasons to hedge, but most producers’ primary objective is to guarantee a minimum level of cash flow that is smooth and consistent. No matter which way things turn in the government’s plans for financial reform, producers would do well to establish a formal risk-management policy and follow it, Corley says.

“They should also do their due diligence. It’s important to research other potential hedging counterparties before you actually need them. If a primary lender is suddenly no longer able to offer hedging, producers need to know where else they can go. There are other counterparties out there, but those relationships don’t form overnight.”