Uncleared margin rules threaten E&P hedging

Oil and gas exploration and production (E&P) firms face a dizzying range of challenges, including hurricanes, oil spills, collapses in energy prices and expropriations of their assets by foreign governments. Now, the firms have a new danger to worry about: the US Dodd-Frank Act.

Buried in the hundreds of pages of Dodd-Frank regulations are several provisions that have sparked alarm among E&P companies, which fear the law will limit their ability to hedge commodity price risk. In particular, market players are worried about a proposed rule that could require E&P firms to post cash or cash equivalents as margin on their uncleared over-the-counter swaps – something that could prove a major problem for the capital-intensive E&P business. Firms warn that if they are forced to lock up cash in margin accounts, they will have to spend less on drilling wells and discovering new oil and gas reserves, while some companies might stop hedging their output altogether.

E&P firms see themselves as innocent bystanders that have been unfairly impacted by Dodd-Frank – a law that was passed in July 2010 aimed primarily at reining in risk-taking among Wall Street banks. “Dodd-Frank was set up for credit default swaps, but it’s snagging a lot of people who drill,” remarks one senior US-based energy trader. “It eats up a lot of their budgets and a lot of their time. The uncertainty is really scaring them.”

Dodd-Frank is aimed at bringing many OTC derivatives trades onto central counterparties, where posting initial and variation margin is a mandatory requirement. However, the law acknowledges that clearing isn’t desirable for all firms, such as commodity market participants using OTC derivatives to hedge their commercial risk. As a result, Dodd-Frank includes an end-user exception to central clearing, designed to help firms in industries like energy, mining and agriculture continue to hedge. But at the same time, the legislation also instructs regulators to craft rules imposing margin requirements for uncleared trades with swap dealers and major swap participants.

Rival proposals

For firms that are not banks, this task falls to the US Commodity Futures Trading Commission (CFTC). For firms that are banks, five ‘prudential regulators’ are given joint responsibility for writing the rules: the Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, the Farm Credit Administration and the Federal Housing Finance Agency.

The overall problem is the uncertainty and the additional costs that are going to be incurred in order to hedge risk

Both sets of regulators issued their proposed rules in April 2011, but they contain key differences. In the CFTC’s proposals, commercial end-users are explicitly exempted from any requirement to post margin – a provision welcomed by energy companies. By contrast, the rules for banks would mean commercial end-users would be required to post margin once their trading activity exceeds certain thresholds.

The prudential regulators’ rule could result in E&P companies being forced to post margin on swaps with bank counterparties, says Paul Pantano, Washington, DC-based head of the energy and commodities group at law firm Cadwalader, Wickersham & Taft. “Under their proposed rule, banks would have to set a credit limit for all of their transactions with a company, including swaps,” he explains. “So if a bank loans money to an E&P company and does other transactions with it, such as helping them hedge interest rate risk, they would have to set an aggregate threshold for how much credit they can extend. Once the E&P company hit that aggregate threshold, the bank would have to impose margin on the swap transactions.”

Energy companies have blasted the prudential regulators’ proposal, saying it would tie up their capital in margin accounts while doing nothing to advance the cause of global financial stability. Among the companies that have written comment letters criticising the rule are Peabody Energy, the Missouri-based coal giant and Noble Energy, the Houston-based oil and gas producer.

If oil and gas firms are required to post margin for swaps that are not cleared, “it would be a problem not only for Noble Energy, but generally for the independent E&P space”, says Ken Fisher, chief financial officer of Noble Energy. “It would obviously have an impact on firms’ liquidity and, in my view, it would increase their enterprise risk.”

In an environment of rising oil prices, Noble Energy estimates E&P companies would need to set aside around 20% of their capital budgets to take care of margin calls on their hedges. According to Fisher, that would leave the industry short of cash just when it is needed most – a perverse outcome for public policy.

“In a rising price environment, you would want to encourage more supply, and hence more investment to support that supply growth,” he says. “If you were posting margin, that would have a big pull on a firm’s liquidity, and the industry would have to adjust somehow. That would probably mean taking down capital plans just when you want the industry to be investing more.”

Smaller firms’ dilemma

Posting margin is especially problematic for smaller E&P firms. These companies usually have sub-investment-grade credit ratings or no credit ratings at all, so they are often forced to find unorthodox ways of securing their trades. That can mean pledging physical oil and gas assets as collateral, or the use of letters of credit, for example.

“One of our main challenges in dealing with smaller E&P companies is that they can have difficulty getting credit support for their hedges,” says Frank Verducci, Houston-based managing director for structured products at BP, a major hedge provider for US oil and gas companies. “Small producers need to look for creative ways to get credit support, such as posting letters of credit or posting assets as collateral.”

In one common structure, E&P firms enter into a three-way agreement with a hedge provider – typically a physical player, such as BP, Shell Trading or Cargill – and a bank. The bank agrees to provide the E&P firm with credit to support its hedge, secured against the firm’s oil and gas assets. Meanwhile, the bank and the hedge provider sign an intercreditor agreement specifying how the two of them will divide up their claims against the company’s assets in the event of a default. The advantage of such a structure, say market participants, is that eliminates the risk of cash margin calls.

“That’s a huge advantage for an E&P company, because instead of having to post half a million dollars in margin, they can take that half a million dollars and drill a well with it,” notes John Lane, a Houston-based executive vice-president at Sovereign Bank, one of several regional banks in Texas that participates in such structures.

Such three-way arrangements have helped bring hedging to small oil and gas producers that might not hedge under other arrangements, says Lane Britain, Dallas-based managing director of the Falcon E&P Opportunities Fund, which invests in working interests in oil and gas leases. “These intercreditor relationships have taken the volatility [and] margin call risk out of hedging,” Britain says.

However, the prudential regulators’ proposed rule would limit the types of collateral that could be used to secure E&P hedges. According to the proposal, the only types of collateral eligible would be cash, US government bonds and agency securities. Justifying their decision, the regulators argue it would be difficult to set supervisory haircuts for other types of non-cash collateral, while the requirements would be further complicated by the fact that asset values are likely to come under strain during a crisis.

“The prudential regulators’ rule, as proposed, is problematic,” says David Perlman, a Washington-based partner in the energy practice at law firm Bracewell & Giuliani. “When you read it, it appears to have requirements in it that would be a game-changer, because it only permits cash and cash equivalents as eligible collateral.”

That stands in contrast to the approach taken by the CFTC proposals, which would allow non-cash collateral to be deployed as margin, as long as “the value of the asset is reasonably ascertainable on a periodic basis”.

Despite the prudential regulators’ rule, Perlman – who represents a group called the Coalition of Physical Energy Companies – advises market participants not to panic. He suggests there is a possibility the proposals might yet be changed: “Based on conversations I’ve had with the regulators, I believe their intentions are less Draconian than you might think from just reading the rule. So we’re optimistic.”

Ongoing uncertainty

Indeed, since the proposals were first announced, the Basel Committee on Banking Supervision and the Madrid-based International Organization of Securities Commissions have jointly launched a group to look at non-cleared margining rules at a global level. Dubbed the Working Group on Margining Requirements, the group was formed in October 2011 with the intention of preventing regulatory arbitrage across different jurisdictions. In July this year, it produced a consultation paper, which accepts the need for a wider range of assets to be used as collateral.

“Keeping the scope of eligible assets broad may help relieve pressure on the supply of eligible collateral assets. It may also help avoid concentration risks,” the paper notes.

Against the backdrop of the global talks, industry sources are optimistic the most onerous elements of the proposed rules could eventually be watered down. Despite this, the current uncertainty over the future regime is making the decision of whether to hedge a particularly tough one for E&P firms.

“The overall problem is the uncertainty and the additional costs that are going to be incurred in order to hedge risk,” says Susan Ginsberg, vice-president of crude oil and natural gas regulatory affairs at the Independent Petroleum Association of America, a Washington, DC-based trade group. “At the end of all of this, we are hopeful that Congress’s intent that end-users should not be subject to additional collateral or margin requirements will ultimately be implemented. But in the two-plus years that this has been going on, there has just been so much uncertainty.”