Mifid II ensures all change for energy firms
There's plenty for companies to mull over in the latest European directive aimed at cleaning up the financial sector
The oil and gas industry is braced for fallout from the biggest root-and-branch reform of European financial markets in a generation—the Markets and Financial Instruments Directive, known as Mifid II, which comes into force in January.
Hydrocarbons firms aren't the focus for Mifid II, but they'll feel the effects from legislation that embraces every part of Europe's financial industry. Seven years in the making, and running to 70,000 pages, this legislation is Europe's belated attempt to clean up the financial sector and prevent a repeat of the 2008 markets crash.
This legislation aims to increase transparency and impose firebreaks to prevent bank collapses. The impetus to create it comes in part from the failure of the European Union to anticipate the financial crash of 2008 after introducing its first version of Mifid, now known as Mifid I, in 2007. That legislation created a single European financial market capable of rivalling the US.
Mifid II is designed to make another crash impossible. In the quest for a level playing field to protect investors there are restrictions on the more opaque forms of trading, and the rules stipulate a hefty increase in record-keeping.
Mifid II's complexity has made its introduction a lengthy process. Its outline was produced in 2011 by Europe's former internal markets commissioner Michael Barnier; but three years of wrangling followed before European Union member states agreed the law in 2014. Fresh trouble erupted when the European Securities and Markets Authority (Esma) failed to finish writing the new law's technical standards in time, necessitating a year's delay from Mifid II's original roll-out in January 2017.
Trimming the hedge
The biggest Mifid II headache for oil companies are position limits imposed on risk investment. Oil companies hedge against losses by investing heavily in commodities derivatives, and have conducted a long and mostly successful lobbying campaign against being lumped together with banks. Mifid II rules oblige banks to disclose details of derivatives investments and maintain a hefty cash float to guard against market fall.
Oil companies and traders argue that their hedging isn't speculative, but is, in effect, an insurance policy to safeguard their operations. Above all, they want to escape requirements to keep a large cash float, arguing it would be a big additional cost.
Trafigura, one of the world's largest commodities trading firms, sponsored research in 2015 that argued energy trader hedges were very different from banking investments: "Commodity Trading Firms are not excessively leveraged," its research concluded. "Their liabilities are not fragile because they do not engage in maturity or liquidity transformations; the risks of contagious runs and fire sales are low."
During testy discussions with Esma, Mike Muller—Vice President of Shell's trading and shipping arm—complained that tough derivative position limits could see companies leaving Europe to raise finance elsewhere.
Hydrocarbons firms aren't the focus for Mifid II, but they'll feel the effects
Esma has accepted the energy companies' arguments, but with strings attached. First, such hedging must be judged "ancillary" to their business, rather than being a profit centre. Secondly, oil firms spending more than 10% of their capital on commodity derivatives will be treated as banks, with the same disclosure and capital reserve requirements.
Esma has also decreed that energy companies are limited to the total share of European derivatives markets they control. That latter control is set to a sliding scale, reflecting the huge disparity between different commodities markets. Oil investments form about €40 trillion ($47 trillion) of Europe's €70 trillion energy derivatives market, and oil firms are limited to controlling 1.5% of the total market. There are larger permissible limits for other energy commodities, rising to 10% for emissions derivatives.
However, those limits aren't set in stone, with Britain's Financial Conduct Authority (FCA), Europe's biggest regulator, declaring it "may change a position limit as a result of an Esma opinion, or in the event we decide it is necessary to do so".
For the moment, oil companies and key traders, including Glencore and Vitol, have pronounced themselves content, telling Reuters in November that their commodities derivatives plans had the FCA's green light.
Another big hiccup for the oil sector are Mifid's rules on research, and the expectation that the research sector will shrink as a result.
One of the headline rules of Mifid II is the requirement that investors—the buy side—get a fuller costs picture from brokers, the sell side. The current practice of brokers is to bundle research costs together with commissions into a single cost for trading shares.
Mifid decrees that these costs be "unbundled", with research costs listed as a separate item. The rule is likely to see investors hunt around for those brokers with the lowest research costs.
In turn, this is likely to see a cull on researchers, including those covering oil and gas. A 2017 study by consultants McKinsey and Co estimates Europe-wide research spending by the top 10 sell-side banks will fall from $4bn to about $2.8bn. A poll of global asset managers by another consultancy, Quinlan and Associates, found they're planning to cut research costs by up to 30%.
Different sell-side firms have come up with different strategies to cope with this. Some will attempt to tot up the price of research for each share sale. Others, such as JP Morgan, are reportedly mulling charging buyers yearly commissions to cover research. Many more, among them the world's largest asset manager, Blackrock, say they will absorb research costs themselves, continuing to provide analysis free of charge. This latter approach may antagonise regulators, if they feel the result is to leave things unchanged, with research costs hidden within broker fees.
And there are a lot of regulators. Despite Europe's boast that it's a single trading block, enforcement falls to 28 national regulators, with the European Commission ready to step in with its own action, via the European Court of Justice, if it feels they're not enforcing the law.
€70 trillion - Value of Europe's energy derivatives market
The picture for oil and gas is complicated because some branches of research, such as analysis of listed oil companies, falls under Mifid, while other areas, such as assessing production and pipelines, doesn't. Mifid also allows brokers to provide research for free if it's judged to be generic and forward looking, such as assessments of the future prospects of the oil sector.
Research cuts are likely to be all the steeper as banks seek to recoup Mifid II compliance costs, estimated by Bloomberg at $2bn across Europe.
One result may be that some areas of oil research, in the more marginal fields or for smaller companies, vanish altogether.
A possible upside is that those oil researchers who avoid the cull will be left in a stronger position afterwards. With some banks likely to trim or even junk their own oil and gas research desks, independent analysts may be in a stronger position to dictate terms.
New financial landscape
Hardest of all to predict is the knock-on effects for oil companies and traders that the myriad changes of Mifid II entail. Big Oil involves moments of big money, whether hedging against risk, borrowing to finance projects or arranging oil sales. That activity moves through banks and finance houses, which will be restructuring to meet the new requirements of Mifid.
An added complication is that Mifid extends worldwide, affecting oil firms far beyond Europe's shores, such as those companies that have European branches or borrow money from European entities.
There's consensus among Europe's bankers that Mifid II's tangle of new rules will mean big changes in the financial sector, but no consensus about how that sector will look in the coming months and years. That means oil companies, traditionally wedded to long-term planning, will be forced into a wait-and-see period as the new reforms work themselves out.
A single thread runs through the regulatory labyrinth that is Mifid II, expressed in the new law's introduction: "The financial crisis has exposed weaknesses in the functioning and in the transparency of financial markets." Thus, the need to "increase transparency, better protect investors, reinforce confidence, address unregulated areas".
The new law aims to achieve a "clean house" in the financial markets, with its effects felt across banks, financial institutions, exchanges and all those who deal with them. The legislation imposes caps on high frequency trading and so-called dark pools that see shares traded outside the public eye. Traders will be subjected to tougher best-practice guidelines, with more market transparency for investors.
Mifid II comes into force on 3 January, but in October the European Commission said 17 of its 28 member states had yet to transpose it into national law, including the Netherlands, Spain and Luxembourg, with some unlikely to meet the roll-out deadline.
In practice, the new law will be given time to bed down, with Britain's Financial Conduct Authority, Europe's biggest regulator, declaring it won't seek early prosecutions of firms who are taking "sufficient steps" to comply.