Europe’s energy crisis could be exacerbated by looming liquidity crisis

Europe’s problems in procuring oil and gas this winter after the conflict with Russia could be exacerbated by a new crisis in a market where prices are already red-hot.

However, European governments belatedly rallied to provide financial support to power companies on the brink of collapse.

“There is a dysfunctional futures market, which causes problems in the physical market, leading to higher prices and higher inflation,” a senior trading source told Reuters.

The issue first came to light in March when a group of top traders, utilities, oil giants and bankers sent a letter to regulators asking for a contingency plan. Read full text

This was caused by market players rushing to cover their financial exposure to gas price spikes through derivatives, by taking a “short” position on future price spikes in the physical market in which the product is offered. Hedged.

Market participants typically borrow to build short positions in the futures market, 85-90% of which comes from banks. About 10-15% of the short value, known as minimum margin, is covered by the trader’s own funds and deposited into the broker’s account.

However, if the funds in your account fall below the minimum margin requirement (10-15% in this case), a “margin call” will be triggered.

As power, gas and coal prices rose over the past year, so too did short-selling prices, resulting in margin calls and prompting oil and gas majors, trading companies, and utilities to tie up more capital. I was forced.

Some, especially the smaller ones, were hit so hard that they were forced to pull out of trading altogether as energy prices soared after the Russian invasion. Ukraine This exacerbated the general global shortage.

Such a drop in player numbers could lead to a less liquid market and even more volatility, leading to price spikes that could hit even the major players.

Since late August, EU governments have stepped in to help utilities such as Germany’s Uniper. Read full text

But with winter price spikes in store, it’s unclear if or how quickly governments and the EU will be able to help banks and other utilities that need to hedge their transactions.

Exchanges, clearing houses and brokers have increased initial margin requirements from 10-15% to 100-150% of contract value, saying hedging is too costly for many banks.

For example, the ICE exchange charges up to 79% margin rates on Dutch TTF gas futures. https://www.theice.com/products/27996665/Dutch-TTF-Gas-Futures/margin-rates

Market participants say liquidity will dwindle rapidly and trading in fuels such as oil, gas and coal will drop significantly, potentially leading to supply disruptions and even bankruptcies, but regulators have warned of the risks. still small. Read full text

Norway’s state-owned Equinor, Europe’s largest gas trader, said this month that European energy companies, excluding the UK, need at least €1.5 trillion ($1.5 trillion) to cover the costs of exposure to high gas prices. said. 1N30D0XO

This is comparable to the $1.3 trillion value of US subprime mortgages in 2007, which triggered the global financial collapse.

But one European Central Bank (ECB) policymaker told Reuters that worst-case scenario losses could reach €25 billion to €30 billion ($25 billion to $30 billion), adding that the risks are real market It’s up to speculators instead, he added.

“Need to hedge”

Nonetheless, some traders and banks offer regulators, such as the ECB and the Bank of England (BoE), guarantees or credit insurance to brokers and clearinghouses to reduce initial margin levels to pre-crisis levels. I am requesting that it be lowered to the level of

Doing so could bring participants back into the market and increase liquidity, according to sources familiar with the negotiations.

The ECB and BoE have been meeting with several major trading houses and banks since April, four trading, regulatory and banking sources said, but no concrete steps have been taken from previously unreported talks. was not obtained.

“This is too big a single risk point for banks. Banks have reached or are approaching levels of liquidity and counterparty risk,” said a senior banking source involved in commodity finance. .

Banks have a certain level of capital that can be tied to a particular industry or to a particular player, and price spikes and player cuts are now testing those levels.

The ECB has repeatedly said it sees no systemic risks that could destabilize the banking sector. The ECB declined to provide further comment.

ECB President Christine Lagarde earlier this month endorsed fiscal measures to provide liquidity to solvent energy market participants, including utility companies, while the ECB stands ready to provide liquidity to banks if needed. said there is.

Meanwhile, the UK Treasury and the Bank of England this month announced a £40bn ($46bn) funding plan for “special liquidity requirements” and short-term support for wholesale energy companies. Read full text

A Treasury spokesman, like his European peers, said action was being taken at the right time after watching the market for some time.

However, the energy and commodities markets remain opaque and physical trades are hedged with financial instruments according to internal rules set by the various companies involved.

It is also impossible to see the full picture because regulators and exchanges do not maintain a central register of trades, sources at several large commodities firms told Reuters.

However, sometimes the signal is clearly visible.

“Open interest and volume have fallen significantly as a result of what’s happening on the unsettled front,” Trafigura chief economist Saad Rahim said at a conference last week.

“Cash traders will need to hedge, which will ultimately affect the physical volume being traded.”

(Reuters)