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Opinion

Energy Credit Crunch Stalks EU Price Cap Plan

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EU action to address soaring electricity and natural gas prices comes with some potentially big risks, including for the oil industry. If the EU goes ahead with mooted plans to place a ceiling on gas and power prices that could create havoc in energy futures. Little if any consideration seems to have been given to how financial markets are going to resolve open positions in energy markets when price controls are imposed — with Europe’s power and gas markets already under severe pressure. The negative impact of actions to ease energy prices could potentially spread quickly to financial institutions. Many of the banks affected by a squeeze already underway in power markets also finance trade in oil, which could consequently suffer from credit constraints.

This threat of further disruption could not come at worse time, with the financial markets that support trading already teetering on the edge of failure. As governments have worked to shore up firms buying natural gas and electricity in Europe, they have shunned offering support for oil. Logically, in these circumstances the financial institutions propping up the oil trading system are pulling away from the business.

The financing problem came to a head on Sunday Sep. 4, when Finland and Sweden announced they would extend €33 billion to their domestic utilities to cover margin payments in the electricity market. As Bloomberg explained, the nations were setting up liquidity facilities made up of loans and credit guarantees, to avoid some power companies going into technical defaults as soon as Monday over surging collateral requirements — with the aim of preventing Russia’s energy curbs from sparking a financial crisis.

Finland’s finance minister told reporters that the market developments had in a way “the ingredients for an energy-industry Lehman Brothers moment.” Sweden’s finance minister warned too that failing to act “could have contagion effects on the rest of the financial market” even though the “issue is currently isolated to energy producers.”

The FT's commodity editor noted that companies earning large profits could need “government-backed” funding to support their hedges, which require them to post huge sums. Jacob Magnussen, chief credit analyst at Danske Bank, told the FT that “margin calls were exploding,” particularly for smaller utilities. “Once the contracts mature and the utilities sell the power they will get their money back, but there’s a huge need for additional short-term funding in the meantime and many banks could be reluctant to increase their exposure so rapidly to the sector,” said Magnussen.

Banks in the Crossfire

The European electricity market crisis has exposed the banks financing the power companies’ margin payments. This exposure is magnified by regulations governing the types of collateral European clearing houses can accept, a restriction that will likely be resolved.

This is not the first time banks have been stuck in the crossfire. Financial crises often threaten one or more banking institutions. The subprime housing crisis destroyed Bear Stearns and Lehman Brothers and nearly caused Bank of America and Wells Fargo to fail. The US Treasury ultimately injected billions into the ten largest US banks to support their liquidity. Some of them did not need the money, but the Treasury determined that all should take the funds to preserve public faith in the institutions.

Before that, when Long Term Capital Management failed in 1998, the New York Federal Reserve also saved one or more major banks by coordinating a bank-organized rescue package. And in 1980, Paul Volcker, then the Federal Reserve Board chairman, orchestrated another bailout of banks, including the Bach Group investment bank when the Hunt brothers’ attempt to corner the silver market fell apart. The Hunts later filed for bankruptcy because their very profitable position was shut by the exchange.

Spreading Contagion

Many of the same banks hit by the electricity market squeeze also finance trade in oil. And most of the banks backing commodity trading, especially in oil, are also located in Europe today. The risk managers at these institutions are no doubt ordering bankers to reduce lending for energy trading, whether in oil or other commodities, as volatility increases. The cutback will affect all energy commodities. Government guarantees for trade in electricity and natural gas may allow continued funding for these sectors. Petroleum, though, will likely suffer from the credit constraints tied to high energy price volatility.

Precisely this effect was observed during the Hunt brothers’ silver crisis. At the time, silver and copper traded on Comex in the US. When federal regulators forced Comex to cut off speculative buying of silver to block the Hunts, open interest in the silver futures contract dropped by 75% percent. Open interest in copper fell 25% and remained low for several years because traders lost trust in the market and banks backed away from financing trade.

Open interest in the three primary crude oil futures contracts — WTI on the CME, WTI on ICE and Brent on ICE — peaked most recently in March 2021 at 5.8 million contracts. As of the beginning of this month, it had declined to less than 3.7 million contracts, a decrease of 36%. It will likely decline further as banks pull back from all comity trade.

Silver Crisis Lessons

If Europe puts a ceiling on natural gas and electricity prices that would create havoc in energy futures markets. Exchanges would be required to pay large sums of money to firms that had been short. Some trading firms that had profited from long positions could find themselves in need of large loans.

The impact of actions to ease energy prices could spread quickly to financial institutions, just as the actions taken by Comex on January 21, 1980 limited silver trade to liquidation only. Silver prices began to fall after Comex acted. Two months later, the Hunts confronted margin calls they could not meet. The solvency of their banks and brokers was also threatened. The Federal Reserve resolved that danger but not without controversy.

The silver impacts spilled over to other markets. Trading in gold and copper, and of course silver, was adversely affected for a year after the crisis. In the same manner, expect the coming intervention in European energy markets to have deleterious effects on oil.

Philip Verleger is an economist who has written about energy markets for over 40 years. A graduate of MIT, he has served two presidents, taught at Yale and helped develop energy commodity markets since 1980. Kim Pederson is editorial director of PKVerleger LLC. The views expressed in this article are those of the author.

Topics:
Policy and Regulation, Gas Prices, Electricity Prices
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