The Division of Market Oversight issued an interpretation addressing whether, under Part 151 of the Commission’s regulations, an electric company may treat as bona fide hedging transactions certain derivative transact...

Summary: The Division of Market Oversight issued an interpretation addressing whether, under Part 151 of the Commission’s regulations, an electric company may treat as bona fide hedging transactions certain derivative transactions that reduce the price risk associated with its unfilled anticipated requirements for natural gas, even though it has entered into some long-term, firm purchases of natural gas at an unfixed price. The interpretation notes that unfilled anticipated requirements may be recognized as the basis of a bona fide hedging position or transaction under Commission Regulation 151.5(a)(2)(ii)(C) when a commercial enterprise has entered into long-term, unfixed-price supply or requirements contracts as the price risk of such “unfilled” anticipated requirements is not offset by an unfixed price forward contract as the price risk remains with the commercial, even though the commercial enterprise has contractually assured a supply of the commodity. Instead, the price risk continues until the forward contract’s price is fixed; once the price is fixed on the supply contract, the commercial enterprise no longer has price risk and the derivative position, to the extent the position is above an applicable speculative position limit, must be liquidated in an orderly manner in accordance with sound commercial practices.

U.S. COMMODITY FUTURES TRADING COMMISSION

Three Lafayette Centre

Division of

Market Oversight

CFTC Letter No. 12-07

Interpretation

August 16, 2012

Division of Market Oversight

Paul J. Pantano, Jr.

1155 21st Street, NW, Washington, DC 20581

Telephone: (202) 418-5000

Facsimile: (202) 418-5521

www.cftc.gov

Cadwalader, Wickersham & Taft LLP

700 Sixth Street, NW

Washington, DC 20001

Re: Your request for guidance regarding the meaning of "unfilled anticipated requirements"

for purposes of bona fide hedging under the Commission's position limit rules

Dear Mr

ersight

Paul J. Pantano, Jr.

1155 21st Street, NW, Washington, DC 20581

Telephone: (202) 418-5000

Facsimile: (202) 418-5521

www.cftc.gov

Cadwalader, Wickersham & Taft LLP

700 Sixth Street, NW

Washington, DC 20001

Re: Your request for guidance regarding the meaning of "unfilled anticipated requirements"

for purposes of bona fide hedging under the Commission's position limit rules

Dear Mr. Pantano:

This is in response to your email dated August 6, and hard-copy request dated August 14, 2012,

to staff of the Division of Market Oversight of the Commodity Futures Trading Commission

("Commission" or "CFTC"). In your request, you asked staff to provide, pursuant to

Commission Regulations 140.99 and 151.5(a)(5), an interpretation addressing whether, under

Part 151 ofthe Commission's regulations, 1 an electric company may treat as bona fide hedging

transactions certain derivative transactions that reduce the price risk associated with its unfilled

anticipated requirements for natural gas, even though it has entered into some long-te1m, firm

purchases of natural gas at an unfixed price. The electric company entered such unfixed price

contracts in order to ensure it will have an adequate supply of a significant portion of its

anticipated natural gas requirements. You believe the reference in Commission Regulation

151.5(a)(2)(ii)(C) to "unfilled anticipated requirements" should be interpreted so that contracts to

purchase a commodity, in this case natural gas, at an unfixed price (e.g., at an index price that

will be determined at a later date) do not "fill" the anticipated requirement, as discussed below

ion of its

anticipated natural gas requirements. You believe the reference in Commission Regulation

151.5(a)(2)(ii)(C) to "unfilled anticipated requirements" should be interpreted so that contracts to

purchase a commodity, in this case natural gas, at an unfixed price (e.g., at an index price that

will be determined at a later date) do not "fill" the anticipated requirement, as discussed below.

We agree; unfilled anticipated requirements may be recognized as the basis of a bona fide

hedging position or transaction under Commission Regulation 151.5(a)(2)(ii)(C) when a

commercial enterprise has entered into long-te1m, unfixed-price supply or requirements

contracts.2 This is because the price risk of such "unfilled" anticipated requirements is not

2

The Commission instructed market participants to seek "interpretive guidance (under§ 140.99(a)(3))

regarding ... whether a transaction or class ofh·ansactions qualify as enumerated hedges under§ 151.5(a)(2)."

76Fed.Reg. 71626, 71649(Nov.l8,2011).

CFTC Regulation 151.5(a)(2)(ii)(C) addresses "unfilled anticipated requirements of the same cash commodity."

Similarly, CFTC Regulation 151.5(a)(2)(i)(B) addresses "unsold anticipated production of the same

commodity."

Paul J. Pantqno, Jr.

August 16,2012

CFTC Letter No. 12-07; Page 2

offset by an unfixed price forward contract. 3 The price risk remains with the commercial

enterprise (the electric company in this instance), even though the commercial enterprise has

contractually assured a supply of the commodity, with continuing price risk until the forward

contract's price is fixed.4 Once the price is fixed on the supply contract, the commercial

enterprise no longer has price risk and the derivative position, to the extent the position is above

an applicable speculative position limit, must be liquidated in an orderly mam1er in accordance

nterprise has

contractually assured a supply of the commodity, with continuing price risk until the forward

contract's price is fixed.4 Once the price is fixed on the supply contract, the commercial

enterprise no longer has price risk and the derivative position, to the extent the position is above

an applicable speculative position limit, must be liquidated in an orderly mam1er in accordance

with sound commercial practices.

Background

The concept of offsetting price risk of unfilled anticipated requirements or unsold anticipated

production in connection with the application of position limits is not new. Prior to the CFTC's

adoption of a definition for bona fide hedging, Congress defined bona fide hedging in the

statute. 5 The statutory definition recognized bona fide hedging transactions or positions in

futures "to the extent such sales or shmi positions are offset in quantity by the ownership or

purchase of the same cash commodity by the same person or, conversely, purchase of, or long

positions in, any commodity for future delivery . .. to the extent that such purchases or long

positions are offset by sales of the same cash commodity."6 That definition also recognized as a

bona fide hedge the offset of "the amount of such commodity such person is raising, or in good

faith intends or expects to raise, within the next twelve months ... " 7 and "an amount of such

commodity the purchase of which for future delivery shall not exceed such person's unfilled

anticipated requirements for processing or manufacturing during a specified operating period not

in excess of one year. "8

Each version of the CFTC's bona fide hedging definition has recognized "unfilled anticipated

requirements" as a basis for a bona fide hedging transaction or position

amount of such

commodity the purchase of which for future delivery shall not exceed such person's unfilled

anticipated requirements for processing or manufacturing during a specified operating period not

in excess of one year. "8

Each version of the CFTC's bona fide hedging definition has recognized "unfilled anticipated

requirements" as a basis for a bona fide hedging transaction or position. In 1975, the Secretary

of Agriculture recognized hedges of unfilled annual requirements in CFTC Regulatimi 1.3(z);

that rule also required a "bona fide purpose" that was "to offset price risks incidental to

commercial cash or spot operations" (the so-called "incidental test").9 The CFTC initially

3

4

5

6

All unfixed price forward contract is a contract for supply of a conunodity at an open price or at a price to be

determined at a later date (for example, by reference to an index based on daily settlement prices of a futures

conh·act).

Similarly, the price risk remains with a producer who has sold a commodity at an unfixed price.

See, for example, 7 U.S. C. 6a(3) (1970).

!d.

7 U.S.C. 6a(3)(A) (1970).

7 U.S.C. 6a(3)(B) (1970).

The newly-established CFTC was required under amended Section 4a(3) of the Commodity Exchange Act to

issue by July 20, 1975, a regulation defining bona fide hedging. Prior to that date, the Secretary of Agricultme

proposed and issued a regulatmy defmition of bona fide hedging that deviated "in only minor ways from the

hedging definition" in Section 4a(3) of the Commodity Exchange Act. See proposed at 39 Fed. Reg. 39731

(November 11, 1974), fmal at 40 Fed. Reg. 11560 (March 12, 1975), and conforming amendments at 40 Fed.

Reg. 15086 (April4, 1975). See also, the discussion of the "incidental test" in the bona fide hedging

interpretation, 52 Fed. Reg. 27195 at 27196 (July 20, 1987).

Paul J. Pantano, Jr.

August 16, 2012

CFTC Letter No. 12-07; Page 3

adopted that rule with minor changes as an interim definition of bona fide hedging

fmal at 40 Fed. Reg. 11560 (March 12, 1975), and conforming amendments at 40 Fed.

Reg. 15086 (April4, 1975). See also, the discussion of the "incidental test" in the bona fide hedging

interpretation, 52 Fed. Reg. 27195 at 27196 (July 20, 1987).

Paul J. Pantano, Jr.

August 16, 2012

CFTC Letter No. 12-07; Page 3

adopted that rule with minor changes as an interim definition of bona fide hedging. 10

Subsequently, the CFTC adopted final Regulation 1.3(z) that retained the requirement that such

transactions must "offset price risks incidental to commercial cash or spot operations." 11

The current definition of bona fide hedging in CFTC Regulation 151.5 incorporates the concept

of offsetting price risks incidental to commercial cash or spot operations. Section 4a( c )(2)(A) of

the Commodity Exchange Act directs the Commission to define a bona fide hedging transaction

or position for a physical commodity, in pmi, to be "economically appropriate to the reduction of

risk in the conduct and management of a commercial enterprise." The CFTC incorporated that

requirement in the definition of bona fide hedging in CFTC Regulation 151.5(a)(l)(ii).

The current definition of bona fide hedging in CFTC Regulation 151.5(a)(2)(ii)(C) also

incorporates the concept of unfilled anticipated requirements. That rule is based on Section

4a( c )(2)(A)(iii)(I) of the Commodity Exchange Act, which enumerates an acceptable hedging

transaction as a position that offsets the risks arising from assets a person anticipates owning or

processmg.

Under the reporting requirements for persons with a bona fide hedging position under old Pmi 19

and new Pmi 151, persons are required to report the quantity of fixed price purchase

commitments of the cash market commodity that is being hedged.12 However, those repmiing

rules are silent as to reporting of unfixed price purchase commitments, and thus such unfixed

purchase price commitments are not required to be repmied

rements for persons with a bona fide hedging position under old Pmi 19

and new Pmi 151, persons are required to report the quantity of fixed price purchase

commitments of the cash market commodity that is being hedged.12 However, those repmiing

rules are silent as to reporting of unfixed price purchase commitments, and thus such unfixed

purchase price commitments are not required to be repmied. This is because such unfixed

purchase price commitments do not give rise to outright price risk and do not otherwise fix an

outright price; thus, unfixed price purchase commitments do not alter the outright price risks

faced by a commercial enterprise. Accordingly, unfixed price purchase commitments do not

"fill" an anticipated requirement.

Sincerely,

Richard A. Shilts

cc: David Van Wagner

Matthew Hunter

Stephen Shenod

Riva Spear Adriance

10 See concept release at 40 Fed. Reg. 34627 (August 18, 1975). See interim final at 40 Fed. Reg. 48688 (October

17, 1975).

11 See hearing notice at 40 Fed. Reg. 58684 (December 18, 1975), proposed at 42 Fed. Reg. 14832 (March 16,

1977) and fmal at 42 Fed. Reg. 42748 (August 24, 1977).

12 CFTC Regulations 19.01 and 151.5(c)(l)(iii) and (g).