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Market Resurgence

Banks are reshaping the energy-trading landscape. When the dust settles, utility companies will face different strategic horizons.

Fortnightly Magazine - March 2006

energy-marketing operation—including the much-celebrated EnronOnline electronic trading platform—the bank quietly shut off the lights in Houston. Hundreds of energy traders were laid off, and EnronOnline—renamed UBSWenergy—vanished completely.

UBS Warburg was neither the first nor the last banking company to pack up its electricity-trading desk after the bubble burst. Merrill Lynch, JP Morgan, Citigroup and several other banks withdrew from or scaled back their energy trading during 2002 and 2003. When the attrition finally stopped, just two major financial institutions—Morgan Stanley and Goldman Sachs—were left to divide the field between them.

By then, it wasn’t much of a field. Volumes were anemic, prices were volatile, and creditworthy counterparties were scarce. Futures markets effectively collapsed, leaving little trading activity except physically settled bilateral contracts. Public Utilities Fortnightly noted at the time, “Electricity trading may not be dead, but it is definitely in a transitory state between its high-flying past life and an unknown future” (“Down But Not Out ,” Public Utilities Fortnightly, Jan. 15, 2003).

However, even at the market’s nadir, signs of recovery began to appear. Bank of America, for example, filed to become an energy trader in 2002, and Merrill Lynch opened a small gas-trading desk in 2003. The following year, a host of banks and investment groups began hiring traders and building their presence on the post-Enron landscape. Since then, banks have plunged into the fray.

“There are more financial entities in the market than there were in the past,” says John Woodley, a managing director with Morgan Stanley. “The outcome has been growth in liquidity, more products, and more competition to provide risk-management services.”

Quantifying the accompanying rise in trading volume can be difficult, because markets have been changing and growing rapidly (see Table 2, “Electricity Futures: Evolution at NYMEX,” p. 34). For example, in mid-2003 three electricity futures contracts were being traded on the New York Mercantile Exchange (NYMEX). At this writing, NYMEX offers 35 financially settled electricity futures contracts, and one options contract. Additionally, the Intercontinental Exchange (ICE), based in London, trades a variety of contracts across 18 U.S. hubs.

Volumes on these contracts vary; NYMEX recently delisted three physically settled futures contracts, and price uncertainties in late 2005 drove some participants into defensive mode, which reportedly constrained volume somewhat. But through most of 2005 and continuing into 2006, traders have seen a healthy flow of transactions, accompanied by respectable levels of liquidity and price transparency.

“The market sprang back very quickly,” Woodley says. “In terms of depth and term, it is probably as liquid as it has ever been. One merely has to look at the recent refinancings of large power plants on the back of long-term off-take contracts to see this.”

As examples, he cites the oversubscribed debt flotation for Complete Energy Holdings’ acquisition of the 1,000-MW La Paloma power plant in California; the successful syndication of $950 million in debt for the acquisition of Reliant Energy’s New York City power plants by Madison Dearborn Partners and U.S. Power Generating; and a competitive field of lenders that assembled to finance the $410 million acquisition of