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Articles Archive
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March 2004
Filling the Energy Trading Gap
Mid-sized trading firms need better software systems as they begin to fill the energy market gap left by mega-traders.
By MATTHEW FRYE
Radical changes in the North American natural gas marketplace are forcing companies trading - mostly market-niche and regional - in energy to seek more sophisticated back-office systems for managing risk.
These once small companies have been filling the void in the energy trading business created by the implosion of mega-traders like Enron, Dynegy, El Paso and Duke.
The failed mega-traders had built their empires on the volumes of their sophisticated price risk management transactions, not the strength of their physical assets. They sought to expand coast to coast and internationally, operating across the energy spectrum to trade in commodities that included electric power, natural gas, crude oil, refined products, hydroelectric power and emissions.
The recent rise of mid-sized trading companies reflects the changed energy marketplace. These companies hold solid physical assets and generally trade in only one or two commodities. They are primarily regional businesses and unlike the mega-traders, they have no aspirations to become Wall Street darlings. But they do want Wall Street to value their stocks more fairly than often is the case today.
Many of these firms are utilities whose long-standing relationships with their customers give them a solid niche in the market, while their expertise, longevity, and reliability make them attractive trading partners today.
Previously some of these mid-sized companies had used the mega-traders to handle various aspects of their business, including risk management, logistics, and asset management for their energy transactions. Now they have resumed control of their trading books, which frequently involve fairly complex deals, sophisticated valuation techniques, and complicated risk profiling.
The changed market environment presents a major challenge for the mid-sized traders. Because of the debacle of the mega-traders, Wall Street has heavily discounted the financial well-being of all of the companies involved in the energy commodity markets. This in turn has caused a serious liquidity crunch for many firms due to the credit squeeze brought on by debt downgrades or, in other words, the capacity to transact, regardless of whether or not they hold substantial physical assets. As a result, companies now have fewer trading partners to choose from and liquidity in both physical and financial markets has plunged. Wall Street financial institutions have also moved to fill the void that was created in the ever changing energy trading marketplace.
All the new players in the energy marketplace obviously see opportunities to glean substantial profits from significant commodity price swings. They recognize that regardless of the failures of the mega-traders, the energy marketplace will continue to need methods to facilitate trading and manage price risks.
Volatility Creates Challenges, Opportunities
Fifteen years ago the North American gas pipeline system was relatively static but less efficient than it could have been.
As the mega-traders grew, they began to optimize the pipeline infrastructure by utilizing spare capacity wherever they could find it. Because the mega-traders had a reach that stretched from the East to the West coasts, they helped tune pipeline transportation to a higher degree of efficiency.
At the same time, introduction of the NYMEX, improved price transparency, deregulated markets, and general competition also worked to reduce margins. This combination of factors eventually resulted in a market that was so efficient that companies often did business in half-cents, quarter-cents, and even tenths of cents.
But the demise of the mega-traders turned the gas industry on its head. Many of the market efficiencies were suddenly lost when the entire middle market was essentially shut down. Gas producers, traders, end-users and utilities had to re-connect and replace products and or services that had more recently been supplied by the larger traders.
The market's recent volatility, as reflected by wide swings in the price of natural gas, is not entirely due to a shortage of supplies or a shortage of capacity needed to deliver the commodity to consumers. It is also the result of a market that is much less efficient and working much harder to link buyers and sellers.
Many observers also think that a buying frenzy occurred as some of the entrants came back into the marketplace, or in some instances, gas was over-bought, resulting in significant price swings as large blocks came in and off the trading floor.
The recent natural gas price volatility is unprecedented in modern times. Where two or three years ago the market might have had daily shifts of 4 or 5 cents or even 10 ten cents per Mcf, it recently has ranged as high as $1 on a $6 or $7 commodity.
Companies venturing into the energy trading void may not be equipped to fully cope with this market because many of them are using software tools that are less sophisticated than those used by the larger players. And they face conditions that obviously are much riskier, since margins of only a few pennies on $6 or $7 commodity leave absolutely no cushion for error.
In the past, companies had no difficulty obtaining market hedges to protect themselves and preserve profit margins. Now over the counter (OTC) hedges are more difficult to secure because there is much less liquidity in the market, while the bid-offer spreads on NYMEX also reflect the increased volatility. The mega-traders are gone and along with them went both the instruments and liquidity they had created for OTC market hedges.
But the key problem for the mid-sized market participants is outdated computer systems for tracking trades and managing risk. They need systems that give them optimal transaction efficiency and real time position reporting, as well as the ability to integrate their physical and financial balances in respect to long and short positions and financial exposure.
The bottom line is that if a company can accurately quantify and evaluate the risks it faces, that company will automatically have a clear picture of its most profitable and low risk business areas.
Better Software Approach
Therefore, many of the mid-sized players are seeking up-to-date, comprehensive software systems to maintain their competitiveness.
A recent PriceWaterhouseCoopers report on the future of energy trading warns that the new market participants can adapt only by installing software solutions that enable them to better control their trades and risks. The report outlined four basic challenges for the energy traders: evaluating and managing price risk and volume risk; ensuring adequate capital; and putting effective credit risk procedures in place.
Most of the mid-sized energy traders are using a mishmash of different software applications supplied by outside vendors or in a few cases, developed by their own in-house programmers. This area presents somewhat of a mixed bag as some of the companies have their own internal IT staffs. Some mix and match applications, but by far, the majority use and abuse spreadsheets. These applications are not always compatible, or well coordinated, and as a result, they are seldom very efficient.
In many cases these companies simply have neglected to make the essential investments to rebuild or update their systems. In some instances they are assuming additional business functions beyond the scope of their existing systems. And a few have been able to use the systems of the mega-traders because of the business they had subcontracted to them.
The mid-sized energy traders have two options for updating their disparate, legacy applications. One option is to wipe the slate clean by installing a straight-through-processing (STP) solution. In practical terms, such a system of record serves as the central nervous system for the business.
If that is not possible, the second solution is for companies to replace older systems or supplement them with needed functionality, one step at a time, taking particular care of certain mission critical areas immediately and others later. But they should be careful not to continue down the same path of disparate solutions - and ensure that all components have or tap a common database. If they attempt to replace sections of antiquated software with current technology that lacks a common thread they may find themselves in a struggle that proves to be impossible.
Obviously the best solution is to combine logistics and risk management in a single platform, using an STP framework to fully integrate front-, mid-, and back-office functions.
STP enables the complete sharing of transaction data across the company. It allows any authorized employee to review a record that has been entered in the application. And it permits real-time updates of trading transactions, a major advantage in a marketplace where commodity prices are constantly fluctuating.
Of course, a single STP system would be less vulnerable to failures and more economical to operate than an array of disparate applications.
And STP will help companies comply with record-keeping transactions under the Sarbanes-Oxley Act of 2002. The law, passed in response to several scandals involving corporate executives of major companies, requires companies to have procedures that ensure an infallible audit trail of transactions.
Implementing the law, the Securities and Exchange Commission has issued a rule mandating that companies retain detailed records regarding their transactions for up to seven years. That will necessitate a software system that permits the efficient retrieval of data under procedures that ensure the integrity of the information to the point that it would be admissible as evidence.
Companies Find Solutions
The situations of two North American companies, principally natural gas pipelines, demonstrate how some firms have found that converting to STP solutions can improve their ability to compete in the marketplace.
A pipeline with an extensive storage and marketing operation asked OpenLink for software solutions to help manage both ends of its business. For its financial transactions involving natural gas, it required a comprehensive scheduling product that would cover elements such as deal capture, nominations, confirmations, settlements, and volume management as well as all related risk management requirements.
And it needed a robust scheduling application to cover the entire life-cycle of physical natural gas transactions so that the company could expand its marketing, storage, and transportation capabilities.
The second company has gas transportation plus other businesses including gas distribution, natural gas liquids, crude oil, and power transactions. It also needed to be able to handle significant foreign exchange and corporate debt activities. That company turned to OpenLink to provide software with a complete cross-market, STP deal-capture environment that leverages a common pricing and analytics engine and transaction-processing environment. The seamless solution generates business intelligence that normally would require a substantial integration effort of multiple systems.
Despite the different needs of these two companies, the STP solution will prove to be a streamlined, sophisticated tool to help them compete effectively in energy markets.
They are proof that an STP solution is winning the battle against many legacy scheduling systems, because for asset-based firms, STP covers all the essential needs: deal capture, risk management, scheduling, operations, and accounting.
Matthew Frye is Managing Director of OpenLink's Houston, Texas, division. He has 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.
As seen in WorldPower 2004 a Commodities Now magazine - March 2004
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