A Chesapeake Energy Corp. official last Wednesday cautioned the Commodity Futures Trading Commission (CFTC) against imposing hard federal position limits or removing the swap dealer hedge exemption in the energy commodity markets, saying it would restrict liquidity in the market and short-circuit domestic exploration and production (E&P) efforts.
"If overly stringent position limits are imposed or a more restrictive application of hedge exemptions is put in place, we believe our ability to continue to protect our exposures would be severely and negatively impacted," said Elliot Chambers, Chesapeake's corporate finance manager, during the CFTC's third and last hearing on whether to establish speculative trading limits on commodities of finite supply, such as energy (see NGI, Aug. 3). The hearing also focused on the futures market impact from entities such as the United States Natural Gas Fund (see related story).
Absent its risk management strategy, the Oklahoma City-based producer said its investment of $3.75 billion in the Haynesville Shale in Texas-Louisiana would not have been possible.
"Chesapeake is not specifically opposed to position limits, but we do have concerns that if these limits are too low, it will remove vital liquidity from the marketplace...Additionally Chesapeake has concerns regarding removing hedge exemptions for swap dealers. It should be recognized that without swap dealers Chesapeake's risk-management program would not be possible," he said. Chambers indicated that Chesapeake Energy deals with 10-15 different swap dealers.
Position limits on swap dealers, such as investment banks JP Morgan and Goldman Sachs, and increased margin requirements on E&P companies "will make it more costly and more difficult for firms in the E&P business. I strongly urge the Commission not to impose limits on these parties," Chambers told the CFTC.
John Arnold, principal of the commodity-focused hedge fund Centaurus Energy Master Fund LP, called on the CFTC to impose hard position limits on physical commodity futures contracts "as they approach expiry," but not to establish hard trading limits on financial contracts -- where there is no agreement to make or take delivery of natural gas or other energy commodities.
He also suggested that the agency "consider replacing [exchange] accountability levels with hard limits on the forward physically deliverable contracts based on maximum position limits in any one month," but he added "there should be no 'all-month' limit."
Arnold asked the CFTC to "suspend or rescind" a June 5 New York Mercantile Exchange (Nymex) rules amendment that would place hard limits on financially settled instruments. He said some traders already are moving their traditionally exchange-traded positions to over-the-counter (OTC) markets in anticipation of the Nymex rule, which is due to go into effect in September.
"I urge the Commission to intervene immediately -- to take control of the limit-setting process and to suspend or rescind the new Nymex rules until the Commission can implement a more appropriate regulatory framework.
"If allowed to take effect as currently structured, the new Nymex limits...will have a range of detrimental effects on the market -- including pushing trading activity from exchanges to the [OTC] market, increasing volatility, reducing liquidity and increasing costs for commercial hedgers," all of which would take a toll on energy industry participants, Arnold warned.
As it is, the energy industry faces "extremely high levels of risk exposure" in the commodity markets, according to Arnold. "There is approximately 75.1 Bcf of supply each day in North America (approximately 228,000 contracts of price risk per month)...Many other activities generate significant exposure to the price of natural gas. Often nuclear, coal, hydro and renewable power generators have revenue streams linked to natural gas. Banks and institutions hold loans where the credit quality is correlated to the value of natural gas. The global LNG [liquefied natural gas] market often benchmarks its pricing relative to the U.S. market even when the product never reaches our shores. The resultant risk exposure to natural gas prices is significantly larger than the purely physical market would indicate," he said.
"Producers tend to hedge more at high prices while end-users shy away from locking in that price environment. The opposite happens when prices are low. This risk exposure requires an active financial market, and a deep pool of speculative capacity, to meet the hedging demand of the industry.
""Chesapeake recently negotiated a hedge facility that allows it to hedge up to 368,813 contracts via swaps with a consortium of banks -- and Chesapeake's production is less than 3.2% of total North American supply. TXU, a power generation company, alone sold at least 125,000 contracts of natural gas swaps to hedge its nuclear and coal power plants -- and TXU's production is only approximately 2.6% of total U.S. generation...It is hard to overstate the need for robust risk management tools in this environment," Arnold said.
Chesapeake's Chambers also said the producer is opposed to clearing in OTC markets. "The end result of our strategy is to lock in cash. If we're to hedge out into the future and we're forced to clear, that creates a very big cash question near term for a long-term strategy...It really negates the whole point behind the strategy" and would significantly hamper the ability of Chesapeake to explore for natural gas, he noted.
"A perfect example of that is 2008 when natural gas prices were so high, we had been selling in the market actively because that price was above our break-even. We had a fairly substantial mark-to-market loss around June 30 of last year, in excess of $6 billion. If we would have had to post that as collateral on an exchange...we don't know if we would have been able to find that cash...It definitely would have impacted our drilling efforts," Chambers said.
"Chesapeake Energy is merely an end-user of OTC derivatives. Companies like ours do not make the market, and we believe that forced clearing ultimately will result in less end-user risk management and more volatility pass-on to the consumer," he noted.
Centaurus' Arnold urged the CFTC to be careful in crafting its rule on position limits and hedge exemptions. "Like any market, natural gas needs rules to ensure fairness and to safeguard its participants from abuse, but...the wrong regulations can be just as harmful as no regulations at all," he said.
"I encourage the Commission to take a considered, reasonable approach to the issue rather than allowing each exchange to adopt discreet regulations that are ineffective, harmful to market efficiency and likely [to be] inconsistent with the Commission's goals."
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