Is your energy company ready for Dodd-Frank?

On July 21, 2010, President Obama signed into law the Restoring American Financial Stability Act, commonly called Dodd-Frank. Dodd-Frank is a sweeping overhaul of the financial services industry in an attempt to address the perceived systemic weaknesses exposed by the recent global economic recession. Key elements of the law include the establishment of a new Consumer Financial Protection Bureau to protect American consumers from deceptive lending practices associated with new mortgages and credit cards; the proscription of banks from engaging in proprietary trading and investment in hedge funds; greater transparency and accountability for hedge funds, mortgage brokers and payday lenders; and the regulation of over-the-counter (OTC) derivatives.

OTC derivative contracts are attractive for energy companies because they enable them to hedge their exposure to changes in commodity prices but do so outside the stringent requirements that are found on commodity exchanges. The new law may require most transactions to be margined as if they were on an exchange. While minimizing the credit risk to the counterparties involved in the transaction, this means energy companies may have to tie up significant amounts of cash to meet margining requirements. While there may be some exceptions for end-users, meaning they do not have to margin every swap, these will not apply to most companies. So it is essential for energy companies to consider the implications of these OTC derivatives regulations on their current risk management practices and, ultimately, their corporate strategy.

What effect will this have on you?

The Commodity Futures Trading Commission (CFTC) is now in the process of drafting the critical rules governing the OTC derivatives market and the implications of its approach are becoming clear. The rules will impact all energy companies, regardless of their market participant designation (i.e., swap dealer, major swap participant and end-user). Companies will need to provide documentary evidence that each swap transaction does in fact hedge underlying commercial risks. If a documentation process is not in place, such as hedge accounting, they will need to invest significant time and resources to meet the requirements.

Those companies that do not qualify for the exception may consider whether or not to remain in their current line of business or to integrate vertically to avoid using derivatives when managing their risks from price fluctuations, so-called natural hedges.

Whatever they decide, they need to understand that, for market transparency purposes, the Dodd-Frank derivatives rules will require all swap market participants, regardless of their designations, to report any swaps they undertake.

Take action

Most energy companies are taking a wait-and-see approach in their response to the uncertainty caused by Dodd-Frank and the subsequent regulatory deliberations. However, given the potential implications of these changes, PA believes, that companies need to make every effort now to understand the requirements and impact of the law on existing operations and strategies and take action as soon as possible. These actions include:

• Determining whether your company will receive the end-user designation. If the company is not designated an end-user, it could have to make major IT investment to allow them to report trades to a Swap Data Repository (SDR) within minutes of execution

• End-users could also face the need for substantial IT investment  to allow them to provide evidence that each swap does hedge an underlying commercial risk. Their systems will also need to be able to provide credit risk mitigation documentation to accompany all swaps that have the end-user exception. Furthermore, they may also need to report the swap to a SDR

• All market participants, regardless of designation, could experience significant increases in the collateral they are required to hold on all cleared swaps. Companies need to ensure that they can manage the risk to their liquidity that these requirements present.

PA has considerable expertise working with energy companies in all the areas where Dodd-Frank will have an impact, from risk management to IT implementation.

To learn more about how PA's energy trading and risk management capabilities can support you, please contact us now.