By Jonathan Leff
NEW YORK, Dec 15 (Reuters) - As a historic oil and gas boomtransforms the U.S. energy sector, Wall Street is losing thebattle to remain the partner of choice for energy producers andmajor consumers seeking to protect themselves against volatileprices.
In the thriving Texas Permian oil patch and beyond, banksare being edged out by a handful of the world's biggestcorporations including BP Plc, Cargill and KochIndustries.
With Wall Street hamstrung by growing regulatoryrestrictions, a recently finalized ban on proprietary tradingand increased capital requirements, these corporate behemothsare leveraging their robust balance sheets and savvy globaltrading desks to capture as much as a quarter of the globalmultibillion-dollar market for hedging commodity prices.
New risks have arisen this year that could tilt the scalesfurther, as the Federal Reserve considers limiting banks'ability to trade in real physical markets, the kind of dealsthat are increasingly important for many of the smaller andmid-sized companies at the fore of the U.S. energy renaissance.
Just ask Alan Barksdale, president and chief executive ofRed Mountain Resources, a conventional driller in the PermianBasin. Early this year his company was shopping for acounterparty to execute derivative trades that would protectsome of its near 900 barrels of daily production from a possibleprice drop. Barksdale, a former investment banker, was lookingto lock in "costless collars", a type of specialized optionstrade.
After reviewing a number of offers, including some from WallStreet firms, he chose BP Energy Corp, a unit of the oil and gasmajor's trading division. In part that was because BP wasalready working with the firm's lenders. But Barksdale was alsointerested in a partner who could one day take physical deliveryof his crude, potentially netting Red Mountain an extra dollaror more per barrel.
"As you grow as a company, you'd like some flexibility toget some physical delivery," Barksdale said. "When you'redealing with somebody who is long a commodity, you get betterservice."
Ten years ago, only a handful of banks would have likelyhandled such a trade. Over the past decade, however, more than adozen rushed into the commodity trading business, acting aslenders, counterparties and risk managers.
Now some of the biggest are beating a hasty retreat.Deutsche Bank became the largest victim last week,announcing plans to exit most trading under mounting regulatorypressure and diminished profitability.
Others are like JPMorgan Chase & Co and MorganStanley are poised to carve out their large physicaltrading operations - things like oil storage tanks, gasolinecargoes and power plants - but will still compete fiercely onderivatives deals, trades they can combine with financing orother activities. Goldman Sachs has been resolute thatthe bank will continue trade both cash and paper commodities.
While most banks have blamed regulations and lower marketvolatility for the sharp slump in commodity earnings, at least aportion of the decline appears to stem from the corporate giantsquietly stealing banks' core business: serving clients.
Commodity revenues at the world's top 10 investment bankshas fallen from a peak of more than $14 billion in 2008 to just$5.5 billion last year, according to consultants Coalition. Onesenior executive at a top 10 commodity bank said corporationshad taken as much as a quarter of the global hedge book awayfrom banks, including deals with airlines and utilities.
"When you look at the market overall, the commercial firmsare making in-roads into the hedging business," says Andy Awadof Greenwich Associates, which conducts an annual survey ofhundreds of companies that hedge commodity prices. "I wouldimagine the pace of change is going to increase."
While the big non-bank companies have not yet cracked thetop tier, four of them made it into the top 20 U.S. energyhedgers this year, he said.
RETURN OF THE CORPORATES
As banks withdraw, the conventional wisdom has been thatforeign, privately owned commodity merchants like Vitol andTrafigura - which typically trade only for themselves - wouldfill the market void, particularly in the costly, complex realmof physical trading.
While they may help bolster liquidity, most of those firmsare loathe to take on the onerous regulatory burden now requiredto become a major derivatives trader.
Yet this year, units of BP, Royal Dutch Shell andCargill all formally entered the big leagues of derivativedealing, registering as "swap dealers" alongside dozens of theworld's biggest banks. As the most heavily regulated type ofderivatives trader under the Dodd-Frank law's financial reforms,they face onerous record-keeping and trade reporting rules, butalso have the latitude to hedge with far more clients, and totrade in excess of $8 billion in swaps a year.
To be sure, banks retain many advantages in the business. Asthe leading lenders to the world's industries, they can offerbundled services and leverage existing lines of credit; thederivatives operations of the biggest players, even thoseselling some parts such as JPMorgan, remain competitive onpricing.
Yet they are suffering set-backs across multiple fronts.
Some of their most valuable traders are now being hired awayby private merchants who can offer higher salaries and biggerbonuses. Tougher capital requirements under the Basel IIIinternational accord are raising banks' funding costs andnarrowing profit margins.
"We have a strong balance sheet and an ability to managethese price risks," said Cody Moore, head of North American Gasand Power at EDF Trading, a unit of France's government-backedutility, EDF.
The group was formed in 1998 and expanded its internationalreach ten years later with the purchase of Lehman Brothers'physical trading unit Eagle Energy during the financial crisis.Its revenue has surged 60 percent since 2008; pre-tax profits atthe firm, one of the few to separate its financial performancefrom that of the parent group, reached nearly 500 million eurosin 2012.
With some 350 people in its Houston office alone, EDFTrading is now the leading energy management provider for powergenerators in the United States. Last year it hired a small teamto expand into oil market logistics.
Corporations have another advantage - unlike banks, they arenot banned from trading with their own money.
Under the Volcker Rule, which was formally approved byregulators this month, banks can no longer engage in proprietaryderivatives trading - giving them less incentive to chasecustomers simply for the benefit of valuable insight into aparticular trend they may be able to trade themselves.
"In the past, the information was worth something to a bankif you had a proprietary desk," says Eric Melvin, a formertrader at an investment bank who now runs boutique Houston-basedrisk-advisory firm Mobius Risk Group.
He estimates that investment banks now account for onlyabout half of the U.S. oil and gas-hedging business, withcorporate merchants accounting for some 40 percent, up fromalmost nothing just a few years ago.
PHYSICAL STRENGTH
For most of these companies, one of their biggest sellingpoints is the ability to manage the risk of some of the mostesoteric or niche energy markets in the world - typicallybecause they already trade those commodities for themselves.
"We're willing to stand in as a provider of risk-managementwhere many or most others won't," says Steve Provenzano, BPEnergy's Chief Commercial Officer for client hedging in theAmericas. "Obviously our involvement in the physical businessgives us credibility."
Long the largest U.S. natural gas trader and a major globaloil operator, BP also has 20 people who help arrange customerderivatives trades in North American alone, and more than 3,000wholesale customer worldwide, he said.
While Wall Street awaits the completion of a Federal Reservereview of commodities trading - the results of which areexpected early next year - corporations that hedge energy pricesare placing a greater importance on the ability of acounterparty to trade in physical markets, according toGreenwich Associates' latest survey.
"I think what we're seeing is that people recognize youcan't divorce the financial and physical, they're linked," saysAwad.
Meanwhile competitors are stealing a march.
Minneapolis-based Cargill, better known for its prowess inagricultural markets, has recently moved its Houston tradinggroup to a larger office with room for over 100 traders, onlineindustry publication SparkSpread.com reported this month.Cargill employs more than 1,000 people in its Geneva-basedEnergy, Transportation and Metals business, and executives havesaid they are looking to expand as others divest.
A spokesman for Cargill declined to comment on the business.
Koch Supply & Trading, a unit of the $115 billion a yearconglomerate owned by Charles and David Koch, is famed forhaving traded the first oil swap over 25 years ago, and says itnow has nearly 500 traders, marketers and energy and metalmarkets professionals worldwide. It expanded its Europeannatural gas team last year, and minces no words in promotingitself as a more constant alternative to Wall Street.
"While some financial institutions' market coverage varieswith global market cycles, KS&T companies take a longer termview," it says in a recent online brochure. Koch offers marketliquidity "at times when others pull back."
BP (BP.)
