In joining private equity firm Carlyle Group to help rescue Sunoco Inc‘s Philadelphia plant from likely closure, the Wall Street titan cast its multibillion-dollar physical commodity business as an essential client service, financing inventory and trading on behalf of the new owners.
This was about helping conclude a deal that would preserve jobs and avert a potential fuel price spike during the heat of an election year summer — not another risky trading venture after the more than $2 billion ‘London Whale’ loss.
But the deal also highlights a largely overlooked clause in the Volcker rule that threatens to squeeze banks out of physical markets if applied strictly by regulators, one that JPMorgan and rivals like Morgan Stanley have been quietly fighting for months.
While it has long been known the Volcker rule will ban banks’ proprietary trading in securities, futures, and other financial tools like swaps, a draft rule released in October cast a net over commercial physical contracts known as ‘commodity forwards’, which had previously been all but exempt from financial oversight.
The banks say that physical commodity forwards are a world away from the exotic derivatives blamed for exacerbating the financial crisis. A forward contract in commodities exists somewhere in the gray area between a derivative like a swap – which involves the exchange of money but not any physical assets – and the spot market, where short-term cash deals are cut.
Banks say they are also essential to conclude the kind of deal that JPMorgan lauded on Monday.
“JPMorgan’s comprehensive solution, which leverages our physical commodities capabilities… demonstrates how financial institutions with physical capabilities can prudently, yet more effectively, meet our clients’ capital needs,” the bank said in a press release.
But regulators say they are keen to avoid leaving a loophole in their brand new rule, named after former Federal Reserve Chairman Paul Volcker, that could allow banks to shift high-stakes trades from financial to physical markets.
“We intended the Volcker Rule to prohibit a broad swath of risky bets, including bets on the prices of commodities,” said Democratic Senator Carl Levin, who helped draft the part of the 2010 Dodd-Frank financial reform law that mandates the proprietary trading ban.
“The proposed Volcker Rule should cover commodity forwards because those instruments often constitute a bet on the future prices of commodities.”
In the latest example of a refining company outsourcing its trading operations to Wall Street, JPMorgan will not only provide working capital for the joint venture between Carlyle Group and Sunoco Inc, but will also operate a ‘supply and offtake’ agreement that has the bank’s traders shipping crude oil from around the world to the plant, then marketing the gasoline and diesel it makes.
If the rule is finalized as it stands the question will turn on whether banks can convince regulators that their physical deals are only done on behalf of clients, making them eligible for an exemption from the crackdown.
BANKS GET PHYSICAL
Over the last decade Wall Street banks quietly grew from financial commodity traders into major players in the physical market of crude oil cargoes, copper stockpiles and natural gas wells, often owning and operating vast assets too.
Bankers argue that forward contracts are necessary if they are to help refineries like Philadelphia curb costs and free up capital, to help power plants to hedge prices, or to let metals producers and grain farmers finance storage.
Forwards are essentially contracts to buy or sell a certain amount of a physical commodity at an agreed price in the future. Their duration can range from a few days to a number of years.
“To pull forwards into the Volcker rule just because someone has a fear that they could, in some instances, be used to evade the swap rules is just ridiculous,” one Wall Street commodities executive said.
“We move oil all over the world. We have barrels in storage. They are real, not just things on paper. They go on ships and they go to refineries. It is basically equating forwards with intent for physical delivery as swaps – and they’re not.”
She added: “You can’t burn a swap in a power plant.”
Unlike a swap, which will be settled between counterparties on the basis of an underlying financial price, a forward will usually turn into a real asset after time. Unlike hard assets, however, the forward contract can be bought or sold months or years before the commodity is produced or stored.
Historically the physical commodity markets have remained beyond financial regulatory supervision and forwards are not mentioned specifically in the part of the 2010 Dodd-Frank law that mandates the drafting of the Volcker rule.
But the drafters of Dodd-Frank say it was always their aim to prevent banks that receive government backstops like deposit insurance from trading for their own gain. They worry that banks could quickly boost trading for their own book in forward markets rather than purely for the benefit of clients.
“The issue is the potential for evasion,” said one official at the Commodity Futures Trading Commission (CFTC) who was not authorized to speak on the matter. He said traders could easily buy and sell the same commodity forward contract, profiting on the price difference, without the goods ever changing hands.
It would be a useful tool “if you want to hide activities or evade margin requirements,” he added.
RISKY BET OR HARMLESS HEDGE?
Kurt Barrow, vice president at IHS Purvin & Gertz in Houston and lead author of a Morgan Stanley-commissioned report on the impact of the Volcker rule on banks’ commodity businesses said deals like JPMorgan’s with Carlyle and Sunoco could be in jeopardy.
“One of the problems with Volcker is the way it is written assumes that every trade the banks make is in violation of it, and then they have to go through a series of steps to prove that it’s not,” Barrow said.
“If the banks have physical obligations they need to hedge, like in supply and off-take agreements with refineries, there are already concerns that they could be seen to be in violation of the Volcker rule. The rules are geared toward equity trading and don’t take account of how commodity markets really work.”
Goldman Sachs and Morgan Stanley, which alongside JPMorgan dominate physical commodity trading on Wall Street, also take part in supply and offtake agreements with independent refiners.
Without leeway to trade forward contracts, banks would have little reason to retain the metal warehouses, power plants, pipelines, and oil storage tanks that are the crown jewels of their commodity empires.
The future of those assets is already in question as the Federal Reserve must soon decide if banks backstopped by the government will be allowed to retain those assets indefinitely.
In the years preceding the financial crisis, major banks were at times booking as much as a fifth of their total profits from their commodity trading expertise, but drew criticism they could combine their physical market knowledge with huge balance sheets to try and push prices in their favor.
That criticism has resurfaced this year.
“Americans are already paying heavily at the pump for excessive speculation in the oil markets,” Senator Jeff Merkley, who co-authored the Volcker provision with Senator Levin, told Reuters.
“The last thing they need is more of that speculation and risk-taking, especially when it would not only drive gas prices even higher but could also contribute to another 2008-style meltdown.”
NO FORWARDS, NO PHYSICAL, NO SERVICE
The inclusion of forwards in the proposed Volcker rule has created concern beyond Wall Street. Some industry groups argue banks have become so embedded in the structure of both financial and physical commodity markets that they are now key trading partners for a wide range of firms.
“We were surprised,” said Russell Wasson at the National Rural Electric Cooperative Association (NRESCA). “To us they are straightforward business contracts because they’re associated with physical delivery. They’re being treated as derivatives when they never have been before.”
The concerns are the same as with other aspects of the Dodd-Frank reforms, the biggest overhaul of financial regulation since the Great Depression: tough new limits will reduce liquidity, thereby increasing market volatility and hedging costs.
The Volcker rule does include key exemptions to allow banks to hedge risk and make markets for clients.
But some commodities experts say proving that forwards fit into these categories may be too onerous to be helpful.
University of Houston professor Craig Pirrong, an expert in finance and energy markets who has generally argued against the proposed regulation, said he was skeptical of the hedging exemption’s utility, and was sure regulators would take a tough line in the wake of JPMorgan’s recent losses.
“They will have to provide justification that these (commodity forwards) are hedges or entered into as part of their “flow” business with customers,” he said.
“In the post-Whale world, banks are on the defensive and I would not bet on them prevailing on an issue like this.”
Banking executives say they are now desperate to convince skeptical regulators that their physical arms have been transformed into purely market making and client facing businesses.
“Banks have been working to reposition their commodities business… under the assumption that physical markets would be covered by Volcker,” one senior Wall Street commodities executive said.
“Several banks shut down their proprietary trading about two years ago in anticipation of this. The argument that physical commodity markets will present some kind of Volcker loophole for banks is false.”
(Reporting By David Sheppard; Editing by Bob Burgdorfer)
- Wall Street Supporters in Congress Unmoved by Libor Probe – Bloomberg (bloomberg.com)
- Reexamining The Volcker Rule After JPMorgan’s Derivatives Loss (seekingalpha.com)
- After Loss, JPMorgan Regulators in Spotlight (dealbook.nytimes.com)
- Oil rises above $84 amid tighter Iran sanctions (news.yahoo.com)
Sunoco‘s Philadelphia refinery is on the banks of the Schuylkill River. The company plans to pull out of the refining business altogether, which could help put the Northeast region in a precarious position. Photo: MIKE MERGEN / HC
Northeastern states are slated to lose half of their regional capacity for fuel production by midyear as financial woes push refineries there to idle, a trend likely to increase the region’s dependency on Gulf Coast supply.
A Houston-to-New York pipeline is making major expansions to accommodate growing demand to transport gasoline and other fuels up north from the Gulf Coast to fill the potential supply void.
The Gulf already supplies about half of the Northeast’s demand for petroleum products, said Mindi Farber-Deanda, head of the liquid fuels market team for the U.S. Energy Information Administration.
But the shutdown of production at two major Pennsylvania refineries last year and potential closure of a third could put the region in a precarious position and stress supplies of gasoline, jet fuel and heating oil, the agency concluded in a new report.
“It’s marginal, but it matters,” Farber-Deanda said of the drop in the Northeast’s local fuel production. “Before, you could get a certain percentage of supply from local refineries. Now you get it from Europe and the Gulf.”
The report noted that Northeastern states could experience “spot shortages with price hikes” for gasoline and other fuels as refineries discontinue operations.
Sunoco announced last month that it will idle operation of its 335,000 barrel-per-day refinery in Marcus Hook, Pa., part of the company’s plan to pull out of the refining business altogether. If Sunoco doesn’t find a buyer for its 178,000-barrel-per-day Philadelphia refinery by July, it will go off line, too, the company has said.
ConocoPhillips announced a similar move in September, taking its 185,000-barrel-per-day Trainer, Pa., refinery off line to prepare it for sale.
A combination of the sagging economy and improved fuel efficiency in vehicles and equipment has caused demand for some fuels to plateau. Meanwhile, competition from larger and more efficient refineries on the Gulf Coast and imports from Europe put pressure on local fuel producers, said Bill Day, a spokesman for San Antonio-based refiner Valero.
“They found it very difficult to compete,” he said. “If there was demand for product there, those refineries wouldn’t close down.”
Valero pulled out of the Northeast in 2010, when it sold its Delaware City, Del., and Paulsboro, N.J., refineries.
The struggling European economy has left refiners on the continent with plenty of gasoline to ship overseas.
Cleaner heating oil
A bigger concern for the Northeast is heating oil.
Demand for ultra-low-sulfur heating oil is expected to rise next fall, when regulations taking effect in New York will require use of the cleaner fuel in boilers that warm buildings. A limited number of refineries are equipped to produce it.
“Heating oil concerns are probably the greatest,” said Terry Higgins, executive director of refining for consulting company Hart Energy. “A cold snap, with a strong surge on heating oil needs, could be a strain on the system.”
Room to grow
The Gulf Coast is replete with refineries that are expanding or have room to increase production, he said. Motiva Enterprises, a joint venture of Shell and Saudi Aramco, is nearing the end of a massive expansion of its Port Arthur refinery to increase production of ultra-low sulfur fuel and other petroleum products.
In 2010, Gulf Coast area refiners produced a net 3.4 million barrels per day of ultralow-sulfur distillate fuel oil, a category that includes the clean heating oil, according to Energy Information Administration data. That’s up from just 23,000 barrels per day in 2005.
Colonial Pipeline, a major thoroughfare for shipping fuels from Gulf Coast refineries to East Coast markets, has seen growing demand from refiners to ship larger amounts of its products north, spokesman Steve Baker said.
The 5,500-mile pipeline transports heating oil, as well as gasoline, diesel fuel and other petroleum products.
Last year, Colonial added 120,000 barrels per day of carrying capacity to its system. By mid-2012, it will have expanded the flow of distillates – including heating oil, jet fuel and diesel – by another 55,000 barrels per day. In December, the company announced it would expand its gasoline transport capacity by another 100,000 barrels per day.
In total, the expansions will increase the system’s capacity by about 8 percent, Baker said.
“We have seen a rising demand throughout the year” for fuel transport between the Gulf Coast and the Northeast, Baker said. “These are big capital investments. It’s a significant increase.”
- Gasoline May Rise Above $4 a Gallon as Northeast Plants Shut (businessweek.com)
- Gas could soar past $4 per gallon by summer, analyst says (nj.com)
- Refining Sector Woes Going From Challenging To Worse (TSO, VLO, MPC, WNR, CVI, XOM, CVX, COP, BP) (247wallst.com)
- Amid fears of price spikes, Dems press Chu to fill Northeast oil reserve (thehill.com)
By unanimous consent, the House on Friday approved a bill that permits three LNG tankers to participate in “coastwise” trade – carrying cargo between U.S. ports. The Senate approved the legislation on Thursday.
The Mariner Project, a joint venture between Sunoco Logistics Partners L.P. and MarkWest Energy Partners L.P., would transport ethane produced from the Marcellus Shale by pipeline to Marcus Hook and then by sea to the Gulf Coast, where ethane is used to make plastics.
Because there are no qualified U.S.-flagged LNG vessels available to carry the fuel between Marcus Hook and the Gulf Coast petrochemical plants, the Mariner Project needed a waiver to the Jones Act, the 1920 law that protects markets for U.S. vessels.
U.S. Sen. Pat Toomey and U.S. Rep. Pat Meehan, whose district includes Marcus Hook, promoted the Jones Act waivers. The Republicans argued the project would generate 300 to 400 new construction jobs and 25 long-term jobs to operate the shipping terminal.
The three LNG tankers are American-built, American-owned vessels that now fly foreign flags. Reflagged as U.S. vessels, the ships must also employ U.S. crews and be maintained in America.
Toomey and Meehan had steered the three LNG tankers into special legislation that was being rushed through Congress to allow 60 foreign ships to participate in the America’s Cup sailboat race. The bill appeared to have smooth sailing ahead.
But as the legislation landed in the House this month, it became freighted with five additional vessels whose sponsors also sought Jones Act waivers. That caused delays.
The American Maritime Partnership, a lobbying group of U.S. transporters and shipbuilders, objected to the five vessels, saying they “could have an adverse competitive impact on existing operators in the coastwise trade.”
Legislators agreed this week to remove two of the vessels, allowing for the bill’s passage.
The maritime association, in a letter to lawmakers, said it did not object to the three LNG tankers because they “present a unique situation insofar as there are no coastwise-qualified U.S.-flag vessels that would compete against those ships.”
But Sunoco’s project is not a sure bet. Energy analysts say the sea route will have a hard time competing with proposals to move ethane cross-country by pipeline, the cheapest mode of transport.
- Canada: Encana Optimistic About LNG Exports (mb50.wordpress.com)
- ExxonMobil Eyes North American LNG Exports (mb50.wordpress.com)
- Japan hopes to buy LNG from U.S. by 2015 (mb50.wordpress.com)
- Chesapeake CEO Opposes US LNG Exports (mb50.wordpress.com)
- Petronet in Talks to Buy Capacity at US, Australia LNG Terminals (mb50.wordpress.com)
- USA: Sempra to Pursue Tolling Fee for Cameron LNG Export Scheme (mb50.wordpress.com)