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Financial Reform: Why Shielding Energy Firms From Derivatives Rules May be Nuts

Concerns that energy companies want to dodge proposed restrictions on derivatives can be summarized in two words: Andrew Hall. He's the star trader who stood to collect a $100 million bonus from Citigroup (C) until controversy over the windfall forced the banking giant to send Hall packing, along with his lucrative energy brokerage unit -- straight into the arms of Occidental Petroleum (OXY).

The 2009 deal wasn't merely the result of mounting political heat on Wall Street, however. It also underscored a trend in which financial firms and a range of companies use derivatives, leverage and other tools of modern finance to place bets on grain, gold, crude oil and other commodities. If energy companies once used derivatives strictly to hedge against price, currency or interest-rate changes, now they see these securities as a way to boost profits. But at what risk? As one equity analyst said of Occidental after it acquired the Citi subsidiary, called Phibro:

They never gambled before, and now they own the casino.
Toeing the line In other words, the bright line between hedging and speculation that has so visibly dimmed in the trading pits of Wall Street is also fading in the commodities world. That's of particular relevance in the oil patch. Crude is the most highly traded commodity in terms of future contracts; its price is also a key measure of inflation and market sentiment.

For legislators and financial regulators, then, deciding what kind of energy, manufacturing and other non-financial players deserve safe harbor from derivatives regs requires making difficult judgments: Do derivatives increase the volatility of commodity markets? Do they spur investment and lower costs? Do they put private gains ahead of public risks? Could contagion in the spot markets wreak havoc in the financial world?

Such questions have few clear-cut answers. Not that oil companies and other large energy players are asking. They simply want lawmakers meshing the House and Senate financial reform bills to exempt them from the legislation's new derivatives rules. The regulations would require investment banks, hedge funds and other securities firms to trade derivatives on regulated exchanges. Major dealers also would have to post more collateral to cover potential losses. More broadly, the goal is to make derivatives trading safer, discouraging the kind of speculative binges that battered the global economy.

Betting on Phibro Energy companies, along with other commodities providers, say they use derivatives not to gamble, but rather to protect themselves against a rise in the price of oil, gas or electricity. Such firms also contend that this activity poses no systemic risk because the deals account for only a small fraction of all derivatives trades.

Indeed, there are good reasons to shelter some non-financial companies from derivatives rules. For instance, everyone benefits when airlines use swaps to guard against spikes in the price of jet fuel. Such companies' "needs are different than those of the dealer entities," Willa Bruckner, an attorney with Alston + Bird who specializes in derivatives, told me in an interview. "Requiring them to post a lot of cash to do a transaction will increase the cost of those transactions. There are many derivative and hedge transactions that allow companies to predict their cash flow a little bit better, and that lets them manage their business better and serve their customers better."

Yet Bruckner acknowledges that it's getting harder to tell when companies use derivatives to exploit risk rather than to hedge it. In the energy sector, that's partly because they do both. As Occidental notes in its financial reports:

Additionally, Occidental, through its Phibro trading unit, engages in trading activities using derivatives for the purpose of generating profits mainly from market price changes of commodities, in part using similar derivative instruments.
Meanwhile, it seems clear Occidental didn't buy Phibro to play it safe. As a small but highly profitable unit at Citi, the trading operation was known for letting it ride. The flamboyant Hall, known for his sterling art collection and penchant for castles, is a legendary energy speculator. The oil company evidently thinks highly enough of his trading abilities that it took a 20 percent stake in a separate $1.4 billion hedge fund Hall launched earlier this year while also working for Occidental.

Remember Enron Energy firms face two primary dangers with derivatives: mispricing them and the sudden disappearance of liquidity. Even companies that use these instruments only for hedging face risks. In 1993, a trading subsidiary owned by German conglomerate Metallgesellschaft took huge energy derivatives positions to lessen the parent company's exposure if it failed to deliver gas, diesel fuel and heating oil. When energy prices went haywire that year, it lost billions. German and foreign banks had to bail the company out.

The comparison to the subprime meltdown, when credit also suddenly evaporated, is apt -- and scary. Like bankers during the crisis, energy traders in 2008 and 2009 experienced wild price swings and sloshing liquidity, especially in over-the-counter derivatives. It's not clear to what extent that rocky ride owes to the use of energy trading, notes economist Chiara Oldani of Italy's University of Viterbo, in a recent paper. In short, we don't know what impact derivatives really have on the energy industry.

Another issue weighs on the debate over energy derivatives: Enron. As you'll recall, it started as a provider of natural gas and electicity. Like energy companies today, it also claimed to use derivatives for hedging. But as it grew, Enron gradually morphed into what amounted to a giant, and utterly reckless, trading firm. To put it another way, a benign energy provider that is shielded from regulation today could in time evolve into a far more malevolent beast, especially as the line between hedging and trading for profit erodes.

Members of the financial reform conference committee will, one hopes, ponder such episodes, and the threat of ignoring them. For their part, energy companies hope to change the Senate financial reform bill, which is stricter than the House measure and which would subject most companies that deal in derivatives to regulation. If lawmakers play ball, they should at least require the Commodity Futures Trading Commission to monitor energy firms' trading units.

Otherwise, we could be playing with, well, oil. Oldani writes, "Like credit derivatives, energy derivatives can be similar to hell: easy to enter and impossible to exit."

Image from Wikimedia Commons, CC 2.0

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