Pam Boschee, Managing Editor
Few people today, if asked to identify the most respected occupation, would choose energy traders. However, in spite of this perception, it’s an occupation that won’t be going away soon.
With nearly one-half billion dollars at risk each day between power and natural gas markets, energy trading remains one of the most effective ways to capture this value via risk management.
Energy trading, as once known, probably should never exist again. However, “kinder and gentler” (or “legal and ethical”) versions continue to evolve.
Redefinition and redirection are words of the day on most energy trading floors these days. On others, subpoenas and show cause orders have become part of the daily vernacular.
In this feature, EL&P delves into the good, the bad and the ugly of what was once generally perceived as the high-flying segment of the energy industry, starting with the fallout from the halcyon days of California and concluding with a glimpse at what the future may hold for energy trading.
FERC kicks it up a notch
In late March, the Federal Energy Regulatory Commission (FERC) showed its teeth in some of its strongest enforcement action related to the 2000-2001 California meltdown. FERC reported there was clear evidence of market manipulation in the western markets. It added that the manipulation was effective largely because of an underlying supply shortage, flawed market design and inconsistent rules, which exacerbated the impact of manipulation on high prices.
Nevertheless, it’s now show cause time for many companies who are accused of using illegal trading practices to manipulate western energy markets (see table). These companies have 21 days to “show and tell” FERC why they should not be punished. Under current law, FERC can seek “disgorgement” of profits in these cases.
Four power marketers face even tougher consequences–revocation of market-based rate authority: Enron Power Marketing Inc., Enron Energy Services Inc., Reliant Energy Services Inc. and BP Energy Co. In other words, they could be barred from selling energy at competitive prices.
These four are accused of scheming and manipulating to such a degree that they may also find themselves delivered to the doorsteps of the Securities Exchange Commission or the Justice Department.
Chairman Pat Wood III commented, “This is all part of our role as the cop on the beat. We have said from the beginning that a belief in the free enterprise system goes hand in hand with a responsibility to see that the playing field is level and that everyone plays fair. If there was ever any doubt that they was part of our core philosophy, that doubt should now be dispelled.”
For those with a need to know the minutiae, FERC posted to its Web site, www.ferc.gov, the more than two terabytes of material compiled, which is the equivalent of 1.5 million floppy diskettes or about 3,300 compact diskettes.
Show me the money
In its recent actions, FERC approved an order that will result in about $3 billion being refunded to California by suppliers. This order nearly doubled the refund amount determined by a FERC hearing judge in an earlier decision.
California officials submitted additional evidence to FERC in March to make a case for a refund totaling nearly $9 billion.
The suppliers, however, maintain that they are still owed $3 billion in unpaid bills for the electricity they provided to the state.
The final tally is expected within six months. That amount will affect yet another type of refund dispute.
Energy trading companies have requested the return of collateral held by the bankrupt California Power Exchange (PX), which once ran California’s wholesale electricity market.
The California PX filed for bankruptcy two years ago and it still holds about $1 billion in letters of credit, surety bonds and cash collateral posted by traders as a requirement to buy and sell in the market.
FERC denied a request in late March by Powerex, the trading arm of Canada’s B.C. Hydro, for the return of a $67 million letter of credit held by the California PX, stating the money is being held for refunds that may need to be paid by wholesale electricity suppliers. (Powerex is included in the group accused of manipulating prices.)
Snapshot of Dynegy today
Enron’s collapse and the California situation brought many merchant generators to their knees (see figure) and brought energy trading to a screeching halt for several companies (such as Aquila Inc., El Paso Corp. and CMS Energy).
Bruce A. Williamson, president and CEO of Dynegy, spoke candidly with EL&P about his company’s change in focus.
“We’re exiting third party trading and marketing. We are working to be substantially done in early 2003 and from that point forward we move from being a ‘market maker’ to a ‘price taker’ in terms of the sale of our product–electricity and natural gas liquids, natural gas–from our equity positions, toward a purchaser of natural gas, oil, coal for fuel for power plants.
“We’re more of a customer of third party trader marketers as opposed to being a third party trader marketer.”
Williamson listed a few companies he considered survivors in the third party trader marketer circle: Entergy-Koch, Sempra, British Petroleum, Tractebel, Shell and Chevron-Texaco.
Williamson agreed that stepping back from third party trading will affect Dynegy’s bottom line. “We will make it up by being leaner, more cost-focused. I think the business model before in the energy merchant sector was focused more on being the optionality driven arbitrageur rather than being a low cost producer. It’s now much more of a back to basics business model rather than trying to work the optionality.”
Williamson identified the need to rebuild confidence and credit as the biggest challenges to revamping trading practices. “The U.S. attorney here in Houston is going to have to complete his work into all the wrong practices of the past. When he’s done with that, and when those issues are put to bed, then I think the country and the economy can look to the energy sector and say that they can trust it again.
“There were a lot of bad practices, a lot of things that were basically wrong, and they need to be resolved and, unfortunately, in some cases, they’re going to have to be resolved through the courts. We will do whatever we need to do to support the U.S. attorney’s efforts and to provide them with whatever they need to get investigations related to our company behind us.”
What went wrong and what lies ahead
The experiences of the past two years within the trading realm have changed what were once accepted as fundamental tenets.
David A. Sobotka, president, Entergy-Koch LP, spoke of some of these changes in his February presentation at the CERAWEEK 2003 conference in Houston. His back to the basics approach and observations about the market included the following:
“- Reliability of income is crucial, but volatile assets, such as peaking plants, are not necessarily the only strength. All assets do matter.
“- Financial strength is back in vogue. It is necessary to manage the balance sheet in the same way as one manages the trading floor.
“- There must be compliance and controls discipline.
“- It is imperative to have quality customers and partners. Companies must create alliances with people in the industry to accurately assess integrity.
“- Companies must develop analytical strength. They can’t bully the markets for long; they’ll run out of cash.
“- Markets will continue to operate efficiently.
“- There will be continued natural gas market volatility.
“- New transparency is required, i.e., accounting disclosure and credit disclosure.
“- Over-the-counter clearing exchanges must be developed because collateral requirements have cut off many players from participation in the markets.
“- Tight capital markets have made it difficult to raise capital. Consequently, more financial players, such as investment banks and private equity, will come into the market.
“- There will be consolidation of players and new entrants into the markets.
Sobotka added that energy trading pre-viously relied upon long-term, highly structured transactions that extended beyond the horizon of actively traded contracts. This created a rich fountain of questionable profits. Now, however, trading must be based on strong balance sheets or physical assets.
New blood joins the regulars
The most likely new entrants, given the need for financial strength, are financial institutions, large regional utilities and large power producers, according to Vincent J. Kaminski, managing director, Citadel Investment Group who also spoke at CERAWEEK 2003.
Williamson agreed that financial institutions may emerge as new players. “I think it’s going to come from energy companies or it might be from financial institutions. I don’t think you’re going to see a high tech company move into this.”
Harold B. Burnham, senior consultant with Houston’s Energy Advisory Group Inc., sees things differently.
In terms of new players, he doesn’t see any surprises being added to the list. “They’ll be the Fortune 10 of companies that you already know that are significantly invested in well-placed physical assets. It will be the big guys and maybe some of them that are stretched thin now in their credit positions, but have correctly placed physical assets in regions and subregions that are going to be running and have access to fuel and to transmission.”
Burnham’s perspective has been seasoned by more than 35 years in the energy industry. He recently became involved with the Energy Advisory Group after serving with Duke Energy North America where he was responsible for the asset management of Duke’s fleet of merchant power plants.
He said, “I don’t thing there’s going to be a complete upside-down change from utilities to financial institutions. That’s not their core business. They would rather be the credit behind successful utility entities rather than being out front in either physical assets and/or trading and risk activities.
“It becomes a game of being able to properly balance risk with having physical assets. It doesn’t make a lot of sense for big banks to be the owners and operators of a large physical generating assets.”
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However, Burnham foresees situations where financial institutions may be forced to play. “There are going to be some companies that are going to have to throw the keys back to the banks and say, ‘We default. These were project finance deals. We can’t make the payments and under terms of agreement, you own it.’
“In those instances the banks won’t have a choice but to come up with some innovative workout plan.”
Trading is here to stay
Burnham observed that “market swings are strong and willful enough that eventually even some of the larger corporate entities that try to bend the will of the market end up becoming more in line with the market direction than what their corporate strategy originally was going to be.
“It has been interesting to see the whole merchant activity–the trading and marketing activity associated with it. What we thought was a brainchild, actually isn’t; it’s the old art of commodity trading. When it’s done with proper governance and guidelines, it’s an age-old, tried and true free market component. It’s very real and it’s going to be here in the future. It has hit a low right now for various and sundry reasons, but it is a very real thing.”
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Burnham notes several differences in trading practices when comparing today’s business vs. that preceding Enron’s collapse.
“Companies today are absolutely risk adverse. One of the biggest problems is that there are fewer trading partners. Only the strong are staying in, quite frankly, because they don’t have any other clear options at this point. They have merchant plants, they have positions–either long or short–they have long-term gas contracts that they have to execute on.
“Pre-Enron, everyone was out there enjoying nice returns in a healthy business, managing risk and doing quite fine. But once they started the tipping point and the freefall of credit ratings and then a few failures, everyone thought the market was definitely giving off a signal and started retrenching.
“Those who could totally divest and go back to core pre-Enron, did so. The ones that are left are those that have a position that they could not immediately get back to without throwing the entire market into a tailspin.”
So, is trading worthwhile today? Is it worth the headache? Burnham thinks so. “Pre-Enron collapse, there were some nice returns made. There was as much as perhaps 50 to 80 percent return made on capital in the business of trading. That’s what makes it a worthwhile endeavor.”
We’d like to hear your thoughts about FERC’s recent decisions and the future of energy trading. Drop me a line at firstname.lastname@example.org.