* JPMorgan deal with Carlyle, Sunoco throws light on Volcker
* Proposed rule curbs deals with producers, consumers
* Commodity forwards are swaps by another name - Regulators
* Commodity forwards are not derivatives - Banks
By David Sheppard and Alexandra Alper
NEW YORK/WASHINGTON, July 3 The subtext of
JPMorgan's landmark deal to buy crude and sell gasoline for the
largest oil refinery on the U.S. East Coast was barely
In joining private equity firm Carlyle Group to help rescue
Sunoco Inc's Philadelphia plant from likely closure, the Wall
Street titan cast its multibillion-dollar physical commodity
business as an essential client service, financing inventory and
trading on behalf of the new owners.
This was about helping conclude a deal that would preserve
jobs and avert a potential fuel price spike during the heat of
an election year summer -- not another risky trading venture
after the more than $2 billion 'London Whale' loss.
But the deal also highlights a largely overlooked clause in
the Volcker rule that threatens to squeeze banks out of physical
markets if applied strictly by regulators, one that JPMorgan
and rivals like Morgan Stanley have been quietly
fighting for months.
While it has long been known the Volcker rule will ban
banks' proprietary trading in securities, futures, and other
financial tools like swaps, a draft rule released in October
cast a net over commercial physical contracts known as
'commodity forwards', which had previously been all but exempt
from financial oversight.
The banks say that physical commodity forwards are a world
away from the exotic derivatives blamed for exacerbating the
financial crisis. A forward contract in commodities exists
somewhere in the gray area between a derivative like a swap -
which involves the exchange of money but not any physical assets
- and the spot market, where short-term cash deals are cut.
Banks say they are also essential to conclude the kind of
deal that JPMorgan lauded on Monday.
"JPMorgan's comprehensive solution, which leverages our
physical commodities capabilities... demonstrates how financial
institutions with physical capabilities can prudently, yet more
effectively, meet our clients' capital needs," the bank said in
a press release.
But regulators say they are keen to avoid leaving a loophole
in their brand new rule, named after former Federal Reserve
Chairman Paul Volcker, that could allow banks to shift
high-stakes trades from financial to physical markets.
"We intended the Volcker Rule to prohibit a broad swath of
risky bets, including bets on the prices of commodities," said
Democratic Senator Carl Levin, who helped draft the part of the
2010 Dodd-Frank financial reform law that mandates the
proprietary trading ban.
"The proposed Volcker Rule should cover commodity forwards
because those instruments often constitute a bet on the future
prices of commodities."
In the latest example of a refining company outsourcing its
trading operations to Wall Street, JPMorgan will not only
provide working capital for the joint venture between Carlyle
Group and Sunoco Inc, but will also operate a 'supply
and offtake' agreement that has the bank's traders shipping
crude oil from around the world to the plant, then marketing the
gasoline and diesel it makes.
If the rule is finalized as it stands the question will turn
on whether banks can convince regulators that their physical
deals are only done on behalf of clients, making them eligible
for an exemption from the crackdown.
BANKS GET PHYSICAL
Over the last decade Wall Street banks quietly grew from
financial commodity traders into major players in the physical
market of crude oil cargoes, copper stockpiles and natural gas
wells, often owning and operating vast assets too.
Bankers argue that forward contracts are necessary if they
are to help refineries like Philadelphia curb costs and free up
capital, to help power plants to hedge prices, or to let metals
producers and grain farmers finance storage.
Forwards are essentially contracts to buy or sell a certain
amount of a physical commodity at an agreed price in the future.
Their duration can range from a few days to a number of years.
"To pull forwards into the Volcker rule just because someone
has a fear that they could, in some instances, be used to evade
the swap rules is just ridiculous," one Wall Street commodities
"We move oil all over the world. We have barrels in storage.
They are real, not just things on paper. They go on ships and
they go to refineries. It is basically equating forwards with
intent for physical delivery as swaps - and they're not."
She added: "You can't burn a swap in a power plant."
Unlike a swap, which will be settled between counterparties
on the basis of an underlying financial price, a forward will
usually turn into a real asset after time. Unlike hard assets,
however, the forward contract can be bought or sold months or
years before the commodity is produced or stored.
Historically the physical commodity markets have remained
beyond financial regulatory supervision and forwards are not
mentioned specifically in the part of the 2010 Dodd-Frank law
that mandates the drafting of the Volcker rule.
But the drafters of Dodd-Frank say it was always their aim
to prevent banks that receive government backstops like deposit
insurance from trading for their own gain. They worry that banks
could quickly boost trading for their own book in forward
markets rather than purely for the benefit of clients.
"The issue is the potential for evasion," said one official
at the Commodity Futures Trading Commission (CFTC) who was not
authorized to speak on the matter. He said traders could easily
buy and sell the same commodity forward contract, profiting on
the price difference, without the goods ever changing hands.
It would be a useful tool "if you want to hide activities or
evade margin requirements," he added.
RISKY BET OR HARMLESS HEDGE?
Kurt Barrow, vice president at IHS Purvin & Gertz in Houston
and lead author of a Morgan Stanley-commissioned report on the
impact of the Volcker rule on banks' commodity businesses said
deals like JPMorgan's with Carlyle and Sunoco could be in
"One of the problems with Volcker is the way it is written
assumes that every trade the banks make is in violation of it,
and then they have to go through a series of steps to prove that
it's not," Barrow said.
"If the banks have physical obligations they need to hedge,
like in supply and off-take agreements with refineries, there
are already concerns that they could be seen to be in violation
of the Volcker rule. The rules are geared toward equity trading
and don't take account of how commodity markets really work."
Goldman Sachs and Morgan Stanley, which alongside
JPMorgan dominate physical commodity trading on Wall Street,
also take part in supply and offtake agreements with independent
Without leeway to trade forward contracts, banks would have
little reason to retain the metal warehouses, power plants,
pipelines, and oil storage tanks that are the crown jewels of
their commodity empires.
The future of those assets is already in question as the
Federal Reserve must soon decide if banks backstopped by the
government will be allowed to retain those assets indefinitely.
In the years preceding the financial crisis, major banks
were at times booking as much as a fifth of their total profits
from their commodity trading expertise, but drew criticism they
could combine their physical market knowledge with huge balance
sheets to try and push prices in their favor.
That criticism has resurfaced this year.
"Americans are already paying heavily at the pump for
excessive speculation in the oil markets," Senator Jeff Merkley,
who co-authored the Volcker provision with Senator Levin, told
"The last thing they need is more of that speculation and
risk-taking, especially when it would not only drive gas prices
even higher but could also contribute to another 2008-style
NO FORWARDS, NO PHYSICAL, NO SERVICE
The inclusion of forwards in the proposed Volcker rule has
created concern beyond Wall Street. Some industry groups argue
banks have become so embedded in the structure of both financial
and physical commodity markets that they are now key trading
partners for a wide range of firms.
"We were surprised," said Russell Wasson at the National
Rural Electric Cooperative Association (NRESCA). "To us they are
straightforward business contracts because they're associated
with physical delivery. They're being treated as derivatives
when they never have been before."
The concerns are the same as with other aspects of the
Dodd-Frank reforms, the biggest overhaul of financial regulation
since the Great Depression: tough new limits will reduce
liquidity, thereby increasing market volatility and hedging
The Volcker rule does include key exemptions to allow banks
to hedge risk and make markets for clients.
But some commodities experts say proving that forwards fit
into these categories may be too onerous to be helpful.
University of Houston professor Craig Pirrong, an expert in
finance and energy markets who has generally argued against the
proposed regulation, said he was skeptical of the hedging
exemption's utility, and was sure regulators would take a tough
line in the wake of JPMorgan's recent losses.
"They will have to provide justification that these
(commodity forwards) are hedges or entered into as part of their
"flow" business with customers," he said.
"In the post-Whale world, banks are on the defensive and I
would not bet on them prevailing on an issue like this."
Banking executives say they are now desperate to convince
skeptical regulators that their physical arms have been
transformed into purely market making and client facing
"Banks have been working to reposition their commodities
business... under the assumption that physical markets would be
covered by Volcker," JPMorgan's global head of commodities
Blythe Masters said in an interview.
"Several banks shut down their proprietary trading about two
years ago in anticipation of this. The argument that physical
commodity markets will present some kind of Volcker loophole for
banks is false," Masters said.