“Federal Energy Trading Policy Environment” or “Never Let A Good Crisis Go To Waste” Global Energy Management Institute 7 th Annual Energy Marketing &

“Federal Energy Trading Policy Environment”or

“Never Let A Good Crisis Go To Waste”Global Energy Management Institute

7th Annual Energy Marketing & Trading ConferenceMarch 19, 2009

Presented by: George D. BakerWilliams & Jensen, PLLC1155 21st Street, NWWashington, D.C. [email protected]

What is the situation in Washington these days?

“One picture equals a thousand words”

Recall what happened to this happy crew?

Guess who you are in this picture?

The people are not happy!

The fact is that there is so much going on affecting the energy trading environment, I feel like this guy trying to get a drink!

In D.C. we are not just drinking out of one fire hose but several going full blast: Tarp SEC initiatives TARF Mark-to-Market revisions Obama budget G-20 meetings Stimulus bill Regulatory Reform New taxes Hedge Fund Regulation

And on, and on, and on…..

All these can affect energy trading, but what is at the core of the energy trading political environment?

Today’s Presentation Themes Dominating Energy Trading Political

Environment on Capital Hill Commodity Exchange Act/CFTC CFTC/SEC Merger and Regulatory Reform Prospects for a Transaction Fee/Tax Energy and Global Climate Legislation

Political Environment “Elections have consequences”

Obama removes Bush veto of Democratic initiatives Increased House and Senate Democratic majorities

House 254 Democrats vs. 178 Republicans Senate 59/60 Democrats vs. 40 Republicans

“New”* Administrative Agency Leadership Geithner at Treasury Gensler at CFTC Shapiro at SEC Summers at CEA

* Geithner, Gensler, Summers all worked on Commodity Futures Modernization Act of 2000 in Clinton Administration, and Shapiro is a Washington “fixture” as well

All Obama policy priorities are dependent on or secondary to economic recovery But that focuses attention on energy trading

Energy and other commodities affect basic economy and consumer/voters perceptions

Widespread anger and sense of insufficient regulation of commodity trading as contributing to economic meltdown

Obama views financial re-regulation as a major policy took to advance his economic recovery program U.S. leadership in international financial markets is

implicated: U.S. “caused” this meltdown and “pushed” the ‘de-reg” model on the world

EU wants a re-regulatory approach

So how is energy trading viewed in this political environment?

Politically significant “themes” running through Congress’s perception of energy trading

All---or most---speculation is evil and should be limited if not stopped, especially speculation by long-only index funds

Speculation “caused” the commodity price spikes of 2008 and subsequent price collapses in 2009

Only commercial physical commodity hedgers are bona fide

OTC markets are insufficiently regulated and such “dark markets” have allowed and invited manipulation of futures markets

Margin can be increased and position limits can be imposed on an aggregated basis across all exchange traded and OTC product markets --- all without adversely affecting the liquidity and efficiency of US commodity markets or driving transactions overseas outside of US jurisdiction; and if there are such adverse affects, who cares!

Manipulation is the same as speculation, or at least the same as excess speculation

“I don’t represent Wall Street or Greenwich, Connecticut and so I don’t care what they think…”

Relative inexperience and lack of sophisticated understanding by Members of Congress re: commodity trading and relevant regulatory regimes

CFTC’s ability to do the job is questioned

Q: So what is Congress’s response to these perceptions for energy trading policy?

I. Commodity Exchange Act/CFTC Congress is displaying a willingness to broadly

revisit basic philosophy of the Commodity Futures Modernization Act of 2000: Trust in “sophisticated investors” is gone and with it

notion that they deserve less regulation Congress is looking for someone to blame for the

economic mess: Speculators and OTC traders are the usual nominees as scapegoats

Strong distrust of OTC markets and skepticism of CFTC as “cop on the beat”

Perception that OTC trading was predatory, manipulative and destructive to cash and exchange traded markets

House Agriculture Committee reported the Peterson Bill (H.R. 977) in February by voice vote

Chairman Colin Peterson (D-MN)

Highlights of Peterson bill reflect the range of issues in play on the Hill for energy trading, so let’s take a quick

walk through H.R. 977

Foreign Boards of Trade/Transparency of Offshore trading

Requires Foreign Boards of Trade with any contract that trades in US or settles against price of any contract listed on a US-registered exchange to: Provide daily trading information comparable to U.S.

exchanges Adopt position limits comparable to U.S. exchanges Adopt comparable rules to prevent manipulation,

excessive speculation and disruption of physical delivery in cash settlement

Provide comparable information to CFTC re: large trader positions and aggregate trade positions

Requires CFTC to define and classify index traders and swap dealers for data reporting purposes for transactions on DCMs, DTEFs, FBOTs and ETFs trading “significant price discovery contracts”

CFTC to disaggregate and publish monthly: Number and total notional value of index funds and

other passive, long-only and short-only positions, in ALL markets (including OTC?); and

Data on speculative positions relative to “bona fide hedgers” in ALL markets (again, OTC?)

Detailed reporting and disaggregation of market data

Transparency and Recordkeeping Subjects OTC transactions for all commodities in

regulated and exempt markets (swaps) to reporting and record keeping requirements as determined by CFTC Includes OTC contracts as part of large trader

reporting requirements Gives CFTC “special call” authority to obtain ANY

OTC market positions, even in “exempt” transactions in order to deter or prevent manipulation, disruption to market integrity or to diminish, eliminate or prevent excess speculation in regulated markets

Requires CFTC to set speculative position limits for all physically-deliverable commodities other than excluded commodities (financials).

Applies to all exempt (energy and metals) and ag commodities Position limits shall apply to spot month, each month and aggregate

positions for all months across all DCMs, DTEFs, or ETFs trading significant price discovery contracts

Requires CFTC to hold bi-annual public hearings for agricultural commodities and energy commodities to provide interested parties opportunity to comment and make recommendations re: positions limits

Establishes conditions for CFTC’s granting of hedge exemption from position limits to restrict hedge exemption to “bona fide” hedgers (largely commercial users of the underlying commodity) CFTC to define a “bona fide hedge”

Trading limits to prevent excessive speculation and protect “bona fide hedgers”

Requires CFTC to hire more employees Raises question of how to pay for the new employees?

Increased federal appropriation?

FY-09 appropriation of $146 million is a 31% increase and directs CFTC to hire 100 new employees

Beyond FY-09?

CFTC employees

Review of all prior actions by CFTC to ensure compliance with new CEA provisions

Compels revisitation of hedge exemptions and other exemptions etc. If you are relying on a favorable “no-action” letter or

exemption, pay attention!!!

Requires CFTC to study and report on efficacy and consequences of potential position limits on OTC trading and aggregated position limits across all OTC markets, DMCs and DTEFs for agricultural and energy commodities

CFTC could impose position limits for speculators in Ag and Energy OTC markets if that OTC trading is determined to have potential to disrupt liquidity and price discovery functions of exchange traded markets, cause severe market disturbance, or prevent prices from reflecting supply and demand

OTC Markets study by CFTC and emergency OTC position limits authority

Generally all prospective exempt OTC transactions and swaps must be settled and cleared through a CFTC-regulated clearing house OTC transactions in an “excluded” commodity

(i.e. financials) may be settled and cleared in an SEC-regulated or FED-regulated clearing house

Clearing of OTC Transactions

Exemption from General Mandatory Clearing Rule CFTC can exempt a contract or class of contracts if:

Highly customized Transacted infrequently Does not save significant price discovery function Parties demonstrate financial integrity of the contract

and themselves and shall include a “net capital requirement” for contract recognizing the risks associated with the absence of clearing

Contract, once executed, is reported to CFTC (or SEC or FED)

All OTC transactions prior to enactment must be cleared or reported to CFTC Concerns

Not all OTC products may be suitable for clearing CDS clearing houses not yet necessarily ready to go

with clearing for all OTC products

Carbon Trading Excludes carbon/GHG allowances from

“exempt” commodity definition, thus requiring such trading to be on futures exchanges and thus be regulated by CFTC Divergent views exist on which agency should

regulate CO2/GHG trading CFTC FERC EPA DOE SEC

CFTC Inspector General Makes CFTC Inspector General a Presidential

appointee to be confirmed by the Senate

Emergency Suspension of Credit Default Swaps Grants CFTC authority to suspend CDS

trading with concurrence of the President during any period of SEC prohibition on short-selling: CFTC order only applies to:

CDS on specific securities subject to and for duration of SEC short-selling suspension

CDS NOT purchased to reduce an existing risk related to the reference entity or its obligations (“naked”)

CFTC Criminal Authority Grants CFTC authority to initiate and conduct

criminal proceedings under CEA if DOJ declines

“How about the Senate?,” you ask.

There are Senate proposals that reflect similar issues to those contained in the Peterson bill

Senate Agriculture Chairman Tom Harkin’s Bill (S. 272) “Derivatives Trading Integrity Act of 2009”

Eliminates “excluded” and “exempt” commodities categories in CEA, thus requiring all financial, energy and metal derivatives commodities trading to be on exchange, period!

Eliminates CEA’s “swap exemption” Looking to expand S. 272 and markup a bill in

coming months Could be vehicle for a wide range of other energy trading

and energy policy provisions on Senate floor! Could be rolled into a larger energy bill that Democrats

want to do in 2009

Senator Levin (D-MI) and Senator Bingaman (D-NM) “Prevent Excessive Speculation Act of 2008”

Thematically similar in many ways to Peterson bill: Authorize CFTC to impose speculation limits on

OTC transactions in all energy products and CO2/GHG allowances

Closes “swaps” loophole for energy and ag commodities

Limits “hedge exemption” to commercials Close “London” loophole (FBOTs)

Even without new CEA legislation, expect CFTC to take action: CFTC “concept release” re: use of hedge exemption by index

traders Public comment solicited soon Culminate in a rulemaking

New CFTC Chairman Gary Gensler Senate Ag confirmation hearing held in February

Hearing was delayed; Senate floor action still delayed by some Senators expressing concerns

Chairman Harkin extracted admissions of deregulatory “mistakes” from Gensler re: his role in CFMA of 2000

Gensler clearly signaled intention to: Revisit all hedge exemptions and no-action letters and process for issuing

no-action letters Require all standardized OTC contracts to be cleared Subject all OTC dealers to increased regulation (record keeping; reporting) Supports treating all physical commodity futures the same (Ag vs. Energies)

II. Transaction Fee/Tax

A Bit of History The last several Bush Administration budgets

all proposed a futures transaction fee to recoup cost of CFTC enforcement program ($87 million) Congress always rejected the Bush transaction fee But that was pre-market meltdown and pre-TARP

Obama budget (thus far!) does not propose a transaction fee, but more details are expected soon

Rep. DeFazio (D-OR): H.R. 108 “Let Wall Street Pay for Wall Street’s Bailout Act of 2009” TARP already has a payback provision requiring President to

produce a plan 5 years from now to recoup net deficit in TARP from the “financial industry”

DeFazio would impose a tax on each “covered securities transaction” equal to the lesser of: a specified percentage set by Treasury to recover revenue equal to the

“net cost” to the Federal Government of the TARP and the Fed’s actions (that is a lot of $ $ $ $!); or 0.25%

“Covered securities transaction” includes anything traded under SEC Act and any transaction subject to CFTC jurisdiction futures potentially includes exempt products (energy, metals) or swaps or

OTC products

Illustration at 0.25% Assume euro dollar contract with $1 million

notional value $1 million x 0.25% = $2,500 Currently, exchange charges 8 cents!

Senator Grassley (R-IA) and Senator Wyden (D-OR) 2008 Discussion Draft

Treat Capital Gain or Loss from sale or exchange of oil and natural gas commodities as short term gain or loss Would apply to oil and gas trading, indexes, derivatives, or any

option, forward, futures, short position or “any similar instrument”

Would eliminate 60/40 tax treatment for futures or mixed straddles

Would “look thru” to treat pro rata share of income or loss of foreign corporations that invest in defined commodities in same manner as if the commodities were owned directly by the investor in the foreign corporation

Treat gains and losses of tax-exempt investors in defined commodities as unrelated business taxable income

III. CFTC/SEC Merger Lots of talk; Gensler opposes; Shapiro more

sanguine Strongly opposed by Congressional Ag Committees Somewhat supported but not a priority for House

Financial Services and Senate Banking Current priority is “systemic risk” regulator Fed?

Pros and Cons Obama Financial Regulation Reform Proposal: Perhaps

just principles for now Aspiration: Release before Obama’s G-20 Summit in April Reality: Treasury has its hands very full and lacks

nomination/confirmation of senior personnel

IV. Energy and Global Climate High priority for Congressional Democrats and

Obama Administration for 2009 Query: Impact of economy on timetable

Aspiration: December 2009 meeting in Copenhagen

Fight brewing over who will regulate CO2/GHG trading: CFTC SEC EPA FERC

Each agency has its Congressional proponents

Energy Bill’s Renewable Portfolio Standard (RPS)

Will encourage national trading market for RPS credits

Proposals begin with 4% RPS in 2012 and variously ramp up to 15%, 20% and 25% RPS by 2020

Bottom Line The energy trading plate is very full and laden

with uncertainty Expect plenty of legislative and administrative

activity in 2009 Prospects for significant regulatory changes are

high

Questions