New bank regs could impact commodities hedging

Conclusion part of 2012 study on OTC energy and metals derivatives

Wednesday, March 21, 2012 Stamford, CT USA — Although regulators in the United States and Europe have agreed to "end-user" provisions that would technically exempt most companies from new derivatives regulations, companies in these and other markets will discover that regulations such as Dodd-Frank, Basel III, MiFID, and a host of other post-crisis rules imposed on banks could have a significant impact on corporate hedging programs.

The results of the Greenwich Associates 2012 Commodities Energy Study show a market in transition. Less than a decade ago, the market for energy derivatives was dominated by just two banks. At that time a sizable share of companies did little or nothing to hedge energy costs, and among companies that hedged these exposures, many did so through processes best described as ad hoc. "Today most large companies have in place formal and increasingly sophisticated hedging policies," explains Greenwich Associates consultant Andrew Awad. "When implementing these policies, companies now have the option of choosing among 10 or more bank and nonbank providers capable of providing relatively high-quality capabilities and service in energy derivatives."

Banks around the world spent much of the last five years investing heavily in platforms that would allow them to compete in a booming energy commodities market. And compete they did: Companies have reaped the benefits of intense coverage and favorable pricing as this expanding group of dealers battled to win business and establish market share.

Regulatory Impact
However, the creation of a spate of new rules governing the banking industry in North America and Europe could represent an inflection point in the development of this market. In particular, the establishment of stricter capital reserve requirements and the imposition of mandatory central clearing for OTC derivatives trades used by banks to lay off their own risks will reduce bank profit margins in derivatives trading and curtail banks' appetite for risk.

As a result of these changes, many of the world's largest banks are rethinking their approaches to a range of important investment banking and capital markets business. In energy commodities, firms that just a few years ago were dedicated to becoming global powerhouses are now rationalizing their businesses. Faced with shrinking margins and a more difficult business environment, they are focusing on where they have a competitive advantage and, with a few exceptions, are switching to narrower strategies targeting specific regions, clients or products.

"Companies might well find that 2011 will represent the high point in terms of banks' pricing, product availability, coverage, and credit provision relating to the OTC commodities derivatives business," says Greenwich Associates consultant Woody Canaday. "As such, companies should be reviewing their own dealer relationships to ensure that they are doing business with the strongest service providers."

Pressure on Long-Term Hedges
One area in which companies can expect to feel the impact of capital requirements and other new bank rules is in the setting of tenor on energy hedges. Currently about 54% of companies around the world say the typical tenor of their hedges is one year or longer. That share approaches three-quarters of companies in the United States and 70% of companies in the United Kingdom. Only about 9% of companies worldwide and 15% in the United States report an average tenor of three years or longer. The share of companies averaging more than one year in hedging tenor has fallen slightly over the past 12 months and it could fall farther in the months ahead. One reason: Regardless of how corporate hedging strategies evolve in response to changes in market conditions, it will become more difficult to execute long-term transactions. "With the new capital requirements in place, banks will have much less appetite for long-term risk, which will increase pricing and decrease availability for transactions of longer tenor," says Greenwich Associates consultant Frank Feenstra.

Hedging Metals Exposures
On average, companies around the world cover 54% of their base metals commodities exposure and 46% of their precious metals exposure with financial hedges. By region, Asian companies cover the biggest share (75%) of their base metals exposure with financial hedges; Canadian companies cover the least (38%).

Leaning on Lenders
Lending relationships play a big role in companies' decisions about which dealers to use for both day-to-day hedging and strategic derivatives trades undertaken as part of metals commodities hedging programs. How big? In day-to-day metals hedging, companies estimate that they allocate 27% of their OTC commodity derivatives trading volume on the basis of lending relationships - making lending the second biggest driver of trade allocations behind only the overall level of derivatives service provided by dealers. For strategic transactions, companies rank lending relationships as the second most important factor considered when selecting a dealer, just behind the quality of service delivered by competing banks and tied with dealers' understanding of their commodities needs. In those terms, lending relationships rank as more important than dealers' ability to provide hedging solutions and even counterparty creditworthiness.

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