After the hype, excess, manipulation, scandal, collapse, restructuring and retrenchment, it's back-to-basics for both the surviving and new players within the energy trading marketplace.
By Matthew Frye, OpenLink.
Although the energy industry is still facing a number of significant and challenging issues, such as re-regulation, credit collapses and corresponding liquidity squeezes, the recovery or rebuilding process has in fact begun with many new and a number of tenured "pipe and wire" type companies stepping-up their involvement. While there are many milestones that deregulated markets have met over the past twenty years, and discussion and debate continue regarding the "how and why" asset-light trading companies emerged and rose to power, one thing is certain; emerging from the cinders of 2002 will be a new kind of marketer, and his/her infrastructure, focus and corresponding system requirements will change. For the most part, it's a trip back to the future.
A Look Back in Time
For those who are old enough to remember it, twenty years ago, natural gas markets were just embarking on the deregulation process within the United States, which allowed for the "release" of natural gas commitments to Interstate pipelines and the settlement of long-term, regulated price commitments. These settlements frequently included large "take or pay" provisions to the energy producer to make up for the future value of regulated price provisions. In essence, the Federal Energy Regulatory Commission (FERC) opened the door to the creation of free, wholesale markets where producers and end-users could assume the logistics and risks of energy trading, or where middlemen could step in and assume the risk of price fluctuations and re-package their services to producers and end-users. Thus were competitive markets and market-based pricing created.
With these changes came a decade of deregulation and re-regulation of natural gas pipelines and natural gas pipeline marketing affiliates through FERC orders and mandates. But as the new rules for market participants began to change, so did the mechanisms and business processes for determining market-based prices and tools by which these marketing companies could limit the unwanted risk associated with price exposure. The breakup of the life of the reserve's pipeline 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 new forwards-based pricing began to emerge, and the extremely successful introduction of the New York Mercantile Exchange's natural gas futures contract forever changed the pricing mechanism of natural gas. In short, through either formal exchanges or OTC markets, market participants could now secure or hedge contract quantities and therefore mitigate future price risk exposure for the underlying physical requirements.
As these new business processes emerged, initially for a physical market, so came the introduction of a new class of trader and tools by which he/she made financial markets around the physical product and assets. Decades old examples in the crude oil markets as well as in other pure commodity markets led to the explosion of pure financial-based traders, desks and companies. In fact, over time, these financial market makers expanded the "physical" commodity market by many multiples and expanded the energy marketplace significantly in both the US and Europe. With the introduction of the financial traders came new business processes, reporting and analysis requirements (or in some instances a lack thereof) and a new view of the burden of managing and maintaining physical books and corresponding assets. As deregulation rolled into the US electric power markets as it had done a decade earlier in the Interstate natural gas pipeline market, very large "mega" marketers emerged with 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 a lot of companies, very profitable OTC trading desks. This new trading profile ushered in more sophisticated business requirements, leading to the introduction of career opportunities for risk analysts, risk officers, "quants" and floors of financial engineers. The beauty of a true financial-based desk is that while a significant investment in intellectual capital is necessary, it requires limited physical assets, or in other words start-up capital. In short, numerous emerging energy trading companies maintained limited asset and debt-based balance sheets, and used the lack of debt or leverage to multiply their financial-based books through relatively healthy credit ratings. Of course, that is, until the liquidity squeeze.
2002: The Equivalent of the 100-Year Flood in Energy Trading
Enough has been written over the past six to nine months that explores and exposes the excesses at some energy trading companies over the past few years. Clearly, a number of companies took too many liberties and they are now paying (or in some instances, we are respectively paying) the price for extending themselves too far on the risk/return curve. But the credit meltdown within the energy trading space has also decimated numerous sophisticated and well managed trading organisations that just got caught up in the ensuing downdraft - in many instances, totally without regard to the viability of their business practices and their trading books.
In essence, numerous organisations have just been caught up in the cycle and are experiencing the effects of a financial 100 year flood. But again, the primary purpose here is not to expand upon what went right or wrong, as that has and will continue to be covered, no doubt, in intimate detail in the near future. Not everything is broken today, but the net effect is that investor confidence is significantly shaken, and that has put a chokehold on the credibility and corresponding liquidity of energy trading companies. Conversation and debate continue regarding whether we have hit the floor and are bouncing back, or generally when will business return to "normal". Of course, no one can say with any certainty when the energy trading space will completely stabilise, but one thing is certain, producers will continue to produce energy, end users and consumers will continue to burn/consume commodities and the marketplace will need to determine prices and manage corresponding price risk. The biggest question is, "Who will fill the shoes of the mega market makers and price risk managers who have emerged over the past ten to fifteen years?"
The New World Order
First and foremost, those remaining organisations with good or any credit will certainly have a leg-up as the marketplace starts to rebuild. But without a doubt, we are seeing a very strong and renewed interest from two primary sources: first traditional, asset-based organisations and second, financial institutions or banks. Companies with strong physical assets, whether they are transportation and storage based or production and generation based, which have previously maintained strong regional or in some instances national presences, but traditionally have limited speculative trading books, are showing an interest in expanding their footprint. Most of these asset-based companies have strong geographic or regional expertise, and most focus primarily on one or two commodities. Their asset structure and long-term customer relationships have provided somewhat of a niche of expertise - and the fact that they have been around for some time has proved to be an effective brand, especially as organisations are closely scrutinising the creditability of prospective trading partners. In general, these organisations' core business is operating and managing physical assets, and their trading activities are secondary around their operating infrastructure. As a general rule, most of these organisations do in fact manage and maintain sophisticated book structures with very complex deals, valuation techniques and risk profiling. However, unlike some of the larger mega marketers, these asset-based groups have a much smaller percentage of their trading books tied to speculative transactions. Their primary focus is to maximize the value of their physical assets, service and maintain their existing customers through structured products, and provide price risk management alternatives.
On the flipside of the coin, renewed interest among financial institutions that have traditionally known and dealt with financial risks and exposures across numerous industries and markets is being established. Obviously, these organisations are well suited to fill the credit void that has been created from the mega marketers, but what is interesting is that both camps (financial institutions and traditional asset-based energy companies) have a strong interest in both physical and financial-based books and corresponding systems.
In fact, while the traditional physical players will continue to require sophisticated modelling requirements around transportation and storage as well as position management and physical scheduling, these organisations also continue to express a strong desire to have the most sophisticated applications for value at risk (VaR), option valuation and financial instrument modelling. Likewise, the financial centre or banking customers continue to maintain very sophisticated systems for fixed-income and currency requirements for their banking interests, and they will continue to have a strong demand for risk tools within the energy market, but they also have expressed interest in asset-based modules that have traditionally been embraced only by the energy producer/distributor. In particular, while banking institutions have traditionally avoided the investment in and around physical assets - as well as the infrastructure requirements around maintaining and operating these facilities - numerous banks are now embracing direct or indirect ownership of these assets as a way to leverage their financial-based books and to increase their market share.
And what does this new world order hold for the remaining mega marketers? As the dust begins to settle, those that remain must now shoulder the burden of restoring investor and regulator confidence by reinforcing the message that the merchant energy sector plays an important role in the process of competition and pricing economics. A long, hard road, this perception turnaround will be achieved only through visible action. In the Spring of 2002, a group of chief risk officers formed The Committee of Chief Risk Officers (CCRO) with the mission of opening the channels of communication, defining industry best practices and providing a format to evaluate risk profiles objectively. Currently, this group's membership now includes 32 companies that together represent approximately half of the natural gas and power transactions within the United States, and has been actively engaging market participants to formulate their recommendations. From credit rating agencies, regulators and securities analysts, to industry trade associations and financial experts, in their short existence this group has made a necessary impact that will assist in the reversal of the downdraft in which their firms were caught up.
Clearly, whether the entrant is a bank, an asset-based organisation, or one of the mega-marketer survivors, there will be a somewhat more balanced focus on physical to financial transactions with a significant amount of the financial focus surrounding hedging and price risk management. Derivatives will continue to be a very useful tool to manage risk and liability, but pure speculation books will be limited under the credit lean marketplace that exists today and well into the future. Enhanced requirements for the physical market maker will also be demanded both from the pipe-and-wire side of the marketplace with an increased emphasis on physical scheduling and asset-based modelling.
Back to the Future
As the year 2003 commences, we are beginning to see somewhat of a return to normality. Sure, a complete recovery will still require a year or more of healing and restructuring, but at the end of the day, numerous underlying business fundamentals are unchanged:
The bottom line is that parties continue to fill the void left by the organisations that have shrunk or disappeared over the last year. And while their base businesses will now resemble more of a physically oriented organisation, they will still continue to require a high degree of risk, modelling and financial expertise in their business processes. Lastly, as it relates to technology and software requirements, the larger mega marketers will maintain a position that is both viable and healthy in the marketplace (with an appropriate return of investor confidence), and their software functionality requirements will generally be both broad and wide. But, that said, the new market entrants who focus on regional and single or dual commodity markets will not necessarily have less sophisticated requirements. Rather, they will have very focused processing requirements in specialised areas. Along with these demands, and due in part to their specialised focus, these players will be primarily interested in systems that are functionally streamlined and delivered on a highly configured basis or "out-of-the-box" with minimal customisations upon service initiation. The strategy of having highly configured systems with a very rapid deployment schedule is both a function of moving quickly to fill the voids left by the departure of some of the larger marketing companies, as well as of the fact that these niche players generally have smaller technology staffs and budgets that are a prerequisite for highly customised applications.
A twenty-year veteran of the energy markets, Matthew Frye is managing director of OpenLink's Houston, Texas division. With an extensive background in trading, risk management and operations software, Frye leads a team of business experts and software engineers that provides adaptive, dynamic and integration-friendly solutions to physical energy trading organisations in North America. He can be reached at: T: + 1 713 655 9600 E: mfrye@olf.com For more information about the software and services that OpenLink provides visit: www.olf.com
