In competitive power markets based on locational marginal pricing (LMP), the facts sometimes conflict with popular belief. Most notably: 1. When there’s congestion, the books don’t balance, and...
Energy trading returns, healthier and wiser.
The recent announcement of a trading joint venture between TXU and Credit Suisse First Boston (CSFB) is the latest in a series of positive news items supporting the return of energy trading. Wall Street firms continue to expand into the energy-trading sector, with Citigroup as well as CSFB moving into an area already well represented by the likes of Morgan Stanley, Goldman Sachs, and UBS.
On June 7, reported on Constellation's continued success in this area. Then, on June 8, Entergy and Koch announced their intention to sell their successful trading business. Entergy's stock price subsequently fell.
Commenting on TXU's newly minted venture, company President and CEO John Wilder stated, "We've surveyed customers, and we think there are unmet needs for customer-oriented risk management. … We're looking to get back into speculative trading." Until recently, such a comment would have led to a plummeting stock price, but TXU's stock price did not fall.
As the overall market and, in particular, credit ratings begin to improve, will utilities and other energy players jump back into this market? Only if the return of trading adds real value to a company ().
What does trading mean today? Utilities have continued to trade. There is no difference fundamentally between the process and controls needed to hedge or optimize existing generation -efficient trade capture, risk evaluation, and compliance procedures-and those used in trading.
In both hedging and trading, these processes allow the business to improve its risk profile and protect future revenue streams. However, hedging is a very different strategy from a speculative trading that sets out to beat the market through superior market timing.
There are a number of different ways a trading floor can add value, including:
- Better market knowledge or position. If, through size, systems, or credit advantage you have a more comprehensive view of the market or ability to trade, you can retain some value in back-to-back deals.
- Correlation or basis trading. For instance, taking limited risk by using some other (lower-cost) product to hedge your position.
- Market timing. Deciding when to place a trade to close a long or short position. This includes spot market and forward market.
- Structured hedging. This involves taking a complex asset or contract, then mapping it to its tradable components and trading them in the liquid markets.
The first three approaches are based on the superiority of one trading shop over another through infrastructure or superior trading skills. For trading to return as a successful industry segment, it will require the demonstration of added value through structured trading, rather than simply trying to beat the market.
Structured trading is basic risk management. It encompasses the process that maps a complex primary asset into its market components. Each market component is then hedged separately. Hopefully, when all the individual components are added together with the principle asset, additional profit has been locked in or risk has been reduced.
Let's look at hedging a power station. Some generation assets are relatively easy to map. A reliable coal