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Articles Archive
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July 2003
Merchant Energy: The Future
While the merchant energy business continues to face issues such as re-regulation, credit collapse and liquidity squeezes, the market will rebound. There has been increased interest by financial firms and existing pipe and wire companies. Although the competitive landscape in the reborn merchant energy business is changing fast, the key to success remains the same: companies must invest in a robust corporate infrastructure that is supported by an efficient and cost-effective technology platform for the full lifecycle of transaction management — from trade capture, risk management, scheduling, and settlements, to accounting.
Reinventing The Market
The independent energy marketer function arose from deregulation of U.S. natural gas markets 20 years ago. The Federal Energy Regulatory Commission, responding to an archaic system of federal price controls that was confining the market, began a deregulation process that allowed producers and pipelines to escape from long-term, regulated contracts.
That spawned short-term contracts, spot markets, phone-based bid weeks and pipeline nomination cycles. Financial markets soon followed, as forward-based pricing began to emerge and the New York Mercantile Exchange introduced a futures contract that fundamentally changed the pricing mechanism for gas. Market participants now could use formal exchanges or over-the-counter (OTC) markets to secure or hedge contracts and mitigate price risk exposure.
The number of pure financial-based traders exploded, as did the physical commodity market. When deregulation of the U.S. electric power market began, megamarketers emerged with large multi-commodity business plans. The result was a number of very liquid and very profitable OTC trading operations that managed few physical assets. The markets began to unravel when a number of these asset-light financial trading companies ventured too far out onto the risk/return curve at a time when credit was to come into short supply due to equity downgrades. In many ways this correction over the long term will be a positive development for the markets, removing most of the hype, excess and abuse.
Although it may take a year or more for the merchant business to stabilize, it is not terminal. The key question is who will fill the void left by the departed marketers. Obviously, those surviving businesses 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 beginning to expand their presence.
Energy companies with solid physical assets, whether based on transportation/storage or production/generation, are expanding physical portfolios that historically have been restricted. Their asset structure and long-term customer relationships provide them with a niche of expertise, and their longevity and reliability are important to prospective trading partners. While they will always be focused on asset management, many are expanding portfolios or adding trading books to fill the gap in price risk management alternatives.
Financial institutions also are showing renewed interest in energy trading. They are experienced at managing financial risk and exposures across industries, and like asset-based energy companies, they have a strong interest in both financial and physical books. Banking institutions previously eschewed investments in and around physical assets, but now some are recognizing that direct or indirect ownership of these assets can help leverage financial books and increase market share.
As the shakeout continues, the surviving energy merchants are beginning to restore public confidence. A year ago they formed the Committee of Chief Risk Officers, which has grown to 31 companies representing about half of U.S. natural gas and power volume. The committee already has affected how credit rating agencies, regulators and securities analysts view merchant marketers. In the future, the energy player — whether a bank, an asset-based company, or one of the megamarketer survivors — will have a more balanced approach to energy transactions.
Getting Ready
Despite its past and current problems, the merchant energy business will not only survive but also thrive because we have to manage energy assets and the corresponding fluctuating demands, supplies and market prices.
Attractive margins will be available to organizations that can effectively manage and transfer the financial risks of production, transportation, and consumption. Learning from past mistakes, companies must review their existing corporate infrastructure and long-term strategy for every aspects of transaction management.
Matthew Frye is Managing Director of OpenLink's Houston, Texas, division. With over 20 years of 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.
Copyright © 2003 Hart Energy Publishing. All rights reserved.
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