The 2002 Sarbanes-Oxley legislation in the United States created new accounting standards for stock exchange-listed companies required to report to the Securities and Exchange Commission (SEC) on a quarterly and annual basis. Section 404 of Sarbanes-Oxley covers internal control over financial reporting and requires that companies demonstrate adequate audit and control process over (among other areas) their financial transactions.
Sarbanes-Oxley implicitly requires U.S.-registered energy trading companies to tighten control over the management of trading risk. It has become critical for risk managers in energy companies to find auditable and independent daily valuations of the forward trades on their books. This mark-to-market process requires a search for what are known as “forward curves”: market values, that can be applied to forward positions in the risk portfolio.
In the near term or spot markets, greater scrutiny of the U.S. electricity and natural gas markets by the Federal Energy Regulatory Commission (FERC) has led to the development of more robust and liquid price reporting indices for day ahead and balance of month transactions. These improvements are documented in FERC’s May 2004 “Report on Natural Gas and Electricity Price Indices” (see http://www.ferc.gov/EventCalendar/Files/20040505135203-Report-Price-Indices.pdf)
As a part of the information gathered for its report, FERC surveyed 189 market participants voluntarily and discovered that while near-term price reporting had improved, “the results clearly indicate that few companies report long-term transactions to index developers; over 75 percent of respondents indicated that they reported no forward fixed price natural gas or electricity transactions to index developers.”
Simply put, traditional price reporting surveys do not provide adequate coverage of forward markets. What follows is a survey of sources of forward curve data presently available to risk managers.
The first and most obvious place to find forward curve data is the exchanges. The New York NYMEX and London International Petroleum Exchange (IPE) provide liquid open outcry and electronic trading markets for key energy futures and options as far as 10 years into the future. Daily published settlement values provide any participant with a clear indication of the forward curve. However, because the NYMEX and IPE curves only cover a narrow range of heavily traded commodities that do not reflect all trading locations or commodities, they only meet a small part of most risk management requirements.
The NYMEX has broadened market coverage by extending its clearing mechanism to include transactions not traded directly on the exchange floor. While developed primarily to satisfy issues of counterparty credit risk, the resulting NYMEX OTC market has greatly extended the forward curves that are publicly available to the energy market.
The NYMEX offers more than 50 OTC instruments in oil, natural gas, coal and electricity. Counterparties that trade in these instruments off the exchange can register their trade with the NYMEX and be assured that they are handled by the exchange clearing house and that settlement values are available for open positions every day. The settlement procedure ensures a published value, but if there is no activity in the commodity, the value is “assessed” not based on actual trading. See the NYMEX OTC offering (http://www.NYMEX.com/jsp/markets/cp_produc.jsp).
The IPE is itself owned by the largest electronic trading platform for energy, the Intercontinental Exchange (ICE). The ICE provides a variety of market data to members and non-members alike through its 10X data group.
Forward curve data from ICE and NYMEX OTC provide risk managers what they need for transactions traded on electronic exchanges. However, according to the May 2004 FERC Report on Natural Gas and Electricity Price Indices survey of market participants, reported trading venues for forward fixed price natural gas and electricity transactions* were as follows:
For risk managers, then, the evidence suggests that prudent price discovery of forward curves should include other data sources besides electronic exchanges. Any thought of finding bilateral market deal data quickly leads one back to the FERC report’s earlier criticism that forward trades are not reported to price reporting services anyway. The broker community is a more fruitful source of additional forward curve data.
As the FERC numbers suggest, voice brokering of forward market activity is still popular. Brokers provide a customized service and have good working relationships with their clients that enable them to respect counter party credit concerns and to provide a human feel for market depth and price indications. This makes customers feel more comfortable committing to longer-term transactions through the broker mechanism.
Until recently, brokers have struggled to provide forward curve data to their customers in a form that can be used by risk managers. Individual brokers might provide data but the format varies from broker to broker and the risk manager was left sifting through large amounts of data to find mark to market values.
Four of the largest OTC gas and power brokers in North America have made that search easier by setting up EnergyCurves, LLC. EnergyCurves combines the end of day indicative price reports of Amerex, ICAP, Prebon, and TFS into one comprehensive and standard product for gas and power mark-to-market valuations. The solution provides indicative, un-biased independent broker data which is aggregated by an independent company (Logical Information Machines, Inc.) and subjected to a number of stringent quality checks.
Even with ready access to exchange, electronic platform and broker data, risk managers looking for forward curves are still not happy.
The common complaint arises that offerings derived from actual market trading activity do not offer complete coverage. If a particular forward instrument in your portfolio is not traded on an exchange or through a broker on a given day, then placing a market value on that instrument at the end of the day is not simple. It used to be OK to ask your own traders to place a value on such transactions, but tighter financial controls make that impossible now. Some commercial solutions to this “curve gap” challenge have emerged in the marketplace.
One such offering is from Sungard subsidiary Kiodex Global Data Management, which provides over 140 curves going out from 2 years to 7 and covering all energy markets. They offer 53 curves for North American Natural gas hubs and 17 for Electricity hubs. The curves have monthly granularity. A list of the curves is available (http://www.kiodex.com/Solutions_Kiodex_Global_Market_Data_Overview.html). Although the methodology Kiodex uses is proprietary, the company surveys a number of reported sources to assess a fair market value for the curves.
There are other commercial forward curve offerings available such as the M2M product from McGraw-Hill. The M2M product is based on editorial assessments of the market combined with model forecasts.
As the regulatory environment changes, the challenges facing risk managers sometime seem to form an uphill forward curve of their own. The good news is that increased data offerings from the marketplace are available to help meet the forward curve challenge. Many of these data sets are themselves available via a one-stop-shop provided by data aggregators such as Logical Information Machines. All of them improve market price discovery and can only increase the prospects of better corporate governance in energy trading.
Sandy Fielden is vice president of energy products and services at LIM and can be reached at 512-697-3013 or firstname.lastname@example.org.