TODAY’S STUDY: FIXING THE ECONOMY = ENERGY PRICE CHANGES = NEW ENERGY OPPORTUNITIES

The Volcker Rule; Impact Assessment on the U.S. Energy Industry and Economy
Yergin, Daniel, et. al., March 2012 (IHS CERA / IHS Consulting / IHS Global Insight)

Executive Summary

Conclusions

• Commodity risk management and intermediation services have become very important to the efficient functioning of the energy economy. Any curtailment in the availability of these services will affect consumer prices, domestic jobs, and economic growth.

• Owing to the unique nature of the commodities markets, the implementation of the Volcker Rule as currently proposed by the regulators—and its narrow interpretation of what constitutes market making—is likely to unduly constrain the ability of banks to provide the necessary market making activities for commodities risk management and intermediation services.

• If the role and permissible activities of market makers are too narrowly defined, the risk of curtailing important services offered by the banking sector will increase. Customers who need these risk management services may find that their cost has increased, or that these services are no longer available.

• Natural gas resource development could be impaired. Independent producers that are responsible for the majority of domestic upstream capital spending utilize bank risk management sevices as a key element of their capital plan. These firms are particularly active in development of tight oil and shale gas resources that are driving growth in production and employment in the sector. Our estimate is that domestic investment would decline by $7.5 billion per annum leading to a 2.1 BCF/D decline in gas production. This equates to a $0.64 per MMBTU increase in gas prices and loss of 182,000 jobs.

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• Electric power costs could increase by $5.3 billion per year. Utilities use a variety of risk management tools to dampen volatility, a key component of which are OTC transactions provided by banks.

• Additional refining capacity could close. Independent refiners are increasingly relying on bank off-take agreements to finance oil inventories and long-term margin hedges to stabilize cash flow and improve access to capital. Bank provided risk management services have been used by recent refinery buyers as part of their acquisition strategy. Without the use of risk management services, it is anticipated that none of the currently announced refinery closures on the East Coast would be averted through successful ownership changes.

• East Coast gasoline prices are estimated to increase by 4 cents per gallon or $2 billion per year.

• Key energy consuming industries could see increased costs and price volatility if the availability of risk management tools is reduced resulting in greater earnings volatility.

• The combination of these effects results in payroll employment estimated to be over 200,000 lower over the 2012–16 period.

• In addition, real GDP is $34 billon and cumulative nominal federal tax receipts over the 2012–16 period are $12 billion lower.

• As the Volcker Rule is implemented, it is important that due care be taken to ensure that market liquidity and the availability of essential services are not constrained, while safeguarding the quality, security and safety of our financial markets. The implementation of the Rule should be closely examined and modified in order to support the soundness of U.S. financial markets but not, inadvertently, curtailing activity that plays a constructive and essential role in the U.S. economy.

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Energy supply is essential to almost every economic, social, and cultural activity within U.S. society. The energy sector is also a significant contributor to overall economic performance and job creation. The efficiency and reliability of the energy industry are vital to U.S. living standards, economic growth, and national security.

As commodity prices and price volatility have increased, both producers and consumers of energy products have developed strategies to cope with higher prices and to mitigate energy price risk. These strategies take different forms for energy producers and consumers, but both segments depend on the risk management (RM) and intermediation services of U.S. banks. These services have become very important to the efficient functioning of the energy economy, and so contribute to the economic growth and vitality of the U.S. economy.

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Role of Banks

In response to the changing demands of their customers, banks have expanded their role of providing financial resources and services to include risk management and intermediation services to companies in the commodities sector. The more common of these services include commodity price hedging, profit margin hedging, and secured financing in a variety of forms. In order to provide these services, banks take on the role of a market maker in commodity price risk. This market maker role requires banks to broadly participate in the relevant physical and financial commodity markets including taking principal positions. As a result of this participation, banks have developed deep expertise and broad functionality across the energy complex.

Owing to the unique nature of the commodities markets, the implementation of the Volcker Rule as currently proposed—and its narrow interpretation of what constitutes market making—is likely unduly to constrain the ability of banks to provide the necessary market making activities for commodities risk management and intermediation services. Customers who need these services may find that their cost has increased, or that these services are no longer available.

What is a Bank Market Maker?

In the role of market maker in commodity markets, banks act in a fashion similar to the traditional role of a financial intermediary. Banks make credit quality judgments regarding customers and counterparties, develop balanced portfolios of assets and obligations, and offer customized services designed for specific customer situations. These functions all fit within the role of the market maker. However, the nature of the commodities markets can make these functions more complex than in other financial markets. The established commodities exchanges cover a very limited range of energy commodities and locations and have very limited liquidity in long dated energy contracts. In order to effectively fulfill the role of a market maker, banks must engage in a wide range of transactions both inside and outside the commodities exchange framework. Market makers are often required to trade as a principal in order to fulfill their customer requirements.

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Impact on Energy Industry

In commodities markets, it is a fine—and indeed uncertain—line between market making and proprietary trading. Too narrow an interpretation of the proposed regulatory Rule’s market making and hedging criteria could constrain banks’ ability to provide hedging and facilitate trades on behalf of clients. Therefore, implementation of the market making exemption should be done in such a way that does not significantly impair the role of banks in commodities risk management and intermediation services.

Impact of Reduced Liquidity

Reduced bank transaction activity could reduce liquidity in commodity exchanges and over the counter (OTC) markets, and even availability of commodities risk management, financing and other intermediation services. Bank transaction activity provides significant liquidity to both exchanges and the OTC markets. A reduction in liquidity and availability is expected to result in increased price volatility for energy commodities, wider bid-ask spreads, reduced access to services, and increased basis risk for hedging strategies.

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The subsequent sections of this document provide detailed analyses of the reliance of representative segments of the energy industry on risk management and related services provided by U.S. banks, and the potential impact of reductions in the availability of these services. The key conclusions from this analysis are as follows:

• Natural gas resource development could be impaired.

Independent producers are responsible for the majority of upstream capital spending in the U.S., with particular emphasis on the tight oil and shale resources that are driving growth in production and employment in the sector. These companies are able to hedge future production revenues in order to stabilize cash flow, which has been critical to sustaining investment plans. Banks are key suppliers of these hedging services. If this capability is curtailed due to the Rule, upstream investment, particularly in gas-prone fields, could be reduced substantially, reducing gas production and associated employment. With lower production, gas prices would increase. Our estimate is that investment could be reduced by $7.5 billion per annum leading to a 2.1 BCF/D reduction in gas production, a $0.64 per MMBTU increase in gas prices and loss of 182,000 jobs.

• Electric power prices could increase.

Utility customers typically place high value on stable and predictable electricity prices. Utilities, however, must operate in an environment of volatile energy prices, particularly for natural gas. Utilities use a variety of risk management tools to dampen volatility, a key component of which are OTC transactions provided by banks. If this capability were reduced, utilities would face higher earnings volatility, which would increase their cost of capital. In addition, higher gas prices could increase overall power costs. Both of these impacts would flow through into higher, and more volatile, electricity prices for consumers. Our estimate is that power costs could increase by $5.3 billion per year.

• Additional refining capacity could close.

U.S. refiners are already under economic pressure from overcapacity and weak product demand. Many oil companies are either exiting the refining business or selling non-core assets. In recent years, refinery buyers have typically been smaller independent companies with limited capital resources. Many of these independent companies rely on bank off-take agreements to facilitate inventory financing in order to maintain operations. In addition, small independent refining companies are often more dependent on long-term margin hedges to reduce earnings volatility and to secure purchase financing. If the availability of these commodity-based services is curtailed due to a narrow market maker criterion, it is anticipated that none of the currently announced refinery closures on the East Coast would be avoided. The resulting additional permanent refinery closures would cause immediate damage to the local economy and contribute to higher gasoline prices on the East Coast.

• East Coast gasoline prices, and price volatility, could increase.

Initially the cost of importing crude oil to supply U.S. refineries would increase, as the banks could be limited in their ability to manage the price risk between offshore and domestic prices during the voyage. This would exacerbate the trend towards refinery closures. To adequately supply East Coast consumers in the face of additional refinery closures, significant changes in global supply patterns would have to take place. Gasoline supply from local refineries would have to be replaced by imports and increased shipments from the Gulf Coast, and prices would have to increase to create incentives for these changes to occur. The ability to import gasoline from distant sources has been enhanced by RM tools that allow importers to reduce exposure to oil price volatility during transit. If the availability of these tools is reduced, then the effective cost of imports would be higher, and the volatility of East Coast gasoline prices would increase. The gasoline price increase is estimated at 4 cents per gallon, which equates to a cost of $2 billion per year to the end-consumer.

• Key energy consuming industries could see increased costs and price volatility.

Trucking companies, airlines, railroads and barge operators all face energy costs that are a large contributor to total operating costs. Companies often use hedging strategies to manage price risk, improve competitiveness and reduce earnings volatility. If the availability of these tools is reduced, these companies would likely face greater earnings volatility, with increased pressure to pass risk on to the consumers for their services through fuel surcharges and other methods.

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Economic Impact

To gauge the overall economic impact, the various industry effects were simulated in the HIS Model of the U.S. Economy over the 2012–2016 period. The specific effects included reduced natural gas drilling and completions investment, higher natural gas prices (which flow through into higher electricity prices), higher cost of capital for electric utilities, higher East Coast gasoline prices, closure of two additional refineries, and increased gasoline imports. The combination of these effects resulted in payroll employment estimated to be over 200,000 lower over the 2012–2016 period than in the current IHS base case forecast. The loss of jobs will peak in 2016 with payroll employment being 243,000 lower relative to the IHS base case forecast. In addition, real GDP is $34 billon (2005 dollars) lower in 2016 and cumulative nominal federal tax receipts over the 2012–2016 period are $12 billion lower than in the IHS base case forecast.

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Conclusions

Risk management and intermediation services are an integral part of the domestic real economy. These services provide many benefits, including commodity price stability, facilitation of investment and security of supply. Broad market liquidity is key to providing safe, efficient and well-functioning commodity markets. Any curtailment in the availability of risk management services will affect consumer prices, domestic jobs, and economic growth.

As the Volcker Rule and other elements of regulatory change are implemented, it is of utmost importance that all due care be taken to ensure that market liquidity and the availability of essential services are not constrained, while safeguarding the quality and safety of our financial markets. If the role and permissible activities of market makers are too narrowly defined, the risk of curtailing important services offered by the banking sector will increase. The proposed Rule should be closely examined and modified in order to support the safety, soundness and security of U.S. financial markets, as well as activity across the economy.