Energy Marketing Editor
Not for the faint-hearted, the business of arbitrage-the simultaneous purchase of one commodity against the sale of another in order to profit from fluctuations in the price relationship-is a dicey game of steely nerve, flush capital reserves and deep-pocket market know-how. In the volatile environment of power arbitrage, few dare to enter-and even fewer survive.
Year after year though, one bold arbitrageur and entrepreneur, Riaz Siddiqi, seems to continue to ride atop the swells, storms and spikes of the power market. A self-professed “student of electricity markets” for over 20 years, Siddiqi entered the world of power markets armed with an MBA and a degree in electrical engineering on the heels of PURPA, and he quickly became enthralled with the concepts of customer choice and the commoditization of electricity.
Since then, he has carved out a career spanning both retail and wholesale power markets, worked for the likes of Southern Company, San Diego Gas and Electric, the Electric Power Research Institute (EPRI) and Cinergy Capital & Trading Corporation, and developed several businesses along the way. Last year Siddiqi co-founded Capstone Global Energy, L.L.C., a firm offering advisory services (like contract and portfolio analysis and valuation, trading support, long-term forecasting, risk assessment, etc.), due diligence (like merger and acquisition analysis) and transaction origination services.
These days, however, Siddiqi seems perfectly content working on Capstone’s platform of experienced professionals in a non-bureaucratic environment-continuing to “sniff out opportunities” months ahead of the rest of the market players, and putting them to work on behalf of a handful of strategic clients.
EL&P: How do you define arbitrage?
Siddiqi: The practical definition of arbitrage is a state of ostensible commercial tension-where a commercial arrangement is out of whack with the realities of the market. It’s when an intermediary with specialized market expertise has the opportunity to come in the middle of the transaction and make money from it. Personally, in the context of energy markets, I don’t consider myself a trader, but an arbitrageur. What I have done professionally for some time now is to see an opportunity three to six months ahead of the time that it becomes mainstream knowledge. I then make a hypothesis, organize a team of experienced people to harvest the opportunity, and either prove the hypothesis or disprove it, and move to the next opportunity. In simpler terms, arbitrage is a perceived opportunity to make a profit while minimizing the risk assumed.
In the initial days of the “commoditization” of power markets, the market was characterized by simple arbitrage opportunities. As the power market has evolved, though, arbitrage is getting more and more complex, and the degree and depth of understanding of the market has to grow exponentially in order to benefit from it.
EL&P: Can you give us some tips on how to successfully structure an arbitrage?
Siddiqi: I’ll give you a past example of a simple arbitrage that was available a few years ago and was successfully structured. Earlier, utilities had shorted full requirements contracts. If you took all those contracts and aggregated the expected take from those contracts, you could have made that into a book of forwards and options. A forward contract, by the way, is the obligation for one party to provide and the other party to take a commodity at a pre-specified time in the future, while an option is a right, but not an obligation, to buy or sell a particular commodity at a pre-specified price.
In these contracts there was no differentiation made, in terms of pricing, between options and forwards. So in general, the options were under-priced, and the forwards were over-priced. Because of the lack of visibility of these prices, and some people with a different view of these markets, we were able to buy options at very favorable prices-below their true value-to hedge out the option positions. The forwards were at equally opportune prices, reflecting the hypothesis that baseload power prices would be going down because of the effects of deregulation. To give you a sense of the value, a $32 dollar forward position was hedged out for $22, which locked in an instant $10 dollar gain.
After all was said and done, it boiled down to someone recognizing the opportunity, formulating a hypothesis, testing the hypothesis, and with a few phone calls, finding counterparties to take the other side of transaction. What you’re left with is locked-in gains plus some credit exposure.
EL&P: Just how risky is arbitrage?
Siddiqi: There is no such thing as a risk-free arbitrage. There are at least two types of risk in affecting arbitrage. First, is your hypothesis correct? That is, have you understood all the important factors that lie beneath your perception of the opportunity? The second, and most important, is competence risk. Do you have the right skill sets organized correctly to put the play together, implement it and tend it while it matures? The combination of these two risk factors have manifested themselves in very significant ways to the benefit of various players, and to the detriment of others in energy markets over the past few years.
I think it’s important that people understand that at the end of the day, arbitrage is in fact speculation. But speculative activity must be separated from hedging activity because the commercial objectives of the two are very different. The objective of one activity is minimizing risk assumption for a given level of return expectation. The commercial objective of hedging is to lay off price risk to others while achieving larger core business activity goals, like budgets and cost-per-unit of input. Within an organization, there needs to be great transparency of activity in arbitrage and an appropriate application of accounting principles.
EL&P: What are some important “lessons learned” in the past few years?
Siddiqi: The electricity market has literally evaporated in many areas due to people being perplexed at price spikes. The impacts of those spikes have been well publicized. It is also being recognized that the true nature of electricity may in fact defy the belief that it can be commoditized much as gas was. The fact is that the power markets have not developed like natural gas. The volatility that has been experienced in electricity prices, the ratio of absolute highs to average levels of prices in the U.S., U.K., Amsterdam and Australian power markets have, in fact, dwarfed volatilities in other commodities and financial products.
A lot of organizations have realized they do not possess the skill sets, the right organizational culture and just do not have the risk appetite for participation in these markets, and have left the business.
In those organizations that are still in the business, a lot of belated attention is now being paid to compliance control to risk management policies and procedures and the enforcement of trading controls. If properly designed and fire-walled, though, electronic trading platforms can assist in this effort. Actually, the more trading and procurement that is transacted over the Web, the better the chance we have to control the trading mechanisms.
EL&P: In your opinion, how have past market experiences affected current and future market structures, regulation and competition?
Siddiqi: I don’t believe all the stakeholders, legislators, regulators and energy service companies have fully understood past market experiences from electricity markets. But by and large, that’s appropriate. Because of the staggered imple- mentation of restructuring in the U.S. electricity markets on a state-by-state basis, and the fact that retail customers have not fully participated in these markets, it’s arguable that the observations of the past few years, in terms of customer behavior and price histories, are representative of the future. In fact, I would strongly argue that they’re not. But even though I have been a strong proponent of customer choice and the application of laissez-faire principles to electricity market restructuring, I have come to believe that if restructuring is to be a long, drawn-out affair because of societal inertia and issues of stranded cost recovery, the restructuring should be actively overseen by regulators, and the degree of regulatory intervention should be inversely proportional to the degree of “true” competition in markets.
What I mean is that if transmission and generation were truly separated by legislative and regulatory orders, regulators should only intervene light-handedly. But, as we’re set up now-with transmission, generation, marketing and trading permitted under the same “corporate umbrella,” then regulators must stay heavily involved to ensure the interests of consumers. One more reason for regulatory involvement is the need for the growth of public interest institutions like the Cal ISO to assure that the reliability of the system is maintained in real-time operation. Over time, technology and market participant’s experience with new market structures may prevent the need for these public interest institutions. But that’s not the case today.
We need to realize this global trek towards privatization and restructuring is simply a mega-hypothesis being tested on a global scale. The results will manifest themselves over several years, maybe even decades. Again, because of the nature and value of electricity to society, we have to be deliberate about restructuring.
EL&P: How has the Internet affected power trading, arbitrage and risk management? What role do you see the Internet playing in the future?
Siddiqi: There are several Internet trading platforms for energy being offered today. Most of the solutions being offered, though, are of doubtful value as lasting value propositions. Most of them are trying to merely copy today’s human practices on technological platforms, and offer cost reduction as the basic value proposition. The other reason that Internet-based solutions are proliferating in the energy industry is because of the perceived bump up in price-earnings ratios and market cap that users are promised they’ll experience. I think the promise of the Net is that it will allow users to express their preferences for customized bundles of commodity, risk management services and then communications packages. It will also allow suppliers to access customers that haven’t been previously cost effective. This interaction between suppliers and buyers will take place in virtual marketplaces, where instead of standardization and cost reduction, the focus will primarily be on customization and value added. The arbitrage, or the opportunity, is for applying creativity in devising a means to access customers, and tailored packages of solutions.
In fact, I’m in the middle of testing this hypothesis. Last November, I co-founded a company by the name of EPXnet, which will offer a unique intelligent energy procurement platform to suppliers and buyers. EPXnet will provide a networked set of marketplaces where buyers and suppliers will be able to come together and conduct energy commerce in an intelligent and Web-enabled environment.
EL&P: Through your extensive market experience, please share with us your top two industry tips to successful arbitrage.
Siddiqi: Well, first of all, you have to remind yourself when you’re in the business of practical arbitrage that, at the end of the day, it’s only hypothesis testing. So don’t bet the bank. A portion of the bank, okay, but not the whole bank.
The second tip is to believe in the portfolio theory. So as an arbitrageur, to maximize the chances of an above-market return, you should develop a book of positions. Say, ten small bets on ten hypotheses-all low cost of entry and high potential payoffs-so that any one of those ten “hitting” should pay off the loss of the others and provide decent returns. The return criteria should reflect the risk of the positions. For example, good fund managers are expected to beat appropriate indices, like the S&P 500. A good arbitrageur should hit 5-10 percent above perceived “risk-less” returns, with an optionality of enhancing it to 10-15 percent above that.
EL&P: What future trends and global opportunities do you see in the next three to five years in power markets?
Siddiqi: There are two global trends taking place now. The first is a demonstration of individual choice. Because of the explosion in communication technology, people and entities have the means to express their individual and specialized desires. The ability of individuals and businesses to express their needs through the Internet puts a huge responsibility on commercial entities. It used to be that standardized products were considered lower cost and would do for most individuals and businesses, but now people want customized products. For businesses, that has important implications, because they have to enhance their ability to find these customers and reach out to them in a cost-effective way and design creative bundles of products and services tailored to their needs.
The second trend is that society is growing more and more dependent on the use of energy. In terms of sources of electrical energy, society has pretty much closed the nuclear option, and is on the road to severely limiting the role of fossil-fuel-fired sources of generation. That leaves us with very little choice to serve the increasing demand for services that individuals and businesses will demand from the computing, communications and energy industries.
As for future opportunities, I think the growth of small, dispersed modular sources of energy, like fuel cells, energy storage devices, solar and so on, is great. I see a future where everyone will have a customized power sources available to him or her. Having energy in the form you need, when you need it, and where you need it will have to be considered a birth right, not a luxury.
So, what will happen is that the infrastructure of financial services, financial engineering, trading and risk management-that has attempted to develop on top of the physical infrastructure in energy companies-will become mainstream and traditional. On top of that infrastructure will be a newly created superstructure of technology, interactive media, computing, communications and new sources of energy production and storage.
The opportunity here is-for those that can spot it-to devise ways to get in the middle of the physical infrastructure and the “superstructure of intelligence” and take part in the flow of wealth between the two. Examples of companies who are already doing that are Enron Corp, Williams, Avista, Duquesne and Montana Power, to name a few.