Ype Panel

Why Energy Markets are important?Looking Back in History

What is the current regulation status?What does this mean for the markets?

Why do we care about regulators?YPE Panel

Questions????Thank you!

Regulation of physical energy commodities

Soumya Kalra

October 2, 2014

c©Soumya Kalra : All Rights Reserved

SK YPE Fall 2014 Thought Leadership Event





Outline

1 Why Energy Markets are important?

2 Looking Back in History

3 What is the current regulation status?

4 What does this mean for the markets?

5 Why do we care about regulators?

6 YPE Panel

7 Questions????

8 Thank you!






Y’ all know this obviously

In 2013, the world oil consumption was approx 90mil barrelsper day while daily consumption in the US was approx 19milbarrels per day.

In 2012 world natural gas consumption 124b mmBtu with theUnited States at 26b mmBtu.

World energy consumption in 2011 13 billionton-oil-equivalent (toe) annually which is 93 billion barrels ofoil per day. At $90 a barrel this is approx 8 trillion USD.World GDP is at approx 72 trillion USD as of 2012.






World wide energy consumption by region from 2008-2011from the IEA

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Figure: sourced from the IEA






Walking down memory lane:Regulation

US congress passed the Glass-Steagall Act of 1932 and 1933Banking Act to separate commercial and investment bankingso banks could help in financing commodities but couldn’tdirectly trade them.

In 1999, the Gramm-Leach-Bliley Act a part of the FinancialServices Modernization Act of 1999 repealed part ofGlass-Steagall which allowed banks to enter every portion ofthe commodity business






Walking down memory lane:Regulation

In 2008, high home prices, subprime mortgages and theEuropean debt crisis led to the financial breakdown with theUS government having to bailout the banks. The Fedimplemented a policy of low interest rates and quantitativeeasing increasing capital flow.

This all changed in 2010 with the passing of Dodd-Frank WallStreet Reform and the Consumer Protection Act by Congress.






Walking down memory lane:Commodity Trading

Banks began entering the modern commodity trading businessin a big way in 1981 when Salomon brothers acquired Phibroand Goldman Sachs acquired J Aron. Banks also expandedtheir services into market making, which is buying and sellingsimultaneously, and profiting on the spread.

Due to mismatches in the product delivery and cashflows aswell as liquidity, the futures markets weren’t utilized heavilyfor hedging. Banks created the over-the-counter-swap asenergy risk management product.






Walking down memory lane:Commodity Trading

In the late 1990s, due to a decrease in market volatlity andtrading large banks exited the OTC energy markets(primarilyin oil at the time). However, After the collapse of Enron in2001 and the deregulation of the gas and power markets,banks reentered the physical markets.Once the crisis hit, new rules such as US Dodd-Frank Act andthe European Market Infrastructure regulation(implemented in2012) forced dealers to centrally clear OTC derivatives.Volcker is set to take effect in 2015 here.Additionally, the Basel Committee on Banking supervisionraised capital that banks should hold against derivatives(BaselIII). Basel III primarily impacts the banks’ ability to participatein long term transactions.






The Volker Rule

On December 10th, 2013, the US federal banking agenciesalong with the SEC and the CFTC, adopted the finalregulations that implement section 619 of the Dodd-FrankAct, commonly known as the Volcker Rule.

Compliance requirements under the Volcker Rule for bankingentities must be implemented by July 21st, 2015.

The Volcker Rule restricts banking entities(All US banks andtheir affiliates as well as certain non-US banks and theiraffiliates) with respect to engaging in proprietary trading, oracquiring (or retaining) an ownership interest in or sponsoringa covered fund.






The Fed’s ANPR

Early this year, the Federal Reserve board published anANPR(advance notice of proposed rulemaking) examiningwhether financial holding companies(FHCs) involved inphysical commodity activities pose systemic risk.Currently FHCs are allowed to engage in 3 types of activities:physical commodities trading involving the purchase and sale of commodities inthe spot market and taking and making delivery of physical commodities tosettle commodity derivatives;

paying power plant owners fixed periodic payments that compensate the ownerfor its fixed costs in exchange for the right to all or part of the plants poweroutput; and

providing transactions and advisory services to power plant owners (collectively,Complementary Commodities Activities).






The Fed’s ANPR

In the ANPR, the Fed outlines concerns about environmentaldisasters as they can be quite costly to rectify and since 11 ofthe 12 FHCs are designated globally systemically importantbanks that could create another crisis like 2008 if the disasteris too costly.






Market Structure

Due to the additional regulatory constraints, the oil, gas andpower producers will face a higher cost structure and lessliquidity to hedge market volatility which make them less likelyto take on new risk and investment.

This allows for startups focusing on regulatory policies andwith new technologies to create market disruptions andprovide new products.






Historic Front Month Oil prices

month-prices.pdf

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Front month Oil prices ($/barrel)

Figure: sourced from Bloomberg






Historic Front Month Crude

month-impliedvol.pdf

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Historical Implied for front month crude futures

Figure: sourced from Bloomberg






Banks

Banks were primarily sold as a core risk management businessto producers and consumers but due to low volatility in thelast few years many banks have elected to eliminate thecommodities business.

In 2014 alone, Barclays, Morgan Stanley, JP Morgan andDeutsche have all exited the commodities business due toincreased of cost of capital and lack of revenue. In their place,trading houses like Mercuria from Switzerland and Glencorehave stepped in.

According to research by the Coalition analytics company, theten largest investment banks generated $8 billion in 2011, $6billion in 2012 and $4 billion in 2013.






Fed

After the crisis, the Fed has been working very hard toestablish rules to force banks to maintain higher capital levelson their balance sheets.On Sep 3rd, 2014 the Fed has finalized its liquidity coverageratio rules.Comments from the fed in 2013 include:nature of risks that physical commodity activities could pose to the safety andsoundness of financial holding companies and to financial stability more broadly;the potential conflicts of interest and other adverse effects of engagement byfinancial holding companies in physical commodity activities;the potential risks and benefits of imposing additional capital requirements orother restrictions on the commodity activities of financial holding companies.Although the CFTC, Commodity Futures Trading Commission, is establishingnew rules, the US Federal Reserve is focused on making trading more expensiveto reduce overall risk in the system. It has also proposed increasing collateral,margin and rules to discourage market making activity.






Panel Introduction

Darau Johnson has over 20 years experience in the Banking Industry focusingprimarily on sell-side Market Risk Management, but also leading other areassuch as buy-side Risk Management, Economic Capital, Regulatory Capital,Counter-party Credit and Liquidity Risks. He began his career at the FederalReserve Bank of NY, and then moved to Deutsche Bank AG, working both inNew York and Frankfurt Germany, but spent the majority of his career atGoldman Sachs. He returned to the New York Fed in 2013 where he is a SeniorAdvisor in the Financial Institutions Supervision Group, which is responsible forMacro and Micro prudential regulation of Financial Institutions.

Mr. Vikram Reddy began his career in the equity derivatives market making andalgorithmic trading group at Goldman Sachs in 2000. After graduate school hejoined Barclays Capital in the North American Power Group. In late 2009 hewas promoted to head of power options and in 2010 was responsible for pricingand hedging large long dated tolling transactions as well as day to day trading inpower/natural gas vanilla and exotics. He holds a B.A. in neuroscience from theUniversity of Chicago as well as a M.S. degree in Operations Research and anM.S. in Computational Finance from Carnegie Mellon University.






Questions????

Questions from audience






Thank you!

Just want to say thank you to all the YPE board members,Vincenzo from Enerknol and Amy Chen from Urban FutureLabs for making this event possible.


Documents

Ype Panel