Chesapeake Energy And Derivatives Reforms

Chesapeake Energy has been a leader in the ‘end user’ lobby to weaken derivatives reforms. But the recent problems at that company – which some in the business press are likening to a new Enron – help show why these rules need to be kept strong.

As in the Volcker Rule, new derivatives rules try to distinguish hedging from speculative activity. Hedging transactions, especially by non-financial ‘end user’ companies like energy producers, are exempted from most new derivatives requirements, including critical clearing requirements. Commercial companies that can classify their transactions as ‘hedges’ can also be exempted from special oversight as major players in the swaps markets, and hedging transactions are also exempted from position limits designed to lower speculation in commodity markets.

That means a key priority in crafting effective derivatives rules is ensuring that the hedging exemption is kept narrow and is restricted to only genuine hedge transactions. But ‘end user’ companies have been arguing for as broad a hedging exemption as possible. Chesapeake Energy was in the forefront of ‘end user’ companies arguing for hedging exemptions to be expanded. Here they are telling the Commodity Futures Trading Commission that they should be exempt from various derivatives rules because they never speculate (emphasis in original):

“we are strictly prohibited from hedging more than our estimated underlying production for any given future month, meaning we can not and do not speculate.”

That’s an argument they also made to ask for exemptions from speculative position limits. But it turns out that that at least their CEO certainly does speculate. Chesapeake CEO Aubrey McClendon has been running his own energy hedge fund out of the same address as the company headquarters, using the company’s own staff. The company’s financials – which show that over one quarter of their total revenues since 2006 have come from ‘hedging’ profits – have led Fortune Magazine to state that “they look more like a Wall Street hedge fund” than an energy firm.  And the Wall Street Journal has now documented that Chesapeake regularly made short-term speculative plays in the energy markets. In an unfortunate irony, the company’s speculative ‘hedging’ strategy seem to have misfired so badly that Chesapeake was forced to go unhedged in the energy markets this year, taking on exactly the risks that hedging is designed to prevent.  Clearly, regulators need to look carefully at end user claims that they ‘do not speculate’.

Here is Chesapeake Energy again arguing to regulators that they should be exempted from new rules requiring companies to put up real money as collateral to back their derivatives bets. Instead, they argue that they should be allowed to put up mortgages on unproven oil and natural gas fields as derivatives collateral. This would tie their derivatives bets on future energy costs directly to the other great risk the company faces, namely whether the energy fields they have purchased will pay off. The value of those fields is yet another issue being questioned by the press.

Chesapeake is apparently overextended along many dimensions and derivatives are just one aspect of this. But the new derivatives rules under Dodd-Frank would help ensure that at least derivatives risk management is done properly and transparently at energy companies. That can help protect the company’s stockholders and the broader financial market from the fallout from reckless speculation. And the Chesapeake example definitely shows that regulators shouldn’t buy the argument that end user companies never speculate.

The Costs (If Any) of Derivatives Reforms

The question of the impact of derivatives rules on ‘end users’ — real economy companies who use derivatives to hedge production risks — has been a constant refrain in derivatives debates.  The claim is that basic requirements to back up derivatives with cash collateral (such as clearing and margin requirements) will impose large costs on end users. These arguments about a supposed burden on real economy companies have already led to a broad exemption from derivatives clearing requirements for non-financial end users. But opponents of new derivatives rules are continuing to push the idea that any kind of margin requirements (including for uncleared derivatives) would create significant economic costs.

Now John Parsons of the Massachusetts Institute of Technology has written the definitive paper on just how small – or possibly non-existent – the costs of new margin requirements will be. The major point of the paper is that the costs of derivatives exposures are inherent in the risks being taken in the derivative. Requirements to temporarily reserve money in margin or collateral accounts against possible future exposures don’t affect those costs, they simply change the form in which they are recognized. Unmargined derivatives are in effect a loan to the company. Reserving money up front means that the company recognizes its risk earlier, and in a more transparent fashion.  These are simply good risk management practices, not new costs. They do change cash flows and the timing of payments. But these changes in the timing of cash flows should have at most a small effect on true costs.