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What made headlines before is now becoming everyday news, that energy companies are scaling back or leaving energy trading. Some emphasize the shift to "trading around assets." Anne Ku investigates just what this means.
Trading with a small t
by Anne Ku
(original version of the 3 page article published in EPRM April 2003 issue)
Before the Enron crash, energy trading was THE business, both necessary and big. Money was made with or without assets - or so it seemed. Trading floors were kitted out by the dozen and fresh graduates joined by the herd. It was trading with a capital T. But when the crooked E of "Energy Trading" fell, the capital T too became shaky.
The capital T shrank along with downgrades of credit ratings, loss of confidence, and hurried departure of American power-trading companies from Europe. The notoriety of round-trip power trades to pump up the volume along with the exodus of the larger power players have redefined what is meant by energy trading, a necessary but no longer a big part of the utility business.
The definition of energy trading on the web site of Allegheny Energy, Hagerstown, Md. could not be more straightforward: "the buying and selling of energy contracts in the wholesale markets with the objective of generating profits on or from the exposure to changes in market prices." Yet, just what does it mean in practice today?
A head of a European energy broking company says energy trading does not just mean buying and selling energy anymore, and neither has the "big T" diminished in European energy markets. If anything, trading is done as much for commercial and risk management reasons as purely for trading's sake. He observes, however, a more measured approach to trading, that is, not just speculation. Despite the noticeable decline in trading activity in the last twelve months, he sees the current period as a necessary part of the cycle. In other words, the trading business will become stronger now that companies are putting proper risk management systems in place. "When America sneezes, Europe 'sometimes' catches a cold. We do feel it here, but the European energy companies have taken up the strife for transparency spearheaded by the Americans who have now left."
Fred Cohen, Global Energy Risk Management Leader at PriceWaterhouse Coopers in New York, likens the big T to a more aggressive approach to market making and taking on larger risk positions than the little T it has become. "Trading with a small t implies mitigating risk or hedging. Initially many energy companies looked at trading as a business in itself, a separate profit centre. Increasingly, such companies are realising the need to integrate it with the rest of the business under one overall strategy of risk transfer and risk mitigation."
From big T to no T
Only a few remaining A-rated energy trading companies (table 1) like Entergy-Koch Trading and Sempra Energy can afford to stay in energy trading with a capital T. The mix of Entergy-Koch's trading business is half speculative and half customer-driven. Almost everyone else has decided to scale down their trading operations, or at least, "trade around their assets."
In the smaller T category are those companies that have announced a scaling back of trading. As one of the earlier proponents of "trading around assets," Duke Energy has also had to reduce staff and scale back because of reduced liquidity and lower volatility. "The main focus is on assets, though it [energy trading] will leverage arbitrage and speculative opportunities for the company," explains Stephen Morriseau, spokesperson for Duke Energy International.
Another term for "trading around assets" is Innogy's "asset-backed trading." According to Brian Senior, managing director, Innogy, Swindon, UK, asset-backed trading does not mean that assets come first or indeed that trading comes first. Rather, it's about a partnership between trading skills and asset management skills - and it is this partnership that will be a critical driver of value in the future. It's about placing the risk where it can be best managed: market risk with the traders as they know and understand the markets and asset risks with the asset owners/operators as they know the limits of the asset.
Senior suggests that the future will be towards balanced portfolios via vertical or virtual integration (an asset based portfolio). "By virtue of owning an asset, you will have a position in market. This 'market' position needs to be managed - and traders know the market and the asset risk also has to be managed."
For A minus rated PPM Energy, Portland, Oregon whose portfolio includes wind power, gas-fired plant, and gas storage facilities, "trading has to happen because we're never in balance 100% of the time," says spokesperson Jan Johnson. PPM Energy changed its name from Pacificorp Power Marketing in January 2003 because the old name did not distinguish itself clearly from its regulated sister utility Pacificorp. In addition, their business is not just the marketing of power, as they have entered the gas storage and hub services business as well as the renewable generation development business.
Companies that have decided to get out altogether fall in the "no T" category. Aquila is one of the larger energy traders who have decided to exit trading and return to its utility roots. Having sold all its gas assets in pipelines and storage facilities, it is now trying to sell its power plants save those which are used to serve its regulated customers. There will still be some trading, but only to balance out the supply and demand. Aquila' spokesperson Al Butkus says they do not think this is a temporary phenomenon but one which will take 4 to 5 years to work out. In fact, Aquila doesn't see a reasonable move on deregulation with the development of Regional Transmission Organisations (RTO) and regional markets before the year 2015. By end of January 2003, Aquila has already shed 1,800 of its workforce.
Energy traders and accountability
Why has energy trading become a controversial business? Soli Forouzan, President, Mind Span Inc, a Houston-based independent energy risk management and asset optimization consultancy reasons as follows. One problem with energy trading in the US is that there is no certification or qualification required to be considered a trader. As such, energy trading is not tightly regulated like the financial markets, where brokers or insurance salespeople need to be licensed. Anybody can call himself an energy trader. In his experience, many "traders" cannot or do not maintain accurate "books" measuring their risk and profits.
Commodity trading books are much harder to track because trades are not standardised. Take the unlimited full requirements contract for example. When a trader says he will supply all the power a customer needs, he is taking on a huge volume exposure (risk) for his company, and yet many companies do not quantify the volume or the profit risk of such trades accurately.
Forouzan defines a trader as one that has profit and loss responsibility with a trading book which isolates ALL revenues, expenses, and risks attributable to him or her. He is not an order taker or someone who does not have a separate book. In the case of collective books, where many people trade in but aren't individually accountable for, the manager in charge of the overall book profits and risks is more of a trader even though he may not necessarily be executing any transactions himself.
Within the energy industry the above problems are magnified by the need for actual (physical) deliveries. Physical delivery of commodities such as energy is a messy business, involving numerous instances of over or under delivery, non-delivery and too many fees and tariffs. While this may be ignored for forward delivery periods, once a commodity, like power, starts flowing, there will often be delivery issues, whose benefits or costs are not reflected in a trader's books.
Most trading systems oversimplify what really happens during delivery. This is not a problem in the financial industry, where products are standardised and execution surprises are few. In the energy industry however, most accounting systems fail to properly allocate transmission or other physical costs and fees incurred in delivering the product. The typical accounting system is incapable of tracking the actual charges and allocating them to the individual trader. These are not negligible either. For that matter, most companies do not charge individual traders for the capital they use or the credit risk they create, thus giving traders no incentive to pick more credit-worthy counterparties or to consider the capital requirements of their trades.
Trading vs speculating around assets
Forouzan distinguishes between "trading" and "trading around assets", as well as "trading around assets" and "speculating around assets" (tables 2 and 3). Forouzan advises energy companies that still profess to trade around their assets to keep two sets of books, one for speculative trades and one for assets.
The asset book is operationally driven, and impacted by how the asset is behaving every day. There needs to be a way to instantly update the asset position through a constant feedback loop with operations. The asset book is typically delta-neutral and is used to track the effectiveness of the trader in monetising the asset's optionality and to lock in a return on the invested capital. Any unhedged or overhedged positions should be transferred to the speculative book, allowing managers to judge their traders on both their ability to manage assets and to speculate on pricing moves.
For the speculation "spec" book, the trader's position typically doesn't change (option positions are an exception) unless he trades. For example, buying a commodity causes a long position and stays long until there's a sell.
In an asset book, there will be a spread position (input fuel, output power) and a volatility exposure. For example, the trader is long volatility because he has an option to run the power plant. And the position is constantly changing due to the exotic nature of these options and the operational considerations which can change at any moment.
As owner of these options, which come "embedded" in assets, the trader should have limited downside risk but unlimited upside. In other words, the trader should not make less money than what he has locked in, which is why companies are joining the "trade around assets" chorus.
But managing to capture the upside is not trivial. It requires different tools (trading systems) and a different mental attitude. It requires thoughtful trades which take into account all operational and legal angles of managing the asset.
"When you truly trade around assets, you have to think about future moves like a chess game, where you think three steps ahead. For example, you have to decide on whether to use your emissions rights today or save them for the next month." Forouzan concludes, "When you speculate around assets, you move in and out of positions quickly and frequently. You're simply watching the flow of trades out there."
The future of energy trading
"Many utilities got seduced by the sexiness of trading as an end in itself and as a means to make lots of money," observes Douglas Swinden, Managing Director, Highmoor Consulting, Bury St. Edmunds, UK, an independent energy advisor. While some energy traders did make a lot of money (some also lost a lot of money), there is now a realisation that trading should primarily have been a means to manage risk, which for the great majority of utility businesses should have meant risk minimisation. "It was only the naive optimists who believed that the liquidity in traded power markets could ever reach the liquidities experienced in the mature financial markets."
While energy companies are returning to their utility roots, financial institutions with better credit are gearing up to trade energy. PriceWaterhouse Cooper's Cohen questions how they will define their roles and whether there will be enough participation to be sustainable after some had entered the market and then diminished their roles or exited completely. "There still needs to be a clear linkage to underlying physicals. You won't expect the kind of multiple trade volumes over the amount of energy to be delivered in other commodity markets," he says.
Meanwhile, Aquila's Butkus expects the large oil companies to move into gas and power trading because they have the credit rating and the physical trading and risk management experience. When that time comes, energy trading may have a chance to return to a capital T.
Table 1: US power companies and trading status
Table 2: Speculating vs trading around assets
Table 3: a clarification of energy trading jargon