On August 13, 2012, the commodity Futures Trading Commission (the “CFTC”) published a long-awaited final rule which defined the term “swap” pursuant to the Dodd-Frank Act (the “DFA”).  This rule completes the “definitional phase” of the DFA and starts the clock for compliance for several important DFA final rules, including real-time reporting, business conduct standards, and registration of swap dealers and major swap participants.  On October 12, 2012, market participants will be required to be in compliance with all applicable rules under the DFA.

For energy market participants, the “swap” definition final rule also clarified the treatment of certain transactions which are not traditionally deemed swaps but, nonetheless, were included in the final rule.  In particular, the final rule includes guidance about commodity options embedded in forward contracts.  The CFTC sets out criteria for determining whether a forward contract that contains an embedded option will be considered a swap or “an excluded non-financial commodity forward contract (and not a swap).”  Further, the final rule provides additional conditions for determining whether a forward contract with embedded “volumetric” optionality is a swap or an excluded forward contract.  These types of transactions are of particular interest to many energy companies because they appear to include some very common energy transactions: tolling, take-or-pay, full requirement, transmission or transportation, gas wellhead, and heat-rate transactions.

With respect to certain physical commercial agreements and transactions, including tolls on power plants, transportation agreements on natural gas pipelines, and natural gas storage agreements, the final rules provides the following test to determine whether such transactions are commodity options (i.e., “swaps”):

“(1) The subject of the agreement, contract or transaction is usage of a specified facility or part thereof rather than the purchase or sale of the commodity that is to be created, transported, processed or stored using the specified facility; 

(2) the agreement, contract or transaction grants the buyer the exclusive use of the specified facility or part thereof during its term, and provides for an unconditional obligation on the part of the seller to grant the buyer the exclusive use of the specified facility or part thereof; and

(3) the payment for the use of the specified facility or part thereof represents a payment for its use rather than the option to use it. 

In such agreements, contracts and transactions, while there is optionality as to whether the person uses the specified facility, the person’s right to do so is legally established, does not depend upon any further exercise of an option and merely represents a decision to use that for which the lessor already has paid. In this context, the CFTC would not consider actions such as scheduling electricity transmission, gas transportation or injection of gas into storage to be exercising an option if all three elements of the interpretation above are satisfied.”

77 FR 48242 (August 13, 2012).

Finaly, the CFTC explains, in relevant part, that:

“…if the right to use the specified facility is only obtained via the payment of a demand charge or reservation fee, and the exercise of the right (or use of the specified facility or part thereof) entails the further payment of actual storage fees, usage fees, rents, or other analogous service charges not included in the demand charge or reservation fee, such agreement, contract or transaction is a commodity option subject to the swap definition.” 

Id.

To my knowledge, every gas transportation (intra-state or inter-state) or gas storage agreement has two payment components.  One is a reservation or capacity fee and the other is a commodity fee.  The capacity fee is usually paid to preserve the right to use a facility and the commodity fee is based on the volumetric usage of the facility.  Accordingly, as outlined by the final rule above, all those gas transportation or storage agreements would appear to be swaps.  This represents a significant departure from traditional treatment of those transactions under the CFTC regulatory regime.  In particular, the CFTC’s willingness to consider the gas capacity as a “commodity” option seems to be inconsistent with the very definition of commodity.  The term “Commodity” is defined under the relevant part of Commodity Exchange Act as: “…all other goods and articles, … and all services, rights, and interests …. in which contracts for future delivery are presently or in the future dealt in.” 7 USC § 1a(9).

In other words, for a particular product, transaction, or agreement to be classified as a “commodity” under Commodity Exchange Act, there needs to be an underlying futures contract traded on one of the exchanges.  However, there is no such a product offered or traded at this time for gas pipeline or storage capacity, whether physical or financial.  The main reason for that is the fact that pipeline capacity and natural gas storage capacity are not liquid products in the market place.  For example, natural gas buyers or sellers can commingle and offer to sell or buy their commodity at any deliverable point.  However, a natural gas pipeline or storage provider cannot offer its capacity anywhere but where the physical assets are located.  Therefore, any such a capacity is only valued by those who need to transport natural gas from point A to point B.  This lack of fungibility and transferability was, at least in the pre-DFA era, generally a distinguishing feature of a product that would not meet the statutory definition of “commodity.”

From a practical standpoint, the final rule could significantly transform the operational and financial aspects of natural gas pipelines or storage providers.  If gas transportation and storage agreements are to be swaps, the affected natural gas pipelines and storage providers would have to comply with several important DFA rules.  This would require a significant investment in risk management infrastructure not usually associated with natural gas or storage companies.  This, in turn, would probably significantly impact the revenues and cash flows of those entities.  Also, since most of the pipelines are governed by various federal and state regulators, their ability to recover any such a cost would be significantly constrained.  One thing is very clear, if natural gas pipelines or storage transactions are swaps, it will significantly increase the cost of doing business and their ability to provide service.  Ironically, those physical assets that are constructed to provide physical liquidity in the natural gas market and, in doing so, to alleviate physical constraints and volatility in the market place, may be forced to curtail their service which could result in increased operational risk and market volatility.

The final rule also makes it difficult, if not impossible, for natural gas pipelines and storage providers to comply with other DFA rules.  For example, in order to comply with the final rule on “major swap participants,” an entity needs to determine its “substantial position” threshold.  A substantial position is calculated by marking all contracts to market and adding all “out-of-money” amounts.  If those amounts, for natural gas category of swaps, were to exceed $1 billion, the entity would probably meet the “major swap participants.”  To mark a contract to market, an entity would compare the contract price with the prevailing market price (by obtaining dealer quotes, or using the prevailing exchange quotes).  A negative number would mean that a particular contract is “out-of-money.”  However, a natural gas pipeline or storage provider could not obtain any such a quote.  As explained above, there are no readily available quotes or exchange traded products for pipeline or storage capacity.  Further, the pipeline transportation or storage agreements, generally, do not have a contractual provision which allows them to collect direct actual damages, unlike standard trading agreements.  

Finally, since the buyers and sellers of a commodity maintain a title to natural gas that is either transported on a pipeline or stored in a storage facility, they incur and manage the underlying risk associated with such a commodity.  The final rule appears to create a completely new commodity, i.e., natural gas pipeline or storage capacity, even though, as outlined above, there is no underlying futures contract for such a capacity.