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ISDA Agreements: Important Hedging Issues for Energy Companies
Overview
• Introduction to Hedging
• OTC v. Exchange-Traded Transactions
• Physical v. Financial
• ISDA Agreements
• Swaps v. Options
• Current Issues
• Dodd-Frank Act
Hedging
Companies use hedging contracts to reduce financial risk, or the prospect that prices “move against them.”
Derivatives
• Derivatives: Financial instruments that
“derive” their value from something else
(that something else can be a commodity, an
index, a security).
• Derivatives refer to a wide range of contracts,
including swaps, options, forwards, and
futures.
OTC v. Exchange-Traded
• Over-the-Counter (OTC) Contracts– General Terms and Conditions (GT&Cs) for Sale and Purchase of Crude Oil
and Oil Products (various forms).
– Base Contract for Sale and Purchase of Natural Gas published by the North American Energy Standards Board (NAESB).
– Master Power Purchase and Sale Agreement published by the Edison Electric Institute (EEI).
– ISDA Master Agreement published by the International Swaps and Derivatives Association (ISDA).
• Exchange-Traded Contracts– FCM/Brokerage Agreements: not a lot of room for negotiation.
Physical v. Financial
• Physically settled transactions: parties
intend to deliver physical product
• Financially settled transactions: parties
settle with cash
ISDA Agreement
• Master Agreement: Preprinted text that includes legal and credit provisions.
– Schedule: Modifies the Master Agreement.
– Physical Commodity Annexes: Incorporates provisions specific to physical energy commodities (e.g. natural gas, crude oil & products, coal, electricity, and weather).
• Credit Support Annex: Preprinted text that includes margining provisions.
– Paragraph 13: Modifies the first 12 paragraphs of the Credit Support Annex.
• 2005 Commodity Definitions: Definitions are incorporated by reference into each commodity transaction (each asset type has its own definition booklet, such as equity, credit, interest rates, and FX/Currency)
• Confirmation: Commercial terms.
Credit Risk
• The risk that a counterparty will fail to meet its payment obligations.
• Credit provisions can be more complex than the commercial terms.
• ISDA credit provisions.
• Collateral requirements.
Bankruptcy Considerations
• Automatic Stay: Notwithstanding the automatic stay, the ISDA parties can:– Terminate the ISDA Master Agreement
– Liquidate all transactions under the ISDA Master Agreement
– Exercise set-off rights and make termination payments
• Contracts that fall within the safe harbor provisions include:– Swap Agreements
– Forward Contracts
Swaps
• Bilateral contracts that provide for the exchange or swapping of a series of cash flows at defined intervals.
Oil Swap Assumptions
• Produce 25,000 bbl in September
• Indexed-based spot prices
• Hedge 100% of production at $50/bbl
• Lock in $1.25 million
Oil Swap Ex. 1
• Produce 25,000 bbl in September
• Indexed-based spot prices
• Hedge 100% of production at $50/bbl
• Lock in $1.25 million
• Index price $65/bbl for specified valuation period
• ($65-$50) X 25,0000 = $375,000 paid to hedge provider
• $65 X 25,000 = $1.625
• $1.625 million - $375,000 = $1.25 million
Oil Swap Ex. 2
• Produce 25,000 bbl in September
• Indexed-based spot prices
• Hedge 100% of production at $50/bbl
• Lock in $1.25 million
• Index price $40/bbl for specified valuation period
• ($50-$40) X 25,0000 = $250,000 paid to producer
• $40 X 25,000 = $1 million
• $1 million + $250,000 = $1.25 million
Options
Option contracts give the holder of the option the right, but not the obligation, to either purchase (call) or sell (put) a specified quantity of an underlying commodity on a specific date (or series of dates) in the future at a price specified for each such date (strike price or exercise price).
Oil Put Option Assumptions
• Produce 25,000 bbl in September
• Indexed-based spot prices
• Hedge 100% of production at $40/bbl
• Lock in at least $1 million
Oil Put Option Ex. 1
• Produce 25,000 bbl in September
• Indexed-based spot prices
• Hedge 100% of production at $40/bbl
• Lock in at least $1 million
• Strike price $45/bbl
• Premium $5/bbl ($5/bbl X 25,000 bbl = $125,000)
• $60/bbl floating price
• $60/bbl X 25,000 bbl = $1.5 million
• $1.5 million - $125,000 = $1.375 million or $55/bbl
Oil Put Option Ex. 2
• Produce 25,000 bbl in September
• Indexed-based spot prices
• Hedge 100% of production at $40/bbl
• Lock in at least $1 million
• Strike price $45/bbl
• Premium $5/bbl ($5/bbl X 25,000 bbl = $125,000)
• $30/bbl floating price
• ($45/bbl - $30/bbl) X 25,000 bbl = $375,000 paid by hedge provider
• $750,000 + $375,000 = $1.125 million
• $1.125 million - $125,000 = $1 million
Force Majeure vs. Market Disruption Event
• Section 5(b)(ii), Force Majeure Event, 2002 ISDA Master Agreement
• Article VII, Calculation of Prices for Commodity Reference Prices, 2005 ISDA Commodity Definitions
• ISDA Schedule
• Confirmation
Specified Entities and Credit Support Providers
• Part 1(a), Specified Entity, ISDA Schedule
• Part 4, Credit Support Provider, ISDA Schedule
Cross Default vs. Cross Acceleration
• Section 5(a)(vi), Cross Default, 1992 and 2002 ISDA Master Agreement
• Part 1(c), Cross Default, ISDA Schedule
Additional Termination Events
• Section 5(b)(v), Additional Termination Event, 1992 ISDA Master Agreement
• Section 5(b)(vi), Additional Termination Event, 2002 ISDA Master Agreement
• Part 1(g)/(h), Additional Termination Event, ISDA Schedule
Credit Support Documents
• Part 4, Credit Support Document, ISDA Schedule
Set-Off
• Section 6(f), Set-Off, 2002 ISDA Master Agreement
• ISDA Schedule
Dodd-Frank Act
• SDs, MSPs and Non-SDs/MSPs
• “Swaps”
• Clearing
• Reporting and Recordkeeping
• LEI
These materials are public information and have been prepared solely for educational purposes. These materials reflect only the personal views of the authors and are not individualized legal advice. It is understood that each case is fact-specific, and that the appropriate solution in any case will vary. Therefore, these materials may or may not be relevant to any particular situation. Thus, the authors and Steptoe & Johnson PLLC cannot be bound either philosophically or as representatives of their various present and future clients to the comments expressed in these materials. The presentation of these materials does not establish any form of attorney-client relationship with the authors or Steptoe & Johnson PLLC. While every attempt was made to insure that these materials are accurate, errors or omissions may be contained therein, for which any liability is disclaimed.
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