Monthly Archives: March 2012

The quickest way to a conclusion, … jump.

Earlier today, the consulting firm IHS released a report decrying the horrible consequences that the Volcker Rule would have for the US energy industry and the economy.

It’s a hatchet job.


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NERA Doubles Down

In a previous blog post, I criticized a study by the economics consulting firm NERA purporting to measure the costs companies would face as the Dodd-Frank reform of the OTC derivative markets is implemented. NERA is working on behalf of a group of energy companies lobbying to avoid some of the law’s mandates. Last week, NERA filed a “Briefing Note” with the CFTC specifically addressing my criticism and explaining the reasoning that leads them to stand by their original numbers.

What is at issue? Dodd-Frank forces companies to margin swap trades that previously could be executed without margins. Does this impose extra costs on those companies? If so, how large are these costs?

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Temporary Hedges eventually force Deleveraging

Companies are often required to hedge when taking a loan, and especially companies with volatile revenues and little flexibility to quickly adjust their costs to stabilize earnings. Creditors care about being paid back, so they worry that the firm does not fall into a state of low earnings. Hedging reduces the likelihood of that happening, and consequently increases the borrowing capacity of a company.

The problems of Energy Future Holdings (EFH), recently reported in the press, highlight an interesting issue of maturity mismatch between hedging and (excessive) leverage.

What are the problems?

EFH was created in 2007 when a group of private equity investors paid $45 bn to acquire TXU, a Texas power company. The takeover, at the height of the buyout period before the financial crisis, was financed with a debt-to-equity ratio of 4.625X. The deal required EFH to hedge its medium term revenues.

A number of things have happened since then: The development of drilling techniques that tap large deposits of natural gas trapped in shale rock formations in the US and Canada. To make things worse, the deal was signed during a period of high gas prices, prompting many power companies to switch to alternative sources of energy.  The additional supply and reduced demand led to a sharp fall in the price of natural gas, currently hovering around $2.30 per BTU. Even if this price makes gas powered turbines attractive, it takes time to convert existing facilities and build new ones.

EFH uses gas price as a proxy for the Texas electricity price. It shorts natural gas derivatives to make money when the price of the commodity falls. The profits from trading gas derivatives offset the decline in revenues from selling electricity at prices indexed to the spot price of natural gas.

The problem is that the hedges covering the anticipated generated output have been declining over the years and will expire in 2014. By then the company will be highly exposed to natural gas prices, and unless these prices recover significantly, the company will not be able to repay the maturing debt.

Currently, 5-year CDSs on EFH debt have an implied rate of 9.5 per cent. Without much hope, creditors have been writing off a significant portion of their loans. This is, in effect, deleveraging. They have also agreed to extend the debt maturities in a gamble that gas prices will rise significantly. This is not consistent with the slight increase in the natural gas futures curve over the next two years.

The example of EFH shows how hedging, or for that matter financial derivatives, can be used to hide more fundamental problems with many leverage deals: That temporary gains in hedges cannot support excessive long-term debt.

Without these temporary hedging profits, investors in EFH are being forced to deleverage. They can do it voluntarily as they seem to be doing, or they can do it through bankruptcy.


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