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The Utility Sector: A Wall Street Takeover?

Financial players bring credit depth to energy markets, but will they play by the rules?
Fortnightly Magazine - January 2004

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Deep Pockets

As 2004 begins, U.S. wholesale power markets are illiquid and opaque.

"Liquidity dries up fast if you go out more than a couple of years," says Ted Murphy, senior vice president and chief risk officer with Cinergy Corp. "If you are looking for a customized product, or anything further down the curve, there are a lot fewer players out there than there were a couple of years ago."

Because discovering accurate prices depends on liquidity, the thin market makes hedging more difficult. At the same time, credit worries have driven up demand for collateral, pushing all but the strongest companies out of the market. Debt refinancing and restructuring activities during 2003 have helped, but a credit drought persists.

"The top 10 energy marketers from a few years ago still have very poor credit," says Mark Williams, an executive in residence at Boston University. "Credit is the lifeblood of trading. The market is very leery about these counterparties, which means there isn't much volume being traded, and it is being done by a narrow group."

For example, as few as 20 traders conduct virtually all the trading activity for electricity futures in PJM. Compare that to some 200 traders for natural gas futures on the NYMEX. While this shortage leaves a lot of room for new entrants, it also makes it difficult for the newcomers to assess risk. Many of the most active traders do much of their business over-the-counter; a large share of the market's price information may not be publicly recorded.

"Those that are taking advantage of the inefficiencies in the market have proprietary models and better access to information," Williams says. "The market and the smaller counterparty can't benefit from that information."

All these trends tend to favor the players with world-class risk-management capabilities and balance sheets. That gives them greater flexibility than leveraged merchant players would have.

"There is clearly an opportunity in the market for entities that have a stronger balance sheet and higher credit rating," says Dan Gates, a managing director with Moody's Investors Service in New York. "In some cases they may be able to get more out of the same asset than an entity that is financially stressed. They can enter long-term contracts and do things from a trading perspective that a weaker entity cannot do."

Nevertheless, this situation could spark two positive trends for the industry. First, it could prompt more plant sales, as deep-pocket players develop comprehensive trading strategies and seek hard assets to back their positions. "You'll see more assets change hands because they will be more valuable in the hands of a better-financed player," Gates says.

Second, it could serve eventually to expand the tenor and terms of contracts available in the market. Companies that enjoy a stronger credit position are better able to manage risks further out on the curve. "Financial players can bring some flexibility on the risk spectrum and might be able to provide specialized and exotic products, such as load-following contracts or other options," Murphy says.

Not all financial players in the market are