A new study out yesterday claims that the Volcker rule, intended to push proprietary trading out of the banks, could end up slamming the U.S. energy sector, slashing two billion cubic feet a day off natural gas production and costing two hundred thousand jobs. The alarming report, commissioned by Morgan Stanley and written by the consultancy IHS, is making waves. I am, to put it mildly, not convinced.
The essence of the IHS argument goes something like this. Much of the U.S. energy industry depends on selling its production forward in order to stabilize cash flow and make long term investment possible. This is particularly true for firms that produce unconventional gas. And while markets for exchange traded near-term gas futures are incredibly liquid, the same is not true for the longer-dated contracts that are essential to much of the business. Instead, producers tend to hedge their long term exposure (6-month to 5-year horizons) through bespoke over-the-counter (OTC) contracts with banks. For a variety of interesting technical reasons that are described in the report, the Volcker rule might make it impossible for the banks to keep providing that service, at least at the same scale as they do today.
So far so good, but what comes next is more questionable. The IHS authors show that increased hedging has been correlated with increased investment. They then use that relationship to predict the impact on investment if long term hedging services were to disappear. By far the biggest impact is in natural gas production, though the authors project small impacts in several other places too.
I’m skeptical on four main grounds.
The authors never attempt to explain why non-bank institutions, such as hedge funds, won’t step in to provide at least some long term risk management services. (There is a brief observation that large integrated oil and gas companies might do that, but it’s never accounted for in the ultimate analysis, which appears to assume that hedging services will vanish.) Perhaps there’s a good argument for why others won’t be up to the task: maybe the scale of capital required is too large, or the overhead burden associated with providing the service requires economies of scale that hedge funds and other non-bank institutions can’t muster. But that argument needs to be made if the broader point is to be sustained. (It isn’t enough to note, as the study does, that the cost of hedging might rise, since the ultimate analysis implicitly assumes that the cost will be infinite.) As it stands, all the study really argues is that big banks will be out of the game.
It is also unclear to me why exchanges might not pick up much, or at least some, of the slack. I understand why producers like OTC contracts: they’re more tailored to their needs than standardized derivatives are. But I don’t see why, if the availability of OTC hedging services were severely curtailed, a much larger market for long-dated futures couldn’t arise on exchanges – or at least I don’t see why such an outcome isn’t possible. The substitute wouldn’t be perfect – there would be more risk to producers since the derivatives wouldn’t be tailored to their specific needs – but I could imagine it becoming a pretty decent replacement if today’s preferred option were curtailed.
My third problem is with the analysis of economic impacts. Let’s accept for the moment the IHS estimate that the currently proposed implementation of the Volcker rule would slash about two billion cubic feet a day off U.S. natural gas production by 2016. Would that really kill 200,000 jobs? I have a difficult time believing that. Let’s say that natural gas is going to be selling for five dollars per thousand cubic feet by 2016 (roughly the current futures price). That adds up to revenues of about four billion dollars a year. It is hard to see how this will support 200,000 jobs, which would imply about $20,000 in revenues (not profits) per job, unless we use some pretty big multipliers and assume that all the people employed and capital used would have been on the sidelines otherwise. That is a stretch.
But the biggest problem with the study may not be with how it weighs the costs of the Volcker rule – it may be the fact that it completely ignores any benefits. Imagine that someone had written the following claim in 2007:
The U.S. government is proposing to bar banks from trading in mortgage backed securities. Yet banks play a central role in making markets in these instruments. Prohibiting them from risk taking in this area would curtail the ability of originators to offer low cost home loans to the American people. This would be tragic: mortgage brokers, by offering innovative products, have helped millions of people attain the American dream. In the process, they have helped grow the construction industry, creating hundred of thousands of new jobs. All of this would be at risk with the new rule.
Sound ridiculous? It should. Much of that argument about the costs of bank regulation would have been correct – yet no one, with the benefit of hindsight, would now say “the financial crisis was a price worth paying for keeping mortgages cheap”. I am not suggesting that the natural gas industry today is like the subprime mortgage industry was five years ago – indeed I’ve argued against that point before. But the arguments coming from the banks today are remarkably similar, and the same sort of skepticism would be wise.
Indeed there is one line in the IHS study that I find particularly troubling:
“Banks play an important role as liquidity providers in less liquid markets, particularly niche and long dated markets. The strong credit quality of many banks makes them a preferred counterparty to transact with.”
And why do the banks have such great credit quality? You’re staring at part of it every time you look in the mirror. The financial crisis proved that the U.S. taxpayer will be on the hook if a big bank ever again threatens to go down. That is the reason for the Volcker rule, and part of the reason for banks’ superior credit quality. If people really believe that government should subsidize risk taking by private energy producers through implicit support for the banking system, they should stand up and say it.
Let me be clear: there are undoubtedly places where the proposed implementation of the Volcker rule can be improved so as to better distinguish market making activities from proprietary trading. That, despite its actual content, is how the IHS report is framed -- and, to be sure, drawing the distinction is a nightmare. Yet the report says nothing about what changes might be wise and what activities might safely be offloaded from the banks. (This is not the fault of IHS – it presumably was not part of its contract.) Focusing on those details would be a far more constructive avenue of debate.