CHAPTER 11 GAS TRADING IN 2001 AND THE NAESB CONTRACT
| Jurisdiction | United States |
(Feb 2011)
GAS TRADING IN 2001 AND THE NAESB CONTRACT
HaedickeHoyt & Associates
Houston, Texas
MARK E. HAEDICKE specializes in (a) energy trading documentation, including ISDA®, NAESB® and LEAP® forms and attachments, (b) dispute resolution regarding trading contracts, and (c) regulatory compliance for trading. Mark is a partner in the law firm of Haedicke Hoyt & Associates. Mr. Haedicke has worked in the trading business for more than 25 years. His initial focus was trading physical energy commodities in both the domestic and international markets. Since 1990, he has focused on financial trading of various financial products and physical trading of commodities. He was the only non-Wall Street representative on the Board of Directors of the International Swap and Derivatives Association for six years. He has recently completed an engagement with (i) a large investment bank to negotiate 25 umbrella ISDAs, (ii) a mid-size oil and gas producer to negotiate LEAPs and ISDAs, and (iii) a major oil and gas producer to assess and design a comprehensive training program for all employees in North America on regulatory compliance. Currently, the clients of the firm include a large investment bank, numerous hedge funds, and several energy companies. Mr. Haedicke has authored training materials on trading documentation, and regulatory compliance including: ISDA® 101; ISDA® 202; NAESB 101; NAESB 202; LEAP Initiatives and the LEAP Master Agreement; Oil and Gas Trading 101; and Power Trading 101. Mr. Haedicke received his law degree from Wayne State University.
Introduction
On September 15, 2008, Lehman Brothers Holdings Inc. ("Lehman Brothers") filed for bankruptcy protection. That event was the start of a credit crisis that spread around the world. Stock markets plunged, lending slowed to a standstill, and recovery is still not complete. There was a dramatic effect on all trading markets, including energy trading. Without adequate credit support, trading volumes declined significantly. This decline made it harder to manage energy price risk and also brought a renewed focus on credit risk in energy trading forms. In addition, on July 21, 2010, President Obama signed into law The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank"), which provides for extensive financial regulatory reforms, and will have a dramatic impact on energy trading. This paper will focus on lessons from the bankruptcy of Lehman Brothers, the impact of Dodd-Frank, and the changes in the NAESB (as defined below) forms. In addition, this paper will attempt to look forward to future changes in the gas markets and gas trading contracts.
Lessons from the Bankruptcy of Lehman Brothers
The bankruptcy of Lehman Brothers is a real life case study of what could go wrong in the trading markets. Lehman Brothers, like most investment banks, pre-crisis, was heavily leveraged, and yet traded, financial and physical commodities, around the world under very favorable contract terms, in part based on its above investment grade credit rating. The demise of Lehman Brothers was unexpected, not unlike the bankruptcy of Enron Corp, nearly seven years earlier. What have we learned from the bankruptcy? How should behaviors change to better manage market and credit risks? How should trading contracts change? After a little more than two years, there are still many questions that have not been answered; however, it is fair to say, at a minimum, the lessons from the Lehman Brothers bankruptcy include the following:
• Counterparties that have large market capitalizations, and are well respected, can nonetheless file for bankruptcy and be liquidated, along with your company's trading positions
• Companies that traded based on trading contracts, with detailed collateral provisions, were better off
• Where your company's trading positions have a net positive mark-to-market valuation, routinely and promptly exercise your rights to collateral, as security for your net positive mark-to-market position
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• Anti-stay provisions are helpful, but counterparties must still protect themselves against market and credit losses in the contract by exercising their rights, especially regarding collateral
• There is risk in posting collateral to a counterparty with poor or declining credit; your company may not get its collateral back, if post to a counterparty that goes into bankruptcy.
• There will be commingling, absent a custodian arrangement, and the provider will "lose" its rights to others (often banks) with setoff rights
• Provider of collateral should generally be able to setoff its secured obligation against its damages for failure to return its collateral, so its credit exposure will be the amount by which the value of the collateral exceeds the amount of the obligation
• Keep your credit provisions and procedures up to date with the market
Impact of Dodd-Frank on the Gas Commodity Markets
On July 21, 2010, President Obama signed Dodd-Frank into law, which provides for extensive financial regulatory reforms. The goal is to reduce risk, increase transparency, and promote market integrity within the financial system. Part of the reform under Dodd-Frank, is a dramatic rewriting of the Commodity Exchange Act, which will cause many changes in the gas commodity markets over the next few years. The precise impact of the changes on the markets is still unclear. In the next two paragraphs, Dodd-Frank and the proposed regulations of the Commodity Futures Trading Commission ("CFTC") to implement Dodd-Frank, are summarized with respect the changes it is imposing on the gas commodity markets.
The CFTC will have vast new powers with respect to the energy trading markets, and specifically with respect to energy swaps, which are typically financial transactions only, with no purchase and sale of physical natural gas. The CFTC has the authority to require the registration and regulation of the Swap Dealers and Major Swap Participants, which would include most of the larger energy traders, such as the financial institutions including Goldman Sachs and Morgan Stanley, and energy companies including BP P.L.C. The CFTC also can require all "standardized" swaps to be cleared through CFTC approved clearing organizations. Dodd-Frank provides that parties entering into swaps to hedge their gas price risk (the undefined and so-called "End Users"), will not be subject to the clearing requirements. The goal of these changes and more is to provide the CFTC with oversight of the lion's share of the swaps taking place in the gas commodity markets. With more government oversight, the hope is that the markets will be more transparent and function more efficiently, and that is far from certain.
The CFTC is charged with drafting and proposing hundreds of new regulations to implement Dodd-Frank over the one-year period after enactment of Dodd-Frank. As of December of 2010, less than one-half of the regulations had been drafted. So far, the CFTC has proposed rules on "Mandatory Clearing", which proposes a process to determine which swaps are subject to mandatory clearing, and which entities could
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qualify to clear swaps. Proposed rules have been issued on "Market Manipulation" and the "End-User Exception" as well. The new market manipulation rules in general track rules of the Securities and Exchange Commission on stock manipulation. The rules are very complex and much more encompassing than prior CFTC rules on manipulation. The CFTC has also proposed new rules requiring the reporting of all swaps to the CFTC, where such swaps are not required to be cleared. The CFTC will now have data on cleared swaps and non-cleared swaps to fulfill its regulatory oversight function. All the foregoing proposed regulations are subject to public comment, discussion, rewrite by the CFTC. Plus, there are many more regulations to be issued over the next six months. It will likely take several years to assess the impact on the gas commodity markets, but it is clear the impact will be huge. More detail will be provided once the regulations have been issued as final regulations.
Importance of Form Trading Contracts in Managing Energy Price Risk
Energy prices are some of the most volatile prices in the world.2 Over the past two years, oil prices have more than doubled from the lows at the end of 2008. Gas prices, have also been very volatile. The effect of these increases is far-reaching. Nearly every economy and every person in the world is affected by higher energy prices. Given the broad impact of energy prices, it is not hard to see why the contracts used to buy and sell energy commodities are very important. These contracts are not only used to buy and sell energy, they are used to manage price risk, credit risk, operational risks and a host of other risks. The importance of having the right contract for your commodity and your transactions can hardly be overstated. Currently, there are four (4) leading forms used to trade financial and physical gas, power and oil in North America. They are:
• International Swaps and Derivatives Association's ("ISDA") forms, primarily used to trade financial energy products: ISDA Master Agreement, and ISDA Credit Support Annex, and Commodity Annexes, including for natural gas and oil;
• Edison Electricity Institute's ("EEI") forms, primarily used to trade physical power: EEI Master Power Purchase & Sale Agreement, and EEI Collateral Annex;
• North American Energy Standards Board's ("NAESB") form contract, primarily used to trade physical gas: NAESB Base Contract for Sale and Purchase of Natural...
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