Friday, April 19, 2019

CFTC’s EEMAC focuses on major developments in shale oil and liquid natural gas markets

By Brad Rosen, J.D.

The first Energy and Environmental Markets Advisory Committee (EEMAC) meeting under the sponsorship of Commissioner Dan Berkovitz featured insightful and spirit discussions across a content filled agenda. Some of the topics of exploration included dramatic recent developments in the physical energy markets and derivative market responses, the changing face exchange-traded energy derivatives markets, as well as mounting concerns around margin and capital requirements and their potentially adverse consequences.

The U.S. has seen significant advances in energy supplies and technologies, particularly with respect to oil, natural gas, and renewable and clean energy sources noted Commissioner Berkovitz in his opening remarks. In providing larger context for the day’s meeting, Berkovitz observed, “The vitality and growth of our domestic energy industry and the improvements in the regulation of our energy derivative markets over the past decade demonstrate that we can have both strong financial market regulation and a strong energy sector. He added, “both are essential for a robust energy sector and a resilient market-based economy.”

Some initial thoughts on tight rock formations and American exceptionalism. In his opening statement, Chairman Giancarlo noted the shale revolution as “one of the greatest economic success stories the world has ever seen.” The chairman has also spoken previously about his forays into West Texas, and what he refers to as the epicenter of American exceptionalism. This is one of the greatest economic success stories the world has ever seen. Shale oil is also sometimes referred to as tight oil, as it is often contained in tight sandstone or shale rock formations.

Panel 1—The U.S. emerges as a leading energy producer on world stage: shale oil and liquid national gas come into their own. Chris Goodenow from the Commission’s Market Intelligence Branch (MIB) provided the committee with a data rich summary on some remarkable developments in physical energy markets, particularly with to crude oil and natural gas, as well as related derivative markets. Goodenow provided some of the current thinking around two reports issued by MIB last year, one of those titled Impact of U.S. Tight Oil On NYMEX WTI Futures. That report analyzed the effect of the growth of tight oil on the WTI and Brent crude oil futures contracts. Some of its findings included:
  • volume and open interest in the contract remain robust;
  • open interest in futures contracts five or more years out has declined; and
  • reduced interest in longer-dated contracts may be due to increased production in U.S. shale oil, price levels, and regulatory impacts. 
MIB’s other report titled Liquefied Natural Gas—Developments and Market Impacts assessed the recent extraordinary growth of U.S. liquefied natural gas (LNG) exports and the potential impacts of this evolution on CFTC-regulated markets. Some of the findings in that report included:
  • Global LNG trade growth is expected to continue with U.S. LNG exports having the most rapid growth rate and a competitive price advantage;
  • U.S. exports capacity expected to double in 2019;
  • U.S. LNG export growth may put upward pressure on U.S. natural gas prices and expose a relatively isolated North American market to global market dynamics; and
  • burgeoning U.S. LNG exports are affecting global LNG market dynamics, including contracting and risk management practices in CFTC regulated markets.
Panel 2—Exchange-traded energy derivatives markets continual adapt and respond to changing markets. The day’s second panel featured presentations from representatives of the exchanges with leading energy derivative products including Bryan Durkin of CME (NYMEX), Ben Jackson of ICE, and Demetri Karousos of Nodal Exchange. A significant portion their discussions focused around about how the changes in the physical energy markets are generating an appetite for new risk management tools, as well as the products the exchanges are creating to satisfy that demand.

The CME’s Bryan Durkin stated that the evolving U.S crude oil environment has generated a global appetite for new risk managements instruments, and that the CME continues to roll out new risk management tools and seeks to build liquidity in existing markets to serve the ever-changing market. Durkin pointed to the exchanges recently launched NYMEX WTI Houston Crude Oil Futures contract (HCL) which provides market participants access to the robust Houston crude infrastructure system.

Panel 3—The availability of clearing services is being undermined by inappropriate capital rules. The day’s third panel featured discussion the availability of clearing and other services in the energy derivatives markets. Notably, there was near unanimity among presenters, EEMAC members, and the commissioners themselves that that the Supplemental Leverage Ratio (SLR) imposed by the prudential regulators may be compromising the provision of clearing services for energy derivatives transactions.

The SLR is a global capital requirement for banks. It is size-based rather than risk-based and is designed to restrain bank balance sheet activity—namely lending. It requires large U.S. banks to set aside roughly five percent of assets for loss absorption. As Chairman Giancarlo noted, “The current implementation of the SLR is biased against derivatives. It does not take into account the fact that outstanding derivative contracts in a portfolio can offset each other and thus reduce the potential risk exposure.” He added, “it incorrectly treats the notional size of a derivative contract as representative of the total potential risk of that contract. It ignores the exposure-reducing effect of margin for clearing firms.”

Rob Creamer, speaking on behalf of the FIA Principal’s Trader Group, asserted that applying the SLR methodology has the potential to “catastrophically destabilize the markets” and posited that it will actually increase risk levels to rather than lead to decreases.

Creamer’s disdain for the SLR is matched by that of Commissioner Quintenz, who described imposition of the SLR to derivative transactions as “gold plating” and caustically, but insightfully, observed, “Gold plating a bad idea does not magically transform it into a good idea.” He added, “By way of analogy, if you build a ship out of gold, it looks great in dry dock. But when you put that ship in the water, it becomes the world’s most expensive scuba diving attraction.”

Previously, a number of commissioners submitted a comment letter to prudential regulators highlighting common concerns regarding the SLR. Moreover, in Chairman Giancarlo’s view, the Commission “continues to speak in a bipartisan voice regarding the SLR.”