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Study: Energy Derivatives a Money-Maker in Downturn

Over-the-counter (OTC) energy derivatives trading was spared the recent round of cost-cutting among capital-starved financial institutions because it "was generating significant revenues and represented a rare opportunity for continued profits and growth," according to a study by consultancy Greenwich Associates.

The firm's 2009 Global Commodities Research Study revealed that the energy derivatives business was hardly immune from the effects of the global financial crisis. However, with the deepening of the credit crunch in the fourth quarter and its continuation into the early months of 2009, companies' choice of commodities dealers was influenced more often than before by lending relationships. Companies concerned about counterparty risk were more than willing to form new trading relationships in order to reduce exposure to any one dealer, the study found.

Universal and commercial banks were the main beneficiaries of these trends. The most prominent examples were J.P. Morgan and BNP Paribas, the two banks that added the most new corporate clients in OTC energy derivatives trading last year, Greenwich said.

The competitive landscape of global derivative dealers has been affected by both the credit crisis and the consolidation triggered by the banking crisis. Among the many notable events of the past year was J.P. Morgan's acquisition of the Bear Stearns derivatives franchise (see Daily GPI, March 18, 2008), Barclays Capital's acquisition of the Lehman Brothers franchise (see Daily GPI, Sept. 23, 2008) and the forced retreat from the business by some of the world's most troubled banks.

"While Goldman Sachs and Morgan Stanley remain the industry leaders in terms of market penetration or 'share' of OTC derivatives client trading relationships, J.P. Morgan and Barclays Capital have emerged as a new tier of tough competitors, and a group of banks including BNP Paribas, Citigroup, Deutsche Bank and Société Générale have positioned themselves as a third tier of up-and-coming dealers," Greenwich said.

The increased market penetration among these banks did not come at the expense of Goldman Sachs or Morgan Stanley, the firm noted. Instead, companies formed new relationships with commercial and universal banks that have been investing in the business and building credible franchises, while also maintaining their relationships with Goldman and Morgan Stanley. "In addition to credit issues, companies last year were motivated to form new trading relationships by increasing concerns about counterparty risk arising from the failure and near-failure of some of the world's biggest financial institutions," said Greenwich consultant Andrew Awad. "Companies had new options available as more banks began to compete in this area, and adding new relationships allowed companies to reduce the concentration of their trading business and limit their exposure to individual dealers."

The average number of dealers used by companies for OTC derivatives trading increased to five in 2009 from four in 2008. In 2007, companies using crude and oil products executed an average of 88% of their OTC energy derivatives trading volume through their top three dealers, including 51% through their single lead dealer. In 2008, the share of business executed through the top three dealers declined to an average of 78%, while the share claimed by lead dealers shrunk to an average 43%.

"These competitive results reveal two things," said Greenwich consultant Frank Feenstra. "First, banks with lending relationships have been able to use these ties as a point of entry to achieve significant gains and improve their competitive positioning in other highly lucrative businesses, like OTC energy derivatives trading. But second, in an area as critical as hedging commodities exposure, capabilities and credibility count, and firms like Goldman Sachs benefit from the fact that companies want to know they are working with a market leader."

The study was based on interviews with corporate users of OTC derivatives on energy commodities. Interviews were conducted in the fourth quarter of 2008 and the first quarter of 2009.

The attitude toward commodities markets in Washington, DC, these days is solidly in favor of more regulation. New regulations in the offing are expected by some to drive more trading to electronic platforms. In Washington "there is a significant amount of momentum going into modifying every aspect of the way the OTC markets operate," Greg Mocek, a partner in the Washington office of McDermott, Will & Emery, told attendees at GasMart 2009 in Chicago recently.

"Over the last year the credit default markets have taken all the deregulatory air out of over-the-counter (OTC) trading, literally," Mocek said (see Daily GPI, May 22). "The congressional vacuum cleaner that's going on in Washington is literally not only sucking the air out of that deregulation, it's sucking the lint, it's sucking the stains, and it's essentially removing the carpet, the whole landscape is changed, and it's going to be changed for awhile and probably permanently."

Federal regulators are weighing reforms to financial markets oversight (see Daily GPI, May 14) that could include the consolidation of the Securities and Exchange Commission and the Commodity Futures Trading Commission (see Daily GPI, May 29).

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