In a post last Thursday, I identified four reasons for skepticism about a new IHS report that estimated the impact on energy markets of the currently proposed implementation of the Volcker rule. Kurt Barrow, Vice President of IHS Purvin & Gertz and lead author of the IHS report, has graciously penned the following guest post addressing the questions I raised. I may comment further on a few of the points below in another post.
We appreciate your careful and thoughtful reading of the report.
On behalf of the IHS team that completed The Volcker Rule study, I would like provide the following response to the questions and concerns you raised.
You ask why non-bank institutions, such as hedge funds, would not provide some long-term risk management services. The Congressional intent of the Volcker Rule was specifically to allow the bank to continue to provide market making and hedging services to their clients, The Volcker Rule sees this as a constructive role. It is, in our view, the regulations as drafted that could to prevent the intent of the Volcker Rule from being realized. It is the same point that Mark Carney, governor of the Bank of Canada and chairman of the Financial Stability Board, made when he said that the regulations – not the Rule – would “if adopted as drafted” could “limit market-making and risk management activities.” Speaking of the impact of the regulation as drafted, he added, “the rule, as currently drafted, could reduce global financial resilience rather than increase it.”
Regarding non-bank institutions, such as hedge funds, providing risk management and intermediation, it certainly was not obvious to us who the natural players, with the requisite capabilities, could be to adequately fill any “void,” at least for some period (our modeling was based on five-years). This role requires an “A” credit rating or better, in order to be a viable counterparty that most corporations could even consider doing business with, and especially for long-dated contracts. It also requires a client-facing business model with account executives out calling on American companies to identify their needs and develop client solutions. It requires a willingness to provide financing, which is often an important component of many structured solutions. And on occasion, this activity demands someone capable of straddling both the physical and financial markets, in order to efficiently provide an effective client solution. Hedge funds are certainly not a good fit with the requisite positional assets and organizational capabilities of this role.
Regarding the concept of moving substantial portions of the OTC trade to futures exchanges, there are a two constraints that make this particularly difficult for energy companies. First, as you point out, exchanges provide only a standardized set of derivatives while OTC contracts are tailored to the commodity size, quality and location for each client. An airline may not find it useful to hedge jet fuel with a WTI contract. One important result, is that this usually allows firms to achieve hedge accounting, which is an important element of realizing the earnings stabilization that they seek. Second, exchanges have no bilateral mechanism on which to base a physical-to-financial hedge offset in the margin requirement. As a result, if the exchange derivative moves “against” the position, margin calls occur for the full duration of the hedge, even if the value of the physical stream offsets this financial “loss.”
By contrast, in OTC markets, a counter-party that understand’s a firm’s business and commodity purchase/sales needs can structure contract terms so that margin requirements account for the actual physical commodity flows.
For the economic impact, the IHS Global Insight macroeconomic forecasting model was used. The fuller description is provided in the report. The natural gas production-related jobs impact is largely driven from the investment reduction of $7.5b per year, not from the gas sales revenue. This study reports on the combined total economic impacts, which includes the direct, indirect, and induced impacts across all sectors of the economy and not just energy sector jobs. We believe the employment-to-investment results are reasonable and consistent. This is a standard way to calculate jobs impact.
To the question of benefits from this Rule, we agree these exist. In fact, as we have said, the report is not in disagreement with the intent of the Volcker Rule and the prohibition of banks from proprietary trading. We do, however, struggle to see the benefit gained from reducing the ability of energy producer and consumers – ranging from airlines to independent natural gas companies—to manage price risk, an outcome that is foreseeable with the current proposed implementation.
Finally, we are not arguing for a course of action either way. As researchers, our task here was to examine the potential impacts of the rule as it is envisioned in the current regulatory drafts. The report was conducted in response to a specific call from the regulators, who, recognizing the importance of getting the regulations right, asked for comment. And our findings tell us that the current regulations would have potentially major impacts on the energy industry, other industries, and energy prices with resulting impacts on jobs. The current regulation would not achieve the intent of the Volcker Rule. While our report did not provide specific policy suggestions, it seems that the findings of our report are consistent with recent calls, by Representative Barney Frank and others, that a simpler, more principles-based regulation might be provide the path forward.