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Articles Archive
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June 2003
Banks See Potential in Tarnished Energy Trading Sector
Despite the well-publicized implosions of some large trading firms, the merchant energy business will continue to be a pivotal component of the deregulated market.
By MATTHEW FRYE
While energy business continues to face significant, challenging issues such as re-regulation, credit collapses, and liquidity squeezes, its nascent recovery is presaged by the increased involvement of financial firms and existing 'pipe and wire' companies. The fresh focus of these newer energy merchants is dictating different infrastructure and software solutions, particularly those that combine logistics and comprehensive risk management in a single platform.
Re-inventing the Market
The deregulation of US natural gas markets 20 years ago was the genesis of the independent energy marketer function. Responding to an antiquated system of federal price controls that offered inadequate incentives for the development of gas supplies, the Federal Energy Regulatory Commission (FERC) embarked on a de-control process that allowed gas producers and interstate pipelines to escape from long-term, regulated supply and price contracts. These early initiatives created unregulated wholesale markets where producers, end-users, or middlemen could absorb and manage the logistics and risks of energy trading.
The subsequent emergence of the competitive natural gas markets led the FERC into a decade of regulatory reforms for natural gas pipelines and their affiliated marketing companies. As the rules for market participants changed, so did the mechanisms and business processes for determining market-based prices, and the tools that marketing companies used to limit the risks of price exposure. The breakup of pipelines' life-of-the-reserves contracts led to active short-term contracts, which then bred spot markets, phone-based bid weeks, and pipeline nomination cycles.
Pricing changes kept pace, as forward-based pricing began to emerge and the New York Mercantile Exchange (NYMEX) introduced a futures contract that fundamentally changed the pricing mechanism for natural gas. In short, market participants now had the option of using formal exchanges or over-the-counter (OTC) markets to secure or hedge contracts and mitigate price risk exposure.
Financial-Based Traders Emerge
As these physical markets developed, so did a new class of trader. Based on the example of the well established markets for other commodities (such as crude oil), there was an explosion of pure financial-based traders, desks, and companies. Over time, these financial market makers expanded the 'physical' commodity market by many multiples and significantly broadened the energy marketplace in the US and Europe. The advent of the financial traders brought new business processes, additional reporting and analysis requirements (or in some instances a lack thereof), and a revised view of the financial and administrative burden of managing and maintaining physical books and corresponding assets. When the US electric power market began the deregulation process, 'mega marketers' emerged with large multi-commodity, multi-continent business plans. These strategies, in combination with an expanded interest in financial markets, opened the door for very liquid and — for many companies — very profitable OTC trading desks. With them came more sophisticated business requirements and many jobs for risk analysts, risk officers, and financial engineers.
The true financial desk required an investment in intellectual capital; it had the major advantage of requiring few physical assets. As a result, many emerging energy trading companies grew through their expertise in the markets and their superior credit ratings, and not through asset accumulation. But a number of these organizations traded into excess, and once the markets began to unravel, it was obvious that the asset-light financial trading companies had ventured too far onto the risk/return curve. Some companies have had to sell assets at discounted prices just to survive, and as a result of the market's meltdown, even solid companies with sound books and business practices have been downgraded.
Filling the Void
The merchant energy business is not totally broken, but confidence in it has evaporated, undermining the credibility and affecting the liquidity of trading companies. Although it may take a year or more for the business to stabilize or rebound, the market obviously will continue to need ways to determine prices and manage risk.
The biggest question is who will fill the void left by the departed energy marketers. Obviously, those surviving energy traders with good or even marginal credit ratings will have an advantage as the sector rebuilds. However, both asset-based energy companies and financial institutions are showing a stronger interest in the trading market.
Energy companies with solid physical assets, whether based on transportation/storage or production/generation, historically had limited their speculative trading books. Now they are showing an interest in expanding them.
Most of these companies have regional or national expertise and focus on one or two commodities. Their asset structure and long-term customer relationships give them a niche of expertise, and their longevity and reliability are important to prospective trading partners. While these companies' trading activities are still secondary to their core business — which is to maximize the value of physical assets and service customers —many maintain sophisticated trading books with complex deals, valuation techniques, and risk profiling.
Financial institutions are also showing renewed interest in energy trading. They are experienced at managing fiscal risk and exposures across numerous industries, and like the asset-based energy companies, they have a strong interest in both physical- and financial-based books.
While the banking institutions historically have avoided investments in and around physical assets — as well as the infrastructure requirements of maintaining and operating these facilities — numerous banks now are embracing direct or indirect ownership of these assets as a way to leverage their financial-based books and increase their market share.
The Future of Energy Trading
As the shakeout continues, the surviving energy traders must publicize the critical role they play in the market and make some visible reforms. They took a major step toward rebuilding US public confidence just one year ago when they launched the Committee of Chief Risk Officers. The goals of the group are to improve communications, define best practices for the industry, and provide a format for the objective evaluation of risk profiles. Membership in the committee has grown to over 30 companies that represent about half of US natural gas and power transactions.
Despite its short life, the committee already has affected how credit rating agencies, regulators, securities analysts, and others view merchant marketers. In the future, the energy trader — whether a bank, an asset-based company, or one of the mega-marketer survivors — will have a more balanced approach to energy transactions and will place a significant portion of the financial focus on hedging and price risk management.
Derivatives will continue to be a useful tool to manage risk, assets and liabilities but purely speculative books will be limited by lean credit. And while mega-marketers will continue to have broad technology and software requirements, and niche players will need sophisticated but streamlined software systems that are delivered 'out-of-the-box' with minimal customization, most of the companies expanding in the merchant energy trade will be asset-oriented. These companies will use business processes and IT solutions that require a high degree of risk management support, market modelling, and logistics coverage within an integrated solution.
Fundamentals Unchanged
Despite its past and current problems, the merchant energy business has sound fundamentals, and energy production will continue to increase in order to continue supplying a growing population and economy.
As with any commodity, imbalances of supply and demand can cause prices to rise and fall — sometimes dramatically. It is this fluctuation of base energy prices that will create a significant price risk that producers, middlemen, or consumers must bear. Attractive financial margins will be available to organizations that effectively can absorb and transfer the financial risks of energy production, transportation, and consumption.
Successful companies must have effective information technology solutions that include sophisticated applications for transaction management, risk management (market, credit, and operational), option valuation, and financial instrument modelling.
These technology attributes should include a comprehensive straight-through-processing framework with fully integrated front-, mid-, and back-office functionality. They should also include an increased focus on asset management, such as asset generation modelling. And finally, energy firms should eliminate the integration nightmares of supporting multiple, deficient legacy applications like in-house, multi-vendor, spreadsheets, and combine comprehensive risk management and logistics in one single platform.
Matthew Frye is managing director of OpenLink's Houston, Texas division. With over 20 years' experience in energy markets, including trading, risk management and operations software. Frye leads a team of business analysts and software engineers focused on dynamic, integrated solutions for energy trading firms.
As seen in Commodities Now magazine - June 2003
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