The Dodd-Frank Wall Street Reform and Consumer Protection Act became law on July 21, 2010. As a response to the financial crisis, it seeks to increase accountability and transparency in financial markets. Much of this legislation is aimed at Wall Street. New over-the-counter derivatives regulation by the Commodity Futures Trading Commission (CFTC) will affect energy companies.

Potential pro-active steps by energy companies to assess the potential effects of new regulatory options being considered by the CFTC would examine staff training and hiring needs, policies and procedure modifications to assure exempt status, cost/benefit assessment of non-exempt activities and infrastructure needs.

A broad energy industry coalition, including the Natural Gas Supply Association, Edison Electric Institute, Electric Power Supply Association, and American Petroleum Institute were active in lobbying Congress to include energy firms in the commercial end-user exemption.

John England

This exemption's intent is to allow energy firms to continue using OTC markets to manage risk and market fluctuations without being subject to the mandatory clearing and margining requirements. The degree to which energy transactions are included in this end-user exemption and the overall impact of this new legislation likely will not be known until the CFTC completes its drafting of regulations, a process that could take 12 months or more.

Of key importance to energy firms will be how the CFTC defines end-user and hedging activities. Congress has provided guidance on how it hopes regulators will interpret the Reform Act. A June 30th letter by Sens. Christopher Dodd, D-Conn., and Blanche Lincoln, D-Ark. aimed to clarify the intentions of exempting gas and electric utilities looking to hedge from the clearing, margin, and capital requirements of the bill. It stated that "the major swap participant and swap dealer definitions are not intended to include an electric or gas utility that purchases commodities that are used either as a source of fuel to produce electricity or to supply gas to retail customers and that uses swaps to hedge or manage the commercial risk associated by its business."

Significant ambiguity remains around which energy firms will qualify as commercial end users, as energy marketing and trading organizations often participate in a variety of asset-backed transacting activities to optimize the value of their portfolios. It appears likely that the CFTC will classify as narrowly as possible hedging transacting versus speculative transacting. Once the regulations are established, energy firms will need to determine which activities they are confident will qualify as bona fide hedges if they do not want to risk their end-user status. At this key juncture in the rulemaking process, industry participants should seek opportunities to confirm the CFTC's understanding of their business activities so that regulations can be properly crafted. The CFTC is likely to initiate at least 50, and perhaps as many as 100 rulemakings. Assuring that the concerns of energy end users are accommodated will be a challenge for the energy industry.

The full effects of the Reform Act will not be known for at least a year. Nevertheless, energy companies can begin to prepare now for potential outcomes of the upcoming regulations which may include tighter cash flows, uncertain dynamics in market liquidity, additional transparency, expanded internal and external compliance oversight and reporting requirements and global transacting impacts.

The Reform Act calls for certain derivatives to be cleared through regulated central clearing organizations and mandatory trading through either regulated exchanges or swap execution facilities, which would impose additional margin requirements as compared to current practices of trading directly with counterparties or through a broker on credit terms. The cash flows required to support these transactions could reduce cash available for new investments in infrastructure or other strategic investments, or force energy firms to raise additional capital through debt or equity markets. The positive effect for transacting companies is that the rule changes could forcibly reduce counterparty credit risk.

Energy companies which transact both to hedge their commodity risk positions and to seek incremental gains by taking proprietary positions should evaluate this additional capital cost of transacting. In addition, portfolio optimization transacting strategies which may appear to have some elements consistent with speculative activity should strongly consider and determine the risk of the CFTC viewing the activity as speculation, thus placing the company's status as an end user at risk.

In preparation for the final CFTC regulations, energy companies may benefit from reviewing and modifying as necessary their transacting procedures to ensure they may confidently claim to be bona fide hedges. A clearly documented transacting mandate could facilitate demonstrating intent in a potential CFTC audit. For firms where proprietary trading is a core business strategy of its trading operations, companies should review their capital allocation strategy as well as their credit and margining procedures to be in position to respond promptly to new regulations.

The intent of the Reform Act was not to hinder the ability of end users to hedge their commercial risk; however, there remains significant uncertainty of how the market will ultimately respond. If an energy company qualifies for the commercial end-user exemption, it will not be required to trade through the regulated exchanges or post additional margin on transactions. Their primary counterparties on the other hand, would likely qualify as swap dealers or major swap participants, and thus be subject to the additional costs of trading that appears, at this time, to be the CFTC chairman's intent. This could potentially decrease the attractiveness for some financial firms to participate in these markets, thus reducing the availability or increasing the cost of customized swaps to energy companies.

Energy companies could thus be forced to decide whether to pay a premium to hedge with customized swaps which better match their risk profile, or purchase more standardized products that do not exactly match the commodity price risks they are trying to hedge and accept additional basis risk. This could also reduce the hedge effectiveness of those derivatives and introduce additional earnings volatility into their financial statements. The lessened liquidity could also contribute to a widening of bid¬-ask spreads. In some cases, there may be a regulatory risk from state public utility commissions, which may not accept the costs associated with transaction on 'dark' markets.

By moving certain derivative transactions to regulated exchanges or swap execution facilities, market participants will have increased transparency to transacted prices. Energy companies previously had limited visibility into what prices like products were closing at, giving dealers a significant competitive advantage with regard to pricing. The increased visibility through the use of regulated exchanges, and the additional reporting to the CFTC, could contribute to a narrowing of bid-ask spreads for these products, with other things being equal.

As the CFTC develops its rulemakings, a significant increase in reporting requirements appears likely. Institutions transacting energy contracts on U.S. exchanges would have to report to the CFTC on volumes in addition to standards they are currently meeting. In addition to standard reporting, energy companies transacting derivatives would be subject to CFTC audits and should be prepared to demonstrate that their activities fall within the parameters of the commercial end user exemption, or that they have complied with the additional requirements. Regulatory oversight could expand beyond the regulation of markets by treading into the regulation of speculative behavior, price movement and price volatility. An increase in reporting would heighten the risk of misreporting and subject entities to potential fines.

Reporting may also introduce significant new requirements relative to positions. The CFTC may, for example, require reporting to verify qualifying for exemption. Reporting on and/or calculating positions will likely result from CFTC position limit rules.

Once the exact nature of the new reporting requirements becomes known, organizations will face assessing their current trade capture practices and technology infrastructure to ensure they maintain the appropriate data; maintaining data for reporting to the CFTC using the required medium and within the required time frames will also become important. Given the CFTC chairman's interest in narrow
exemptions, it does not take much to anticipate that those not reporting as required would lose exemptions.

The CFTC in the United States and the United Kingdom's FSA have shared information between their respective regulatory bodies to more effectively track global market manipulation. Now that the United States has passed legislation to centralize regulation, the CFTC must proactively pursue international agreements for regulatory standards in the major global markets, otherwise risk the migration of commercial transactions to less onerous markets, further affecting liquidity and potentially increasing transactional risk.

The effect on energy companies and their transacting strategies, supporting processes, and infrastructure could be significant. The Reform Act expanded CFTC regulatory authority and granted a commercial end-user exemption. However, it is not well defined where each energy company will fall within that exemption or what activities will be permissible to maintain it.

Although the answer may be one year away, energy companies that want to stay ahead of these transformational changes can begin evaluating their businesses today.