The Dodd-Frank Energy Train Wreck11/20/13
IHS The Energy Daily
By SPENCER ABRAHAM and MARK MILLS
There is an ironclad rule when it comes to energy politics: prices matter. And specifically when they spike up. Meanwhile, there is a reality in the business of energy that you can take to the bank-- energy is a volatile commodity and there are always spikes. These two realities are now on a collision course, and it is one that Congress unwittingly created.
With the passage in 2010 of the Dodd-Frank Act, Congress has unintentionally set a course to damage one of the core tools used by energy suppliers and users to tamp down energy price volatility.
When energy prices spike, the effects are felt throughout the entire economy. There is no corner of civilization that doesn’t use energy. And price spikes, which Murphy-Law-like seem to occur at the least convenient or expected times, impact not just gasoline but electricity generation, home heating and food prices, and can drain enough profits on the margin to depress employment from retail to manufacturing.
Businesses have long managed or “hedged” the volatility in energy prices using financial tools called derivatives like swaps and futures. (A derivative contract can gain value if the price of the purchased commodity rises.) Thousands of firms that produce or purchase energy depend on these derivatives, including electric utilities and wholesale power generators, oil and gas producers, refiners, municipalities, rural cooperatives, farmers, shippers, airlines and manufacturers.
The main domain of derivative contracts, however, is in the financial-- not the energy—industry. It was the credit default swap (CDS) that achieved notoriety as a key factor in the 2008 global financial contagion. With a CDS the risk being managed or traded is not an energy price but the possibility of a loan default. The ‘08 market collapse and subsequent scrutiny of the actions of financial institutions led to the passage of the Dodd-Frank Act and restructure of the financial industry.
But energy-producing and energy-using businesses that are neither banks nor financial firms were swept up into Dodd-Frank. This happened despite the fact that, according to data from the Bank for International Settlements, less than 0.3% of the total swaps market involves energy transactions. It is arithmetically obvious that the use of energy swaps is as relevant to global financial stability as gasoline use for lawnmowers is relevant to global aviation fuel supply.
The Commodity Futures Trading Commission (CFTC), which has the authority to interpret and implement Dodd-Frank, has set a figure of $8 billion in swap dealing activity (swap contracts can total 10 to 100 times more than the underlying physical purchases) as the trigger that now requires an energy business to be subject to regulation as a financial firm with all the associated costs and controls.
Already, Bloomberg reported, huge swaths of the formerly free-wheeling and productive trades in energy have moved out of the swap market and onto commodities exchanges. Whatever remains will almost certainly exit ahead of a scheduled 2018 lowering of the regulatory trigger to just $3 billion of dealing activity.
Thus, when energy price volatility rears up again—as it inevitably will since no one has yet found a way to eliminate volatility—the effects this time will be more widely felt in the economy because energy companies will have been driven out of their traditional role as providers of risk management products to their energy-using customers. This disruption could not come at a worse time.
The United States is now the world’s fastest-growing and greatest producer of oil and natural gas. The shale hydrocarbon revolution has already driven a 45 percent reduction in oil imports and is contributing hundreds of billions of dollars and millions of jobs to the U.S. economy. Energy producers use derivatives as a tool to manage and plan future production expansion in the face of uncertainty about what price they will receive.
Arguably more important than the direct impact on energy producers is the burden of risk energy users will now face. Because of the new energy abundance, America is experiencing an unprecedented resurgence in energy-intensive manufacturing.
There are now not only hundreds of new--but also thousands of existing—energy-intensive businesses that benefit from America’s new abundance. For them, planning, investment and day-to-day operations and even survival depend on confidence in estimating future energy prices. It is notable that all these businesses are at the epicenter of creating high-value, well-paid and “sticky” jobs for Americans. With a diminution in the availability of financial tools to manage energy price risks, the alternative for such businesses is to take fewer risks, expand more slowly and hire fewer people.
Not only has Dodd-Frank already created confusion and uncertainty in the formerly robust and useful market for energy swaps, but more damage is on the horizon. The CFTC has set in motion an automatic lowering of the regulatory threshold without the opportunity for public comment and the usual back-and-forth that accompanies important policy changes.
The solution? Congress should consider entirely exempting physical commodity businesses from financial regulation that was meant to address the players that caused the global financial crisis. Short of that, Congress should at least ensure that the relevant threshold for regulation doesn’t automatically drop below current levels with no regard for future prices or market conditions. This would have the dual benefit of avoiding impediments to America’s salutary energy boom while allowing the CFTC to focus its own energies on the 99.7 percent of the swap market where financial market systemic risks reside.
--Spencer Abraham, former secretary of the U.S. Energy Department, is chairman of The Abraham Group. Mark P. Mills is CEO of Digital Power Capital and a senior fellow at the Manhattan Institute. The authors recently released an in-depth report regarding the energy implications and consequences of the Dodd-Frank law, which is available at AbrahamEnergyReport.com.