Don’t Punish Energy Producers for Wall Street’s Misdeeds
Congressional passage of Dodd-Frank was intended to address the root causes of the 2008 financial collapse. Most people think that the legislation just applies to banks. But swept into Dodd-Frank are the financial tools used by major energy producers and consumers
to reduce business and consumer risks from the inherent volatility in the prices of primary energy commodities. This is problematic, as well as costly to consumers, because the use of swaps and futures hedging by energy businesses had nothing to do with triggering the Great Recession.
A renaissance began a decade ago in the U.S. energy sector, in particular in oil and natural gas. While the unexpected and unplanned growth of the oil and gas sector is still expanding, it has already created greater economic and employment benefits than has any other part of the U.S. economy in recent years.
America is now the world’s fastest growing, and soon, the world’s greatest producer of oil and natural gas. The rapid growth in U.S. oil and gas production has not arisen from new discoveries or opening up off-limits federal lands. It has come from new technologies and techniques that have unlocked America’s long-standing vast hydrocarbon shales.
America’s enormous and now rapidly growing energy-intensive industries necessarily depend on a continual and predictable supply of fuels.
Price volatility in natural gas and oil markets has long been managed, or “hedged,” using financial tools called derivatives (for example, swaps and futures). Nearly every type of business or organization that produces and purchases energy in significant quantities employs, either directly or indirectly, derivatives.
Financial tools that allow one to “hedge” or “speculate” around commodity price uncertainty have been used for centuries whenever either sellers or buyers seek more predictable future prices. Futures contracts, hedges, and swaps now include virtually all agricultural and energy commodities, as well as foreign currency and interest rate fluctuations—essentially any traded good that exhibits the feature of unpredictable variations in future price. The total universe of financial activity associated with the global swaps market is estimated at $600 trillion annually. But less than 0.3 percent of all swaps are associated with energy commodities.
It is not arguable that energy commodity swaps or “speculation” contributed to the 2008 collapse. The fact that energy markets employ swaps is as relevant to global financial stability as gasoline use for lawnmowers is relevant to global aviation fuel supply.
Nevertheless, the 2010 Dodd-Frank Act—motivated by the financial contagion caused by credit default swap trading—has swept the energy sector under its jurisdiction.
Dodd-Frank will affect every area of the financial market, but the largest set of rules is around derivatives—5,000 of the 14,000 new pages of rules thus far relate to derivatives.
Under Dodd-Frank, the Commodities Futures Trading Commission (CFTC) regulators created a new regulated entity, a swap execution facility (SEF), where they expected energy business that would become registered “swap dealers” would then undertake trades—instead of using the previous Over The Counter (OTC) market. The broad, diversified, and loosely regulated but smoothly functioning OTC swaps market would be forced to migrate to highly-regulated, costly SEFs with each player a registered energy “swap dealer.”
The shift to SEFs did not happen. Firms instead confined their risk mitigation to “futures” exchanges. These have been regulated for some time, but they are standardized and lack the flexibility that OTC trades provided.
Additionally, many rules created by the CFTC under the authority of Dodd-Frank have yet to be written. This uncertainty creates problems for companies trying to reduce future energy price risk. As these companies are some of the main drivers of the still-recovering U.S. economy, this regulatory uncertainty could not come at a worse time.
None of this is good. None of it makes any sense. None of it was necessary to avoid a future systemic failure and repeat of 2008. None of it is relevant to the 99.7 percent of the financial activity in the markets that was the ostensible target of Congress in passing Dodd-Frank.
It is probably too late to unwind jurisdiction of Dodd-Frank over the energy industry. But it is not too late to ensure that regulators and the Congress avoid rule-making that creates unintended negative consequences in energy markets, specifically increasing the cost of managing price risks and ultimately the cost of energy and food.
A wide variety of issues are associated with proposed rules, ideas, or existing rules from the CFTC pursuant to that agency’s interpretation of Dodd-Frank. Essentially all of the problems for the energy industry emerge from the same root cause—treating and regulating the energy businesses in the same fashion as financial institutions. To fix this problem, Congress should as a minimum:
Exempt physical commodities businesses from being regulated as financial businesses.
Exempting physical commodities businesses from Dodd-Frank jurisdiction would be logical, economically beneficial and remove an unintended impediment to the budding American energy and energy-related manufacturing revival.
Remove CFTC’s authority to arbitrarily reduce the $8 billion trigger for regulating energy swaps.
The CFTC ruled that $8 billion in annual energy trades is the de minimis activity triggering a firm’s requirement to register under Dodd-Frank and is set to drop automatically to $3 billion in 2018, which will put at risk the exit of any remaining commercial energy swap activity. Congress should at least ensure that the relevant threshold for regulation does not automatically drop below current levels with no regard for future prices or market conditions. Any change in the registration trigger should require a formal rulemaking process and Congressional input.
Issue to the CFTC guidelines and standards to restrain ad hoc rule-making.
Imprecise language in Dodd-Frank has led the CFTC to promulgate inappropriate or ill- advised rules that fail to recognize damage to, and have eliminated long-standing effective energy market practices.
Immediately hold the CFTC to account to resolve and clarify critical jurisdictional conflicts.
The conflicting overlap between the CFTC and the separate authority of the Federal Energy Regulatory Commission is damaging to energy markets. Dodd-Frank required the two agencies to establish a jurisdictional Memorandum of Understanding: it is now almost three years overdue.
Primary energy prices vary continuously and largely unpredictably. For energy-intensive businesses, energy price variations are unpredictable, can be financially damaging and even threaten business survival. An acceptable known future price—rather than gambling on lowest theoretical price—is preferable to and vital for rational business planning and operations. Congress should change Dodd-Frank so that it does not apply to energy companies.
The Honorable Spencer Abraham is chairman and CEO of The Abraham Group. Mark P. Mills is CEO of the Digital Power Group and a senior fellow of the Manhattan Institute. For a more in-depth discussion about the effects of the energy sector caused by Dodd-Frank, and proposals to fix the problems, read the full report here.