Category Archives: commodities

Fear of the Future-ization of Swaps #1

The reform of the derivatives market, like other parts of financial reform, has been a very slow moving process. As when a giant ocean tanker is being slowly turned around, progress is so slow that it can be hard for the naked eye to confirm that the event is actually happening until the great ship’s silhouette overtakes a distinctive landmark on the horizon. And derivatives market reform, too, is happening. Each time the reform slowly approaches a new landmark on the horizon, the fact of reform is confirmed once again to proponents and opponents alike. And each time this happens, there are new howls from opponents that the ship’s current course will surely lead to disaster.

The current occasion for complaints goes under the heading “futurization of swaps.” Pre-reform, derivatives could either be traded in regulated marketplaces, generally called futures markets, or in the un-regulated marketplaces, generally called the OTC swaps market. The Dodd-Frank Act brought regulation to the OTC swaps market. Those regulations are only now beginning to take effect, or the deadlines are approaching. As that happens, companies on all sides of the derivatives markets are beginning to rethink where they should do their derivatives business. Should they continue to trade swaps, or can they get the same result using futures? Should they continue to market swaps, or should they now market futures? The swaps marketplace used to have the advantage of being unregulated, but as that advantage appears to be disappearing, where is the rationale for swaps? Derivative consumers and producers alike are giving the futures markets a fresh look. Some swap products have been relabeled and moved over to futures markets. Other, new futures products are being developed as substitutes for old swap products.

Obviously a major shift of business from the swaps market to futures markets threatens major business interests. Throughout the legislative battles leading up to Dodd-Frank, and the rulemaking and legislative battles surrounding implementation, the big banks that controlled and profited from the OTC swaps market hoped to preserve their monopoly. So far, they have mostly failed. The current debate about the ‘futurization of swaps’ is a major milestone in the process, and it is no surprise that it is raising new howls. These interests are complaining that the legislation is killing the swaps market, ruining a valuable financial innovation.

In the coming days, I will look at various arguments being made against the futurization of swaps. None of them hold up.

You say ‘futures’ like it’s a bad thing.

Early last month, the Intercontinental Exchange (ICE) announced that it was transitioning its cleared energy swaps products into futures products. That move precipitated a chain of commentary warning that other swaps business might soon transition to the futures markets. The blame is placed on various alleged problems with the CFTC’s rulemaking for swaps. CFTC Commissioner Scott O’Malia is a prominent voice making this argument recently.

What if this switch is a feature and not a bug?

Once upon a time, all derivatives trading was regulated, with transactions taking place on an exchange and with positions cleared and margins posted. Then along came the OTC swaps market, which grew enormously, far surpassing the futures markets.


Many champions of the swaps industry point to flexibility as a major advantage of swaps—the terms of a swap can be tailored to each customer’s needs. Futures, because they must be standardized, are too inflexible.

There is a grain of truth in this, around which is spun a giant ball of misrepresentation.

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¿Prepare for the bad, close your eyes to the worst?

Javier Blas at the Financial Times reports on the Mexican state’s new strategy for hedging the oil price. In recent years, the state had bought puts. But in the last couple of years, those puts expired out of the money. Whenever that happens, people start second guessing a strategy. The premium paid begins to look expensive. So this year the Mexican state has found a way to save on the premium. Instead of buying a simple put with an exercise price in the range of $80-85/barrel, it is buying a put spread with a second strike price around $60/barrel. If the price drops below the first strike around $85, then the put begins to payoff. But below the second strike of $60/barrel, the gains on the put are capped. The cost of the simple put on approximately $200 million barrels is said to be in the neighborhood of $1-1.5 billion. Using the put spread, the costs are halved, according to the Financial Times.

Of course, the cost is less because the Mexican state is buying less insurance. What is odd is that it is foregoing insurance exactly when the state will be in direst need.

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Alice’s Adventures in Australia

Liam Denning at the Wall Street Journal has a nice piece today on why Chevron has chosen not to hedge its apparent exposure to fluctuations in the value of the Australian dollar.

The apparent exposure arises from its Gorgon liquefied-natural-gas project. Sales of natural gas are denominated in US dollars, but a large fraction of Chevron’s costs at Gorgon are denominated in Australian dollars. Let’s look at the project’s value measured in US dollars. How are they exposed to fluctuations in the exchange rate between the Australian dollar and the US dollar? A mechanical sensitivity analysis will show the US dollar costs fluctuating as the exchange rate fluctuates, while the US dollar revenues will be constant. That creates the apparent exposure.

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Moody’s correction

Moody’s issued a correction today.[1] It had previously tagged as ‘credit negative’ for energy companies, the decision by ICE to move many of its cleared energy OTC swap contracts over to its futures exchange platform. Now Moody’s recognizes that as ‘credit neutral.’ Platt’s coverage is here. Continue reading

Moody’s Slips on ICE

As reported by Platts, Moody’s recently issued an analysis of the decision by ICE, the Intercontinental Exchange, that starting January 2013 its cleared OTC energy swap products would switchover and be traded as futures products. Moody’s called that “credit negative for power producers.”[1]

There are many things wrong with the Moody’s analysis. Continue reading


On Monday, the Intercontinental Exchange, ICE, announced that as of January 2013 all of its cleared OTC energy swap products would switchover and be traded as futures products.

This is one of the outcomes of the Dodd-Frank Act’s reform of the OTC derivatives markets. A very large fraction of swap transactions are economically identical to futures transactions, and the only rationale for that portion of the OTC market had always been evasion of regulation. Now, with the OTC swaps market subject to a parallel set of regulations substantially comparable to the regulation of futures contracts, the rationale for trading many products as OTC swaps is gone.

The OTC swaps market will continue to provide customized products not suitable for trading and clearing on futures exchanges, and in its press release, ICE confirmed that that portion of its OTC swaps business would remain: “All uncleared swaps will continue to be listed on ICE’s OTC platform, which will register as a swap execution facility.”

During the debates over reform of the OTC swaps market, much was made of the OTC market’s ability to offer customized products. While this ability was advantageous, its relevance to the size of the OTC market was always exaggerated. ICE’s announcement for its energy products is likely to be just the first in a major switch back to futures trades for a sizable fraction of the OTC market. The exact extent and the timeline for this switch will depend on many factors, including the ongoing battles over how specific rules are implemented and the ongoing shakeout in the future business model for banking.

“A lot of weather we’ve been having lately.”

The winter of 2011-2012 was the fourth warmest on record in the U.S., according to the National Oceanic Atmospheric Administration (NOAA). One consequence of this has been a sharp drop in demand for natural gas use to heat buildings, and that is a hit to the bottom line of many gas distribution utilities with revenues tied to the quantity of gas consumed. For example, the Delta Natural Gas Company, a Kentucky utility, reported in its second quarter 10Q that:

Heating degree days were 78% and 84% of normal thirty year average temperatures for the three and nine months ended March 31, 2012, respectively, as compared with 102% and 105% of normal temperatures in the 2011 periods. … For the three months ended March 31, 2012, consolidated gross margins decreased $890,000 (7%) due to decreased regulated and non-regulated gross margins of $707,000 (7%) and $183,000 (6%), respectively. Regulated gross margins decreased due to a 26% decline in volumes sold as a result of warmer weather, as compared to the same period in the prior year. … Non-regulated gross margins decreased due to a 26% decline in volumes sold due to a decline in our non-regulated customers’ gas requirement, partially offset by a decline in the cost of gas and the sale of natural gas liquids.

Some of this quantity risk might be hedgeable using weather derivatives. And hedging this risk can decrease the volatility in corporate cash flow, increasing both the company’s debt capacity and its dividend ratio and ultimately raising shareholder value.

A research paper by Francisco Pérez-González of Stanford University and Hayong Yun of the University of Notre Dame, forthcoming in the Journal of Finance, uses this setting to explore the question of whether financial innovation is useful to the real economy. They take the case of the innovation of weather derivatives in 1997 as a kind of natural experiment and explore the cash flow volatility situation for natural gas and electric utilities before and after the introduction of this risk management tool. Altogether, they examine stock market and financial statement data on 203 companies over the years 1960 to 2007. Their data show that the utilities most likely to use weather derivatives are those with the greatest cash flow sensitivity to weather, and that those that do make use of the derivatives significantly decrease the volatility of their cash flows. This increases the debt and dividend ratios of these utilities, and ultimately their share prices, too.

Chesapeake’s Two Natures

In yesterday’s post I said that Chesapeake’s management was speculating on natural gas and oil prices. But Chesapeake claims that it is a hedger. Speculating and hedging are different things, so is Chesapeake a hedger or a speculator?

In representations to regulators, Chesapeake’s Vice President for Finance and Assistant Treasurer, Elliot Chambers, has stated categorically that “we never speculate.” Is that true? Is his definition of a speculator the same as mine?

Chesapeake is a hedger. It uses exchange traded futures and options, OTC swaps, and a specialized financing vehicle called Volumetric Production Payments, among other things, to mitigate the price risk on its production and “predict with greater certainty the effective prices we will receive for our hedged production.” (10K for FY2011 p. 72)

But Chesapeake is also a speculator. The company is straightforward in its SEC filings that it tries to profit off of price swings: “We intend to use this volatility to our benefit by taking advantage of prices when they reach levels that management believes are either unsustainable for the long term or provide unusually high rates of return on our invested capital.” (10K for FY2011 p. 6) “Depending on changes in natural gas and oil futures markets and management’s view of underlying natural gas and oil supply and demand trends, we may increase or decrease our current derivative positions.” (10K for FY2011 p. 59) “Our general strategy for attempting to mitigate exposure to adverse natural gas and oil price changes is to hedge into strengthening natural gas and oil futures markets when prices allow us to generate higher cash margins and when we view prices to be in the upper range of our predicted future price range. Information we consider in forming an opinion about future prices includes general economic conditions, industrial output levels and expectations, producer breakeven cost structures, liquefied natural gas trends, natural gas and oil storage inventory levels, industry decline rates for base production and weather trends.” (10K for FY2011 p. 87) As I related in yesterday’s post, Chesapeake’s decision last fall to remove its natural gas hedge was based on its prediction that prices were temporarily low and would recover, allowing it to replace the hedges and capturing a profit on the short-run volatility. This is all speculation.

A company can be both a hedger and a speculator.

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Chesapeake takes its eye off the ball

Chesapeake Energy has been going through a shake-up of late, most recently at Friday’s shareholder meeting. The low, low price of natural gas is contributing to a cash squeeze. This has made all the more vital the many debates about corporate governance and the company’s investment strategy. To the list of items needing review, I would add the management’s short-term speculations on natural gas and oil prices.

Here’s a slide from a deck distributed in advance of last week’s meeting:

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