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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

toward more sophisticated risk-management strategies—albeit less so at operating companies than at the holding company level, where investors will seek growth in unregulated businesses. “The market is back, in a different way,” Shields says. “The future of energy trading is global, multi-commodity and both physical and financial.” As old wounds heal and experience builds, integrated companies will look again at energy-price arbitrage as a competitive opportunity.

“Utilities are at a strategic crossroads,” Shields says. “They are asking whether the parts may be greater than the whole, whether they should keep them conglomerated or not, and in either case, how energy trading fits into the business.”

Another key question for utilities—as well as their ratepayers and regulators—is whether the current market trends are sustainable, or whether they are just part of another boom-bust cycle. This uncertainty is exacerbated by what is perceived as the sudden interest of so many banking and investment groups, some of whom are notorious for following the latest exuberant fad on Wall Street.

“A lot of the new players have a history of getting in and out of the commodity business,” says Brett Friedman, managing director with Risk Capital Management Partners in New York. Many of these firms could pack up their trading desks again if they find margins are tighter than they expected.

“Some banks are overestimating the returns they realistically will see, because they’ve heard about others making a lot of money,” Friedman says. “But 2005 had a lot of volatility. If you couldn’t make money in 2005, I don’t know when you would.”

Moreover, the hedge funds and investor groups that are providing volume and liquidity in the markets depend on the current volatile-and-rising fuel-price conditions to generate arbitrage income. While current trends suggest energy-price pressures and volatility will persist for at least several years, hedge funds might lose interest in an increasingly competitive and efficient market. Time and experience will show which of the new market entrants have staying power.

“Getting all those traders in one room is a capital-intensive exercise,” Friedman says. “I see liquidity and volume going up, but the market isn’t that big. Not all the banks will be able to make a living at it.”

Exchange Clearing

Despite a measure of skepticism about some of the market’s participants, the energy trading business in general is being rebuilt in a way that seems inherently more stable and sustainable. Instead of being dominated by “paper” trades, energy-marketing volumes today reflect a better balance of physically and financially settled transactions. The physical markets themselves are more accessible, with RTOs and ISOs maturing significantly in the past two years. And market participants are subjected to rigorous credit-control policies and standards, developed to prevent the kind of counterparty defaults that decimated confidence in the markets the last time around.

“The overall credit quality of the industry is better,” says Sid Jacobson, managing consultant with PA Consulting Group’s global energy practice in New York. “Financial institutions are bringing their balance sheets to the game, and the industry’s sophistication is increasing, with more sophisticated price structures and more