CFTC Staff Letter 98-31: No-Action Letter for Electronic Physical Natural Gas Trading System

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  U.S. COMMODITY FUTURES TRADING COMMISSION
  ThiN Llfayetto Centre
  1155 21st ~out, HW, Wuhlngton, w Mii
  Tolephone: (202) 418·5000
  Fac::.lmlli: (202) 418·5521
  ~. Brian Soutiere
  President
  Energy Exchange Inc. · 1950,801 - 6th Avenue s.w.
  CAlgary, Alberta 'r2P 3W2
  September ~1, ~996
  Re: Electronic Natural Gas Trading System
  Dear Mr. Soutiere:
  9f-3/
  This is in response~ to your letter datt'~t December 20, 1994, and subsequent correspondence, in which you request confirmation from the Off-Exchange Task Force (•OETF") that the OETF will not recommend that the Commodity Futures Trading Commission ("Commission") initiate enforcement proceedings against Energy Exchange Inc. ("EEl"), Enerchange L.L.C. (•Enerchange•), or QuickTrade L.L.C. (•QuickTrade•) if such firms commence ·operation of an electronic system for trading physical natural gas in the United States. Based upon the representations made in your December 20, 1994 letter, as supplemented by additional correspondence, telephone conversations, and your presentation to the· ·oETF, the OETF understands the facts to be as set forth below. EEI is a wholly-owned subsidiary of Direct Energy Marketing Limited ("DEML"), a natural gas marketing company. Both EEI and PEML are incorporated under the Business Corporation Act of Alberta, Canada and are based in Calgary, Alberta. Since January of 1994 EEl has operated in Canada an automated natural gas trading system with delivery at hubs in the Alberta market. EEI represents that the Alberta-based system is a physical delivery trading system which mirrors local natural gas cash market practices. EEl further represents that traders on the Alberta system are commercial participants of the natural gas market. On August 8, 1995, BEI signed a letter of intent with Enerchange to develop and operate an electronic natural gas trading system (•System•) which will offer delivery at eeveral United States-based natural gas hub locations as well as provide System l~bscribers with access to the existing Alberta-based system. l The System commenced operation in the United · / l.l Enerchange is comprised of affiliates cf NGC Corporation (a gatherer, processor, transporter and marketer of energy products (continued ••• )

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  . Mr. 'Brian Soutiere
  States pn January 8, 1996, and is operated by QuickTrade which is ';' oWned SO percent by EEI and so percent by Bnerchange. QuickTrade ' i' ·based in Houston, 'l'exas. . ·

• .'.' ~>, .; 'l'he System initially provides for delivery at the Chicago · · HUb •. QuickTrade plans to expand delivery locations to include
  the Ellisburg-Leidy Northeast Bub in Pennsylvania and the California Energy Hub in southern California as well as several gulf coast pipelines in the near future. Bnerchange administers the ope~ations of' each of t.hese hubs.· System subscribers are classified into one of two separate categories: View·Only Subscribers and Active·Status Subscribers. View-Only Subscribers are per.mitt-.d to access the System for the limited pu~ose of obtaining curr.ent price information only. View-Only Subscribers are not able to execute trades.on the System. Active-Status Subscribers may enter bids and offers to buy or sell natural gas, or alternatively, accept existing bids or offe~s. Subscribers may access the System via their personal computer and modem on a twenty-four bour·per·day, seven day-per- week basis. All trading is perfor.med on an anonymous basis. :
  , Qu'ickTrade represents that the System is a physical delivery trading system. Participation on the System as an Active-Status Subscriber is restricted by QuickTrade to participants of the natural gas market who have valid service or transportation agreements in place with pipeline operators who will tr,nsport natural gas to or from the designated delivery points.~ QuickTrade represents that natural gas. producers, gas end users, and gas marketers are authorized to trade on the System. QuickTrade also represents that individual speculators, commodity pools, passive collective investment vehicles, and other non￾commercial entities are not now, nor are anticipated to be, Active-Status subscribers. ll ( .... continued) and services in North America and the United Kingdom), NICOR Inc. (~ holding company whose principal business is Northern Illinois Gas), Pacific Ente~rises (a Los Angeles, California-based utility holding company primarily engaged in supplying natural gas throughout most of southern and portions of central California), a~d National Fuel Gas Company (an integrated gas company with a number of subsidiaries that are engaged in utility, pipeline and storage, exploration and production, hub services and natural gas marketing operations). ~I A service or transportation agreement is a contract between the pipeline operator and natural gas shipper which governs the terms of the tr~nsportation service provided by the pipeline operator.

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  Mr. Brian Soutiere
  ~ansactions executed on the System pre~ominately result in the physical movement of natural gas from sellers· to buyers. QuickTrade prepares pipeline nominations for each individual subscriber on a net intra-day basis. lf a Dubscriber has contractual obligations to both deliver and receive natural gas at the Dame delivery point on the Dame day, QuickTrade will net the delivery an~ receipt obligations. QuickTrade represent• that the netting of an individual Dubscriber'D overlapping delivery and receipt obligations to simplify the delivery process and reduce transaction costs is Dtandard practice in the natural gas cash market as well other cash markets which use pipelines to effect delivery.AI Data provided by EEI indicates that during the period July 1, 1995 through September 30, 1995 more than 83 percent of the total volume of natural gas contracted on the Alberta trading system was physically delivered. Furthermore, of the 4,918 transactions executed·on the Alberta system during the period January l, 1994 through August l,Al995, only 225 transactions (4.57 percent) were fully netted.~/ QuickTrade represents that. it does not expect the level of netting on the u.s. trading system to deviate substantially from the levels observed on the Alberta trading system. Relevant Commission staff is of the opinion that the netting proce~ures used by QuickTrade mirror the current cash market practices of natural gas a1ld other petroleum product pipeline delivery systems. Moreover, the percentage of netting that has occurred on the Alberta system, and which is expected to occur on. the QuickTrade system, is not inconsistent with that which has been observed on other physical pipeline delivery systems. 'J./ The high inci~ence of physical delivery differentiates the operati.on of QuickTrade' s electronic market from the operation of a futures market. .In futures markets, commercial participants use futures contracts primarily as a hedging mechanism to provide price protection and not as a source of supply of the underlying commo~ity. By contrast, contracts executed on the System require, and the commercial participants anticipate, the movement of the unt5~rlying commo~ity through normal cash market channels and any netting is incidental to the pipeline delivery mechanism • .t/ Full netting takes place only when a subscriber has contractual obligations to both receive and deliver natural gas and such contracts have identical terms as to quantity, delivery start and end times, and delivery point. In such situations, the contractual obligations remain open until the delivery date when the subscriber's delivery and receipt commitments cancel each other out to avoid duplicative deliveries and no gas flows into or out of the subs~riber's .natural gas account.

~. Brian Soutiere
As describe~ in more detail below, transactions execute~ on the System are:
(1) p:r:incipal-to·p.rincipal transac::tions,l/ (2) betveeri qualified commercial parties, . . (3) establishing binding physical ~elivery Obligations, (4) for delivery within customary cash market time frames, (5) not collateralized or subject to variation margin payments,IJ..I and . (6) are primary obligations of QuickTrade.ll Purchases or sales of natural gas on the System are principal-to-principal transactions between commercial parties who meet Active-Status criteria and establish firm-delivery commdtments that convey the legal· right and obligation to transfer natural gas in accor~ance with the contract's specifications. . Subscribers may enter individualized terms as to price, volume, and delivery start and end dates for each contract. The standard Subscription Agreement executed by each System user provides that title transfers from the seller to Quick'I'rade at i/ The terms of transactions are individually negotiated between subscribers. Due to the policies of pipeline operators as discussed in footnote B, infra, the Quick'I'rade system is structured so that once a transaction has been negotiated, two simultaneous transactions occur, one between the purchaser and QuickTrade and the other one between Quick'I'rade and the seller. 'rhus, Quick'I'rade is market neutral. i/ As discussed below, a subscriber who does not satisfy Quick'I'rade's credit criteria may be granted access to the System by posting security with Quick'I'rade. Such subscriber's open positions, however, are not subject to initial or variation margin payment8. 2l QuickTrade has primary responsibility for all obligations because of its separate obligations to the buyer ~nd seller under each transaction. However, because of the contracting process required by the System, these obligations are completely offset by the obligations of the other buyer or seller, as the case may be.

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  the delivery h~.· OUickTrade will then immediately transfer title to the J:>uy~;r.J./ · . · • 'l'he. fi~eiat'br~d,~~"ort.hiness of each Active-Status Subscriber ia examined by QUickTrade prior to gaining access to the System. Active-Status Subscribers with an insufficient credit history or financial. condition are granted access to the System only by po~ting a~curity with QuickTrade. QuickTrade continuously monitors the financial condition of the Active￾Status Subscribers by periodit:ally requiring auch aubscriberB to aubmdt financial information and may, in itB aole discretion, demand additional eecurity and/or curtail, trading activity •. Once a trade has been executed, QuickTrade is liable for the physical component of the transaction. If an Active-Statuti Subscriber defaults on its de~ivery/receipt obligation, Quick'I'rade will .. remedy· the defaul; by either Bupplying or receiving the natural gas ori behalf of the defaulting party. Quick'I'rade will rely on physical backstopping of supply and/or market from its affiliated companies to ensure that a default does not disrupt the operation of the System. Quick'I'rade also is liable for the ~inancial component of each transaction. lf an Active-Status Subscriber defaults, QuickTrade will satisfy the defaulting party's financial obli'gations. Quick'I'radehas obt~t.ined insurance coverage from Trade Indemnity Group PLC ·{fi'I'rade Indemnity") to protect the financial integrity of the System. Under the terms of the agreement, Trade Indemnity is responsible for insuring 90 percent of each transaction 'executed on the System, up to each subscribe~'& predefined credit limit. Quick'I'rade remains liable for the temaining 10 percent. Trades executed on the System are individually negotiated transactions between Active-Status Subscribers. 'l'he System does not provide for mutualization of loss~ System subscribers do not guarantee and are not responsib~e for the defaults of other subscribers. A subscriber who faila to perform ita contractual obligations ia liable to Quick'I'rade for all costs incurred in i/ Quick'I'rade Btates that pipeline operators have a policy that prohibits a buyer or seller from both contracting individually with the pipeline and contracting through an agent. This policy would hinder the operation of the System since subscribers contract directly with the pipelines for· the vast majority of their transactions. Quick'I'rade has addressed this problem by providing that title passes from seller to Quick'I'rade with an immediate re· transfer to the buyer.

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  guaranteeing such subsc:d.ber's physical anti financial obligations .. A subscriber who fails to perform its contractual /. obligations is also assessed an administrative fee equal to the greater of $5,0,00 or five percent of the· total cost of remedying tbe breach_"nd· may have its access to tbe System revoked or . uuspended.V QuickTrade perfonns administrative and bookkeeping functions on behalf of the ·subscribers. QuickTrade prepares confirmations for each_ transaction executed on the System. QuickTrade also prepares monthly invoices detailing each 111ubscriber'u transactions executed on the System. Active-Status Subscribers with a ne·t payment due for natural gas shipments received are required to remit payment to QuickTrade by the 25th day of each month. Conversely·; Active-Status Subscribers with a net receivable from natural gas shipments receive payment on the 25th day of each· .month directly from QuickTrade. Subscriber funds are segregated from QuickTrade's operating accounts. QuickTrade represents that these invoicing and payment ter.ms are consistent with gas industry standards between buyers and sellers in the cash market. As noted above, QuickTrade commenced operation of the System on January e, 1996. QuickTrade represents that its expansion into the United States market is largely a result of the Federal Energy Regulatory Commi·~si,o.n' s Order No. 636 which ext·ensively revised the federal sales, transportation, and st~rage regulations governing the natural gas industry and is intended to facilitate mor~ .transparent cash natural gas pricing mechanisms.

• The Commission understands that on December 30, 1993, the
  Alberta Securities Commission issued a temporary Order exempting EEl, its electronic natural gas trading system, and the subscribers, from registration.and re~orting requirements of the Alberta Securities Act. This Order was subsequently renewed for a two-year period expiring on June 8, 1997, when it will be subject to review by the Alberta Securities Commission upon an application for renewal. The Commission further understands that as a condition of the registration and reporting requirement · exemption, BEI has agreed to provide the Alberta Securities Commission with the following info:nnation:
  ~I QuickTrade will assess the factors surrounding a breach before determining if the suspension of trading pri~ileges is warranted.

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• Mr. Brian Soutiere
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• Unaudited intertm financial statements en a quarterly basis;

• Audited financial statements on an annual ~sis;

• Notice of any revisions of tbe Subscription Agreement and
  gas contract;

• A quarterly summary of trading activity, including:

• any change's in the number and identity of subscribers,

• confirmation that each subscriber is in compliance vitb
  the credit policy at the end of tbe last preceding calendar quarter,

• the identity of any subscriber who has been suspended from
  trading on the lEI system, and the reasons therefor,

• the number of defaults and the actions taken to remedy the
  defaults, and · • a summary of any investigations performed with respect to the system and/or subscribers. QuickTrade has represented that it will maintain records comparable to those set forth above and provide such information to the Commission upon request. Further.more, to facilitate Commission monitoring QuickTrade agrees to submit reports on an annual basis, commencing with calendar year 1996, to the Commission setting forth the following information:

• A summary of the total number of 'contracts executed on the
  System by each subscriber and the total number of transactions fully netted by each subscriber; and

• A summary of the total volume of natural gas contracted en
  the System by each subscriber and the total volume of natural gas delivered/received by each subscriber. QuickTrade also represents that it will keep and maintain transaction and financial records and make them available to tbe Comrndssion and submit data to the Commdssion promptly upon request and that it will provide information on its operations and the cash market as necessary to the Comrndssion for its monitoring of markets subject t.o its jurisdiction. In addition, the Commission may request information or reports concerning operation of the System as authorized under various provisions of

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. , ( Mr. Brian Soutiere the CommocUty_Exclumge Act ("Act•)l.O./ and Commission regulations.Uf Based upon the foregoing, the OETP will not recommend that the Commdssion take enforcement actions against BEI, Bnerebange, or QuickTrade for failing.to obtain designation as a contract market, registering under the Act, or otherwise complying with the Act or Commission regulations in connection with those firms' operation of QuickTrade, an .electronic system for trading physical natural gas in the United States. 'l"his letter is based upon the information that has been provided to u•, including the data on the netting activity on the Alberta trading system and QuickTrade's representations · concerning anticipated netting on the u.s. system •. In this regard, QuickTrade represents that it will notify the Commission immediately if it deter.mines that less than 75 percent of the total volume of natural gas contracted through the System, measured on an annual basis, is delivered, and understands that the Commission may consider added terms and conditions in such an event. Furthermore, QuickTrade represents that it will notify the Commission of any applications for trading privileges ~ received from non-commercial entities prior to granting such applicants access to the System. Any different, changed or omitted facts or conditions, including increases in the netting activity, mdght require us to reach a different conclusion. The position set forth above is that of the Off·Exchange Task Force only and does not necessarily represent the views of the Commission. Furthermore, the relief granted by this letter is prospective only and should not be construed to limit in any way the Commission's ability to take enforcement action against EEl, Enerchange, or QuickTrade for any past violations of the Act or regulations if the Commission deems such action appropriate. lQ/ 7 u.s.c. i 1 ~t eeg. (1994). ~ ~ s nee ely,, . i J' (Vf-,/7, Pat G. Nicolette Co-Chairmen Off-Exchange Task Force 11/ Commission regulations are found at 17 C.P.R. Ch. I. (1995), as amended by Fed. Reg. 38,146 (July 25, 1995).