Recent trends in the risk management of exposure in natural gas & LNG markets

Dr Lawrence Haar's picture
Dr Lawrence Haar, Senior Research Fellow, King Abdullah Petroleum Studies And Research Centre
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Although the 2015 sharp correction to prices in global energy markets has produced challenges for both producers and consumers, certain long term trends in how exposures to petroleum and natural gas markets may be managed should be noted.

Last year, faced with new regulatory requirements and priorities, many financial institutions severely reduced their activities in both financial and physical risk of commodities, particularly energy and petroleum. Basel 2.5 and the looming Basel 3 regulations upon financial institutions means that the amount of Tier 1 and Tier 2 capital which must be set aside against proprietary trading activity has increased.  Over the counter activities wherein banks traditionally earned stronger margins as well as created opportunities for book management, have now become problematic because of the costs attached to taking counter-party credit risk.  Meanwhile, politicians in the United States and elsewhere have questioned if banks should have any involvement in physical commodity markets as it poses systemic risk to the financial system.  Whether because of the costs of trading or fears of over potential losses, many financial institutions have withdrawn from taking proprietary risks of any form, especially in commodities, where the presence of large physical players with informational advantages, presents specific challenges.  Faced with negative publicity and the need to re-build balance sheets, some financial institutions which had created considerable presence in such areas as storage and warehousing and integrated supply chain management have withdrawn.  Barclays, Deutsche Bank, JP Morgan, Morgan Stanley, UBS and others have all reduced their presence in commodity markets.

What do these unfolding trends mean for physical players, long or short with exposure to Natural Gas and LNG markets?

  • The withdrawal of financial institutions means a loss of liquidity and even creativity in managing exposures.
  • Risk never goes away but will move to participants who can manage the risks more cheaply, such as the trading houses and integrated supply chain managers.
  • Trading houses with smaller balance sheets than those of financial institutions and physical markets to service, may not have the same incentives to build books or carry inventory required by participants needing to hedge.
  • Although the standard exchange traded products remain available, the additional liquidity once provided banks, OTC, through huge balance sheets has diminished.
  • Global petroleum prices have dropped sharply, putting downward pressure on long-term natural gas sales and bi-lateral LNG contracts, but market volatility driven by geo-political matters, is here to stay.

Given the illiquidity found in long-term futures contracts, the departure of major banks from the business of trading and hedging petroleum and natural gas, may be sorely missed. With lower prices, the scope for producers to absorb balance sheet risk will be reduced. Perhaps the regulatory community should remember the adage….be careful of what you wish!

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