The Dodd-Frank Act is a long, complicated law that is several times longer than the Sarbanes-Oxley and Glass-Steagall Acts combined and energy companies will need to react to changes to the ways commodities are hedged in the United States as more regulations promulgated to implement the law. When the Act was passed in July 2010, the implications for energy companies were uncertain and timelines were set forth to make sure the process was run efficiently. The Act lays out general concepts but leaves specifics to be set forth in rules promulgated by the Commodity Futures Trading Commission (CFTC).
At this time, implications are still uncertain and timelines have been delayed, but the CFTC has proposed many important rules that energy companies need to consider.
The main concern for energy companies is whether they will be able to enter into hedges outside of exchanges ("over-the-counter" or "OTC"), and whether these OTC hedges will be subject to margin or capital requirements for either the energy company or its counterparties. A second important concern is the administrative burden of complying with the Act.
Companies would prefer to continue entering into OTC hedges without the Act imposing margin requirements or significant administrative burdens. Many companies believe that mandating exchanges will make hedges uneconomic or unavailable because the exchanges would not offer the hedge products that energy companies need, but instead require cash or other liquid assets to be posted as margin -- cash that would be diverted from investment. If companies choose to save their cash and hedge less, the increased commodity price volatility from the lack of hedging would mean less access to credit. Either option results in decreased development of energy assets and ultimately higher energy prices.
A further concern is that companies will try to find ways to hedge risks in more favorable regulatory systems abroad. Crude in particular is an international commodity that would lend itself to this approach. But if energy companies can run the gauntlet of regulation domestically, perhaps "commercial end users" will avoid these outcomes.
Commercial End Users
The issue of whether energy companies will be able to enter into OTC hedges turns on the "commercial end user" exception. Commercial end users do not have to use the exchanges. Rules proposed in December 2010 provide guidance on who may qualify as a commercial end user. These rules were proposed by the CFTC and have been subject to public comment.
The Act has three criteria for commercial end users: 1) to not be a financial entity, 2) to use swaps to hedge or mitigate commercial risk, and 3) to notify the CFTC how it generally meets its financial obligations in connection with its swaps.
For the "not a financial entity" and "meets it financial obligations" criteria, the rule relies on detailed reporting requirements to elicit whether the applicant falls within one of the seven types of financial entities (this is most likely not applicable to energy companies) and to explain the financial arrangements relating to the swap.
Upon electing use of the commercial end user exception, energy companies will be required to disclose their identity. They will have to disclose, whether they are a “financial entity”, and if so, whether they qualify for the affiliate of a non-financial company exception, and whether they are required to file reports with the SEC. Energy companies required to file reports with the SEC will also be required to provide their SEC Central Index Key number and to disclose whether a committee of the board of directors has reviewed and approved the decision not to clear the swap. This last requirement has the effect of making a committee of the board of directors more involved in and aware of an energy company’s derivative transactions.
Energy companies will also be required to disclose how they intend to meet their swap obligations. Such obligations may be met by use of a written credit support agreement, such as a credit support annex or security agreement, pledged or segregated assets, a guarantee, available financial resources (i.e. general creditworthiness), or some other means. This last catchall is intended by the CFTC to capture any other means used currently or in the future to meet a company’s swap obligations.
In determining whether an energy company uses swaps to hedge or mitigate commercial risk, the CFTC has incorporated two commonly used definitions that effectively serve as safe harbors. If an energy company’s swaps qualify for hedge treatment for accounting purposes under FASB 815 (formerly known as Statement No. 133) or for bona fide hedging status under the Commodity Exchange Act, they will be deemed in compliance with the risk mitigation requirement of the commercial end user exception. A swap’s failure to qualify under these two safe harbors does not preclude use of the commercial end user exception. The proposed rules include six additional categories for determining whether a swap is used to hedge or mitigate commercial risk. These six categories include use of swaps by energy companies to protect against:
• Potential changes in the value of assets that are owned, produced, manufactured, or processed in the ordinary course of business;
• Potential changes in the value of liabilities;
• Potential changes in the value of services provided in the ordinary course of business;
• Potential changes in the value of assets, services, inputs, products or commodities that are owned, produced, manufactured, processed or sold in the ordinary course of business;
• Potential changes in value of any of the foregoing arising from foreign exchange rate movements; or
• Fluctuations in interest, currency, or foreign exchange rate exposure arising from assets or liabilities.
These six categories are intended to capture all swaps used to hedge or mitigate risks. Additionally, the rule has a final criteria that swaps that are used for investment, speculation or trading or to hedge or mitigate the risk of another swap, unless such other swap is used to hedge or mitigate commercial risk, do not satisfy the requirement that the swaps hedge or mitigate commercial risk.
The Act requires that the CFTC obtain swap transaction data for each OTC swap transaction for public disclosure. A rule proposed by the CFTC would require that a detailed notice be filed by one of the parties to the swap after each trade--a notice that would disclose details about the company relating to the economic terms of the swap, including whether the material terms of the swap were negotiated and the settlement terms of the swap. An energy company that wants to hedge its production on a monthly basis for 18 to 24 months into the future, which requires recalibration whenever production changes or for a variety of other factors, enters into numerous trades each year. It would be a significant administrative burden to produce such a high number of reports each year, even if the content of each report is substantially similar.
Also of concern is the prospect that this report might need to be sent to the CFTC within 15 minutes of each trade. The 15-minute time period would apply only when a noncleared swap is executed and confirmed electronically.
There has been a great deal of speculation about what margin or capital requirements will be imposed under the Act. High margin requirements could make hedges uneconomic or unavailable. The Act treats commercial end users differently than other hedge parties, but its not clear yet whether commercial end users will be burdened with high margin requirements or not. Recent proposed regulations by “Prudential Regulators” (regulators that govern banks and similar financial institutions) would require their regulated entities to collect margin from commercial end users, with the threshold and size of the margin determined by a variety of factors. The CFTC, by contrast, has a more flexible approach in its proposed regulations. There is a lot of work to be done in finalizing these regulations to make clear what margin requirements will be imposed on energy companies from these different types entities. If banks are required to collect higher margin from energy companies than other hedge providers, banks would lose this business.
It was hoped that all of the rules would be proposed by the end of 2010 so that comments could be processed and final rules published before the Act was set to be implemented this summer. That schedule was delayed (and delayed), and various groups have called for delayed implementation because of the complexities involved. The piecemeal publishing of rules causes a reexamination of each in light of subsequent rules that interrelate.
Based on what we know now, we can be cautiously optimistic that the "commercial end user exception" will be meaningful, and may provide energy companies with the opportunity to continue using hedges to mitigate commodity risk. We have a long way to go before the consequences of the Act filter through the regulations and markets generally.
Nichols and Adams are Houston-based attorneys at Haynes and Boone, LLP, an international law firm with offices in New York, California, Texas and Mexico. Nichols received his B.A. in Economics from the University of Michigan and his J.D. and M.B.A. from Southern Methodist University. Adams received his B.S. in Economics at the University of Texas at Arlington and his J.D. from the University of Houston Law Center.
Published in Oil & Gas Investor, June 2011. To read the full article, click the PDF linked below.
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