Betting the Business

When it’s a derivatives dealer.

On Tuesday, February 15, 2011, the U.S. House of Representatives held a hearing that focused on the regulations to implement the end-user exemption to the new clearing requirements for the OTC derivatives market. The New York Times covered the hearings, and reported that “the law exempted end users like United Airlines and Shell Energy from the clearing requirement.”

Is that true? Certainly the law didn’t expressly name United Airlines or Shell Energy. It simply exempted end-users—the very non-financial companies organized to produce real goods and non-financial services that trade derivatives to reduce the financial risk arising from their commercial activities. These are the types of companies and the type of risk management that this blog is expressly targeted to.

But I was taken aback to see the New York Times identify Shell Energy as an “end user” that “the law exempted … from the clearing requirement.” Of course, the average man-on-the-street thinks of Shell as a company with gas stations, refineries, storage tanks and oil wells. It is. But that’s not the whole picture. The average Wall Street investment banker running an energy derivatives trading desk also thinks of Shell Energy as one of its biggest competitors, dealing derivatives and running a proprietary trading business. Reproduced below is the awards list for the top 10 derivatives dealers in energy in 2009 as ranked by the financial industry magazine Energy Risk. Shell is at seventh place, following Morgan Stanley, Barclays Capital, Deutsche Bank, and others.

Surely the banks on this list don’t count as “end users” and neither should Shell’s dealer business. Shell the oil producer, refiner, shipper and marketer is an end-user, and Congress expressly drafted an exemption for this type of commercial activity—under certain circumstances and with certain provisos yet to be fleshed out in detail. But, Shell the derivatives dealer and prop trader? Why should they be exempted? Surely not because they happen to be owned by the same parent company that owns the wells, refineries, storage tanks and gas stations.

Whatever regulations are ultimately finalized, they should not create an exemption for derivative dealers simply because the dealer happens to be owned by a company that also owns a legitimate commercial end-user business as well. That would create an enormous loophole in the regulatory system and bring us right back to the unregulated OTC derivatives market of the past with no transparency or oversight, but lots of unseen systemic risk

Shell is not an isolated case.  There are many large scale commodity derivative dealer operations that happen to co-exist within corporate entities that also run a typical commercial end-user business.

The classic example I have used for years in my lectures on commodity trading businesses is Sempra Commodities (SC for short). It was owned by Sempra Energy, which also owns a San Diego electricity and natural gas utility as well as a number of unregulated power plants, LNG supply operations and gas pipeline and storage operations. But, SC is also a commodity trading house with headquarters and main trading desks in Greenwich, Connecticut. It is a classic financial business: a major “liquidity provider” in the global gas, power and metals markets. It is a market maker, offering risk management services to commercial end-users, and running a proprietary trading portfolio, among other things.

SC evolved from Drexel Burnham Lambert in the 1980s and AIG Trading Corp in the mid-1990s before being bought by Sempra Energy. At Sempra, the SC trading business was a stand-alone profit center with no discernable relationship to the end-user lines of business headquartered in San Diego. Eventually, in 2008 Sempra Energy spun-off the SC business into a joint venture with the UK bank RBS. In the course of the financial crisis, when the UK government found itself forced to take an ownership stake in RBS, it forced the bank to sell the SC trading business. It is now owned by JP Morgan.

Throughout this entire history of ownership—originally by financial houses, then by an energy company, and then once again by financial houses—the SC trading business has always been doing its non-commercial dealer business in pretty much the same way: it always was a derivatives dealer and proprietary trading operation focused on commodities, and the nature of the other commercial businesses that its successive parents also happened to own had no discernable impact on its fundamental non-commercial operations.

It would make no sense for SC to have benefited from a commercial end-user exemption for the window of time it happened to be owned by Sempra Energy, but that is exactly what many such companies are lobbying to obtain.

For example, Shell has attempted to exploit the man-on-the-street’s familiarity with its gas stations and lack of familiarity with its non-commercial financial trading operations. It has explicitly lobbied the Commodities Future Trading Commission (CFTC), representing itself as an “end-user”. In a submission filed with the CFTC in November 2010, Shell joined with other companies under the title “Coalition of Physical Energy Companies”. The key word in the Coalition’s title is “physical” which is intended to suggest “commercial” and definitely “not financial”.

The Coalition’s submission describes the member companies as “a broad and diverse group of companies engaged in various aspects of the physical energy business, including –oil and natural gas production, -electricity generation, –retail natural gas and electricity sales, -midstream natural gas, oil and petroleum products transactions.” Notably missing is any mention of market making, derivative dealing or prop trading.

Instead, the Coalition claims that “Members hedge commodity price volatility with OTC swaps”, as if their use of derivatives was all about reducing the risk of their underlying commercial businesses. The submission explicitly makes the claim that “COPE members are ‘end-users’ of swaps – not ‘swap dealers’ as that term is used in Dodd-Frank” and “COPE members use swaps for risk management, not speculation.” But, for Shell (and possibly other members of the Coalition), both of these claims are only partly true and only regarding some of their/Shell’s commercial operations and swap trades related to those commercial operations.  But, neither are true of all of their/Shell’s non-commercial derivatives trading operations.  No question that some of Shell’s operations are classic commercial end-user operations and it uses risk management to hedge its commercial risks. But, other of Shell’s operations are classic financial house non-commercial derivatives dealing and prop trading.

Much of the lobbying on the regulations is being done by entities that claim to speak for “end-users”. Reporters, editors, legislators, regulators and the public need to drill down and examine much more thoroughly just exactly what types of operations are looking for cover under that moniker.

Top corporate executives of end-user businesses, too, need to drill down and examine the different operations within the company and exactly what they do and how they fit together. I have been writing on the topic of commodity trading operations for several years, long before this became a political topic under Dodd-Frank. My motivation has been to help companies make more sensible business decisions. There have been episodic cases of end-user businesses being undermined by the co-existence of poorly understood financial businesses within the same corporate parent. This happened most recently with the near bankruptcy and eventual asset fire sale at Constellation Energy. It happened before at a number of electricity and natural gas companies that followed the Enron corporation in building up large trading desks. I have written about both cases here.

Both sound business and sound public policy demand that we understand that where the term “end-user” is concerned, extra scrutiny is required and there is merit in making distinctions. Ultimately, hiding non-commercial dealer activities behind the “end user” label and obtaining an unwarranted exemption—whether from a regulator or from a risk management committee or from an auditor or a Board of Directors—will lead to poor management and accounting decisions, which will obscure risks, interfere with risk management, and damage a company, perhaps gravely.