By Julia Payne and Dmitry Zhdannikov
LONDON (Reuters) – Europe’s troubles sourcing oil and gas this winter after a row with Russia could be exacerbated by a new market crisis where prices are already red-hot: a liquidity crunch that could send them even higher .
But European governments belatedly banded together to offer financial support to energy suppliers on the brink of collapse to ease pressure on a market whose smooth functioning is vital to keeping people warm.
“We have a dysfunctional futures market, which then creates problems for the physical market, leading to higher prices and higher inflation,” a senior trading source told Reuters.
The problem first came to light in March when a coalition of top traders, utilities, oil majors and bankers sent a letter to regulators demanding contingency plans.
This was prompted by market participants rushing to hedge their financial exposure to rising gas prices through derivatives and to hedge against future price spikes in the physical market where a product is delivered by taking a ‘short’ position.
Market participants typically borrow to short positions in the futures market, with 85-90% coming from banks. About 10-15% of the value of the short, known as the floor, is covered by the traders’ own funds and deposited in a brokerage account.
However, if the balance in the account falls below the minimum margin requirement, in this case 10-15%, a “margin call” will be triggered.
As electricity, gas and coal prices have risen over the past year, so have short selling prices, with resulting margin calls forcing oil and gas majors, trading firms and utilities to tie up more capital.
Some, particularly smaller companies, have been hit so hard that they have been forced to halt trading altogether as energy prices soared after Russia’s invasion of Ukraine in February, exacerbating a broader global tightening.
Such a drop in the number of players reduces market liquidity, which in turn can lead to even more volatility and stronger price spikes that can hurt even big players.
Since the end of August, the governments of the European Union have been stepping in to help energy suppliers like Germany’s Uniper.
However, with winter price spikes looming, there is no indication if or how quickly governments and the EU can support banks or other utilities that need to hedge their businesses.
Exchanges, clearing houses and brokers have raised initial margin requirements from 10-15% to 100%-150% of contract value, senior bankers and traders said, making hedging too costly for many.
For example, the ICE exchange charges margin rates of up to 79% on Dutch TTF gas futures. https://www.theice.com/products/27996665/Dutch-TTF-Gas-Futures/margin-rates
Although market participants say rapidly dwindling liquidity could severely limit trading in fuels like oil, gas and coal, leading to supply disruptions and bankruptcies, regulators say the risk is small.
Norwegian state-owned Equinor, Europe’s largest gas trader, said this month that European energy companies, excluding Britain, need at least 1.5 trillion euros ($1.5 trillion) to cover the cost of exposure to rising gas prices. [1N30D0XO]
This compares to $1.3 trillion in US subprime mortgages in 2007, which sparked a global financial crisis.
However, a policymaker at the European Central Bank (ECB) told Reuters that worst-case losses would amount to 25-30 billion euros ($25-30 billion), adding that the risk rests more with speculators than with investors actual market.
Some traders and banks have nonetheless asked regulators like the ECB and Bank of England (BoE) to provide brokers and clearing houses with guarantees or credit insurance to bring initial margin levels down to pre-crisis levels.
This would help bring participants back into the market and increase liquidity, according to sources familiar with the talks.
The ECB and BoE have met with several major trading houses and banks since April, four trade, regulatory and banking sources said, but no concrete action has emerged from the consultations, which were not previously reported.
“It’s too big a single point of risk for a bank. Banks have reached or are about to reach their liquidity risk and counterparty risk,” said a senior banking source involved with commodity finance.
Banks have a certain level of capital that they can tie to a particular industry or player, and price spikes and player reduction are currently testing those levels.
The ECB has repeatedly stated that it sees no systemic risk that could destabilize the banking sector. The ECB declined to issue a new comment.
ECB President Christine Lagarde said this month she would support fiscal measures to provide liquidity to solvent energy market participants, including utilities, while the ECB stands ready to provide liquidity to banks if needed.
The UK Treasury and Bank of England, meanwhile, this month announced a £40 billion ($46 billion) funding program for “extraordinary liquidity needs” and short-term support for wholesale energy companies.
A Treasury spokesman said the measures would be timely, having observed the market for some time, and in line with European counterparts.
However, the markets for energy and commodities remain opaque as physical trades in financial instruments are hedged depending on internal rules set by the different companies involved.
And with no regulator or stock exchange maintaining a centralized registry, it’s impossible to see the big picture, sources from several major commodities houses told Reuters.
For some, however, the signals are plain to see.
“Open interest and volumes have come down significantly due to what’s happening on the margining front,” Saad Rahim, Trafigura’s chief economist, told a conference last week.
“It will ultimately impact physical volumes traded as physical traders need to hedge.”
(Reporting by Dmitry Zhdannikov and Julia Payne; Additional reporting by Francesco Canepa in Frankfurt; Editing by Alexander Smith)
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