The regulations to implement the Volcker Rule—in the form currently proposed under the Dodd-Frank Wall Street Reform and Consumer Protection Act— could adversely impact energy markets, raising energy costs and increasing price volatility, according to a new report by information and analytics provider IHS. The ensuing economic impacts on the segments examined in the report could result in up to 200,000 fewer jobs and $34 billion (2005 dollars) less in U.S. GDP on an annual basis over the 2012-2016 period, the report finds.
The report, The Volcker Rule: Impact on the U.S. Energy Industry and Economy, examines the impact on segments of the energy industry if the services that rely on U.S. banks were to be curtailed through the implementation of the Volcker Rule regulations in their current form. While commodities markets were not the primary focus of the legislation, the specialized nature of much of the commodity risk management and intermediation services that banks provide to companies would nonetheless be seriously affected. The study examined segments of the upstream (independent natural gas producers), power and downstream (U.S. East coast petroleum market) sectors as a case study.
Among the key findings:
Potential impact on energy industry segments
Potential overall economic impact
The report results were previously submitted in a comment letter to the five regulatory agencies that are responsible for creating and implementing the regulations for the Volcker Rule—the Office of the Comptroller of the Currency, Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Securities and Exchange Commission and the Commodity Futures Trading Commission—as part of the public comment period for the Volcker Rule. The final report, released today, provides detailed analysis of the likely impact of the regulation as currently drafted.
"The report provides constructive input to the ongoing discussion about the implementation of the Volcker Rule regulations," said Kurt Barrow, vice president, Purvin & Gertz (recently acquired by IHS). "The economic analysis demonstrates the possible unintended consequences that the proposed Rule, in its current form, could have on broader segments of the U.S. economy. The findings indicate that the regulations, as currently envisioned, could create a significant ripple effect through the energy economy that would reduce production, increase the cost of electricity and gasoline and ultimately affect jobs."
The Volcker Rule is intended to prohibit proprietary trading by U.S. banks while allowing these institutions to continue to provide market making and hedging services for their clients. U.S. banks play a particularly important role in providing these services to energy producers and consumers.
"While the intent of the Volcker Rule and other elements of regulatory change are important towards safeguarding the quality and safety of financial markets, the actual proposed regulations for commodities markets lay down a narrow definition of market making and hedging," said IHS CERA Chairman Daniel Yergin. "The result could sharply limit the market making activities that are necessary for commodities risk management— services that provide significant liquidity to commodities exchanges and over-the-counter markets. Accordingly the regulators have been wise to seek a broad range of public comment."
The loss of liquidity would result in increased price volatility for energy commodities, wider bid-ask spreads (the difference between what a buyer is willing to offer and what a seller is willing to accept), reduced access to services and increased basis risk for hedging strategies, the study says.
Banks are currently key suppliers of services that allow independent natural gas producers to sustain investment plans by hedging future production revenues. Curtailing this capability could result in a decrease in investment levels by $7.5 billion per year leading to a 2.1 billion cubic feet per day (BCF/D) reduction in gas production and a $0.64 per MMBTU increase in gas prices, according to the study.
Higher natural gas prices—combined with increased price volatility in the absence of current risk management tools provided by banks—would flow through into higher and more volatile electricity prices for consumers at an estimated $5.3 billion more per year in additional power costs, the study says.
Refineries—increasingly owned by smaller independent companies with relatively-limited capital resources—have relied on bank off-take agreements to facilitate inventory financing to maintain operations and long-term hedges to reduce earnings volatility. With the curtailing of these services it is anticipated that none of the currently announced refinery closures on the U.S. East Coast would be averted through successful ownership changes.
The refinery closures would require significant changes to global supply patterns in order to adequately supply the U.S. east coast gasoline market with foreign imports and shipments from the U.S. Gulf Coast, the report says. However, the curtailment of risk management tools to allow importers to reduce the exposure to oil price changes during transit would increase the cost of imports. The combination of these factors would result in a 4 cents per gallon increase in gasoline prices—equal to an additional $2 billion per year to the end-consumer.
In addition to the energy sector segments directly examined for the report, implementation of the Volcker Rule regulations as proposed is also likely to have adverse affects on key energy consuming industries—such as trucking companies, airlines, railroads and barge operators, the study notes. The absence of the ability to manage price risks and earnings volatility could increase the pressure to pass risk along to the consumer through fuel surcharges and other methods.
The Volcker Rule: Impact on the U.S. Energy Industry and Economy draws on the multidisciplinary expertise of IHS. The methodology included modeling the energy sector response to a curtailment of risk management services and then translating this effect into the broader economy. IHS specializes in industry cost, supply/demand and price modeling and maintains extensive databases on energy sectors and the economy. Numerous IHS databases and models were used to complete the analysis which spanned across the financial commodities, three energy sectors and included economic input-output modeling. In addition, research and fundamental analysis was completed to estimate the energy sector response to a change in risk management. The energy sector response (e.g. change in investment or product price) provides inputs to the economic model that estimates the resulting impact (e.g. jobs and GDP). A discussion of the research, analysis and modeling is provided in the report.
The report was commissioned by Morgan Stanley. The analysis, content and conclusions of the study are entirely those of IHS.
To download The Volcker Rule: Impact on the U.S. Energy Industry and Economy complete report and methodology visit www.ihs.com/volckerrule.
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