The energy market is becoming increasingly competitive and volatile. The key to maintaining a competitive advantage is to develop effective hedging strategies and minimize risk exposure. With the new regulations introduced by the Dodd Frank Act, energy companies have seen a big change in their approach to hedging and they are on the look-out for establishing effective hedging strategies to value their assets and optimize their revenue.
Stephen Wemple, Vice President, Regulatory Affairs, Con Edison Competitive Shared Services recently spoke with Global Financial Markets Intelligence (GFMI) about key topics to be discussed at the upcoming GFMI Intelligent Hedging and Portfolio Optimization for the Energy Markets, October 24-25, 2013, in Houston. All responses represent the view of Mr. Wemple and not necessarily those of Con Edison and its subsidiaries.
A major topic of focus right now is the impact of swaps to futures on hedging strategies brought on by Dodd Frank. Can you explain your thoughts on what kind of impact this move to futures will have on hedging? Do you think energy companies will switch to the so called “futurisation” in order to avoid being a swap dealer?
SW: The trend from swaps to futures was highlighted by the conversion of all of the Intercontinental Exchange (“ICE”) products last year into futures. That decision takes significant pressure off larger energy producers and/or trading shops that may have otherwise been getting close to the $8 Billion de minimis threshold for potentially being classified as a Swap Dealer or the equivalent tests for Major Swap Participants.
With the increasing cost for hedging with OTC derivatives, do you think energy companies will reduce their hedging or will just hedge with futures instead? Is there still room for bilateral contracts?
SW: The increased cost may reduce some speculative trading but should not impact hedging activity which is determined by each company’s risk tolerance. As for bilateral contracts, they have been under pressure even before implementation of Dodd Frank as credit concerns have increased the use of exchange brokers to clear transactions. However, there is a real cost to clearing transactions that can be avoided if parties are willing (and able) to transact bilaterally. As a result, we believe there will be a continuing level of bilateral contracts, albeit diminished from historical levels.
Living in the New Regulated Market: What needs to happen for energy companies to better understand how to implement Dodd Frank into their procedures?
SW: By now, I expect most companies have integrated reporting and record retention requirements into their internal procedures to ensure that the reporting party is clearly identified and each party understands their obligation as well as begun the process of obtaining board approval to use the end-user exemption.
One remaining challenge is the determination of what constitutes a hedge. Unfortunately, CFTC has not provided much, if any, guidance; leaving companies to develop their own criteria for determining if a transaction is hedging commercial risk and can be considered a hedge.
Impact on End Users: How will Dodd Frank affect their counterparties and their credit risk? Do you think that the new rules imposed by Dodd Frank will effectively reduce speculations and increase transparency in the market?
SW: From our perspective, the energy industry had already taken significant steps to address credit risk before the implementation of Dodd Frank such as clearing more transactions and providing credit support for bilateral contracts.
One potential impact of Dodd Frank is it may constrain the types of energy products offered to municipal and governmental entities due to the lower de minimis threshold for Special Entities and smaller counterparties that may not have the capability to clear swaps or are not Eligible Contract Participants and are therefore not eligible to enter into swaps.
As counterparties shut down their swap-trading desks and shift their focus on exchange-traded products, end users fear that liquidity in bilateral markets will dry up. Is this worry warranted?
SW: The lack of bilateral liquidity and the increased use of exchange traded and cleared products does have an economic cost to market participants in the form of working capital to post initial margin and meet daily margin calls, but the trade-off is a reduction in the risk of the counterparty defaulting.
“The best option for energy traders is hedging physical assets.” Would you agree or disagree with this statement? Why?
SW: Clearing products on an exchange is clearly the most risk-averse way to execute hedges but may not be the most cost-effective, especially for those market participants that are entitled to elect the end-user exemption and transact bilaterally.
Stephen Wemple is the Vice President of Regulatory Affairs at Con Edison’s Competitive Shared Services company. He represents Con Edison’s non-utility affiliates, Con Edison Development, Con Edison Energy and Con Edison Solutions in State and Federal regulatory proceedings and has been an active participant in the New York, New England and PJM wholesale markets. Mr. Wemple has worked for the Con Edison family of companies for 26 years with responsibilities ranging from resource planning for steam-electric generation, the design and implementation of energy efficiency programs, the development of retail access programs as well as marketing and business development for the wholesale and retail commodity businesses. Mr. Wemple received his Bachelor of Science and Master of Engineering degrees from Cornell University and has been a volunteer firefighter in New York since 1987.
The GFMI Intelligent Hedging and Portfolio Optimization for the Energy Markets Conference will take place in Houston, October 24-25, 2013. For more information, visit the event website.
For more information, please contact Tyler Kelch, Marketing Coordinator, Media & PR, GFMI at 312-894-6377 or Tylerke@global-fmi.com.
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