Energy traders and risk managers reengineered their business dealings to manage against unexpected political and financial risks posed by California and Enron in 2001.
The rules of energy market survival changed forever in 2001. California, one of the biggest U.S. energy markets, and Enron, the biggest domestic energy trader, were both humbled by gyrating prices and blackouts in the Golden State, and financial misadventure dethroned the once-crowned king of energy trading.
These twin events sent shockwaves through the very foundation of the energy trading and risk management establishment, which found it was caught ill prepared to handle the financial repercussions of the California crisis and the Enron financial debacle.
"We look at political risks around the world. We look at political risk in South America, Europe, everywhere. Two years ago, we didn't expect California to be the political risk it became," says a still disbelieving Harvey Padewer, Duke Energy's group president, energy services.
"The lesson in California is that it has a big crisis if they don't let market signals work. If they don't allow and encourage power development, they are going to be right back where they were. I think clearly over the long-term the federal government has to understand that price caps really limit market signals," Padewer says.
But while many energy traders and risk managers have since quantified, calculated and curtailed their financial exposures to the California crisis, many are still at a loss to explain what the impact to the industry will be as a result of Enron's financial woes.
On Nov. 28, Dynegy reported that it had terminated its previously announced merger agreement with Enron. The merger was seen as a last-ditch effort to save Enron from its financial troubles.
Surprise disclosures, including the admission it overstated earnings by almost $600 million since 1997 and kept huge debts off its books, led investors to lose faith rapidly in a company valued at almost $80 billion a little more than a year ago, according to Reuters press reports.
In early December, Enron's market value was barely $450 million. A U.S. regulatory probe into its murky off-balance sheet dealings and the unexpected departures of its chief executive in August and its chief financial officer in October helped fuel the fall.
On the day of the Dynegy's merger termination, Standard & Poor's, Moody's Investors Service and Fitch Inc., all downgraded Enron's long-term debt to below investment grade or "junk" status. In Enron's own acknowledgement of the merger termination, the company said that it would temporarily suspend all payments other than those necessary to maintain core operations.
"The industry has reacted well to the potential loss of a market participant over the last several weeks. With superior systems, technology infrastructure and people, Dynegy and its industry are ready to absorb any added volatility in the energy market," said Steve Bergstrom, Dynegy president and COO.
Dynegy said it stopped trading with Enron the morning of Nov. 28, pegging its exposure at $75 million. Other traders said they would deal with Enron on a cash-only basis, a virtual death sentence for a trading outfit that has $16.86 billion in debt and other obligations-and less than $2 billion in cash on hand, according to Reuters press reports.
Operations were also suspended indefinitely at Enron's once highly lucrative online trading system, EnronOnline. The unit accounted for up to 90 percent of Enron's earnings, and was considered the jewel of the trading franchise that Dynegy coveted most.
Enron filed to reorganize under Chapter 11 bankruptcy protection on Dec. 2, in one of the largest U.S. corporate bankruptcies ever. Enron also sued rival Dynegy for $10 billion, claiming the fellow Houston-based company had no grounds to scuttle a proposed buyout, according to a press statement.
"I think overall ... that liquidity has tightened up considerably. Whenever you have a major player, whether its PG&E or Enron, and you remove a participant you have fewer counterparts to deal with. If you look at the top 10 or top 6 trading companies, that represents about 80 percent of liquidity in the trading market. It makes it a little bit more challenging to do transactions. Sometimes it will cause a little lack of depth in liquidity in long-term transactions," said Lyn Maddox, president and COO of PG&E's National Energy Group, Trading.
As a result, some say that Enron should be likened to Long Term Capital Management. In September 1998, the Federal Reserve (Fed) organized a rescue of Long-Term Capital Management, a very large and prominent hedge fund on the brink of failure. The Fed intervened because it was concerned about possible consequences for world financial markets if it allowed the fund to fail.
According to one source, the Fed, as well as other energy traders, had been investigating whether an Enron failure would have dire consequences to world energy markets and the U.S. economy. The domestic implications could be substantial, some say, as Enron has represented approximately 25 percent of the U.S. energy market.
"I don't think this is a Long-Term Capital situation. The counterparts of Enron have had time to reduce their exposure to Enron and to begin trading with other counterparts. We ourselves have worked down our exposure. If everyone has done the rational thing, this should not be an issue," says Padewer.
A Power Trader's Trial by Fire
Lyn Maddox, the head of PGE's energy trading subsidiary, has seen the worst of it. He's had to maintain a trading business as his company's utility slipped into bankruptcy in 2001-one of largest in U.S. history-as a result of the California crisis. Maddox says he has learned some very valuable lessons from the event-lessons that many in the industry are only beginning to learn as a result of Enron's misadventure.
"I can tell you from experience when you have a bankruptcy event ... as Enron ... as with our utility affiliate Pacific Gas & Electric ... you'll find that some of the credit provisions you have in your trading contracts where you were once a healthy investment grade company and now considered junk is a very challenging event," he says.
One thing that always happens in credit that people forget about is that contracts have to be unilateral in case the tables are turned, Maddox says. "That is oftentimes what haunts you. If you are high investment grade at one point in time and the next thing you know you are junk, your own language will eat you alive.
"[Furthermore], what surprises people is the amount of cash that it can draw out of an organization. I know that Enron [had] to be feeling [the] pain. Certainly, we went through our period where we tried to keep up with those things. But counterparts were very good to work with us and we managed through it," he says.
Maddox says his success at restoring investor and counterpart confidence could be attributed to doing one very critical thing: living up to the letter of the law in all his contracts with counterparts.
"The first thing we had to do is we absolutely lived to the letter of the law in all of our contracts. We did not want anybody to use the case that we had defaulted on a performance event or payment event, or anything like that. That gave our counterparts the confidence that [we're] going to perform no matter what under our contracts."
The other thing Maddox did was to make sure that the credit department's independence remained strong when enforcing its requirements on the trading organization.
"Particularly in energy, there seems to be a lot of strong personal relationships out there and often times that clouds the best judgment while people try to manage their credit issues. But it is nothing personal. You have to make sure you protect your shareholders and protect your company by having sound credit requirements. We have very formal requirements through our risk management policy that we have to produce."
Furthermore, Maddox says that during a credit crisis a company wants to have many different types of collateral facilities at its immediate disposal so the company can respond to the event.
"The perception creates the reality. There are events in the market that will make it look like you are a worse credit call than you are. People get concerned about your ability to be able to handle your market calls. Often times, the only way to deal with market calls if you have big positions on, and high volatility, is to either liquidate those positions or to post cash, or letters of credit."
Finally, Maddox believes that the company's asset-based strategy helped it through its darkest hour. "A strong balance sheet, whether you are regulated or non-regulated business, is absolutely necessary to be in the energy business."
Yet some feel Enron will never be able to be completely replaced-since the company took risks that most others were unwilling to take-which has precipitated the current liquidity crisis.
David Shimko, a principal consultant for Risk Capital Management, a boutique risk consultancy, and a finance professor at the Harvard Business School, explains, "There are two kinds of liquidity crisis [that developed] with Enron. One is that a lot more people are trying to be more vigilant about demanding collateral in trades, anticipating the possibilities of default and trying to be more aggressive to make sure they have cash or securities on hand in case of default.
"At the same time, there is also the other liquidity crisis, which is that Enron was the only market maker in a lot of different areas. I was out in Calgary last week and talking to some folks who were saying, 'What are we going to do about our Rockies' power position?' There was no one out there except for Enron that was willing to offer anything of length in the Rockies in electricity. These folks thought that they had a market that they could go back to and reverse their positions if they ever thought they wanted to. But now they are stuck with these five-year plus positions. They can no longer liquidate. They are now viewing these risks differently in looking at these trades as things that cannot be offset but risks that have to be warehoused."
Shimko also says the only way to truly unload the position is to unwind the position with Enron. "But if Enron is not in a position to do so, than you are stuck," he says, explaining that setting up a hedge for that position would be useless because if Enron eventually defaulted on its contract, "you wouldn't be hedged at all."
Managing the Risks: The New Frontier
Mark Williams, vice-president of global risk management at Edison Mission Marketing & Trading, says there is a higher level of sophistication in regards to what goes into credit and market risk analysis. There is particular emphasis on not just standard credit ratios, but also on the understanding of the volatility of market prices and how that influences both credit exposures and market exposure, he says.
"The level of sophistication and analysis that is being done on the credit risk and the market risk side has been elevated because there is a tighter link between market price movements that affect credit events. Because of the speed in which these companies can go from investment to junk status, there is a lot more emphasis on really understanding cash flow and standard type ratios, and stressing under certain scenarios how these various balance sheets and income statements would hold up."
Duke Energy: The New King?
With the bankruptcy of Enron, the industry is now looking for a new leader and role model. Some have started looking at Duke Energy to pick up the torch from Enron in the areas of electric competition advocacy and lobbying, as well as looking to the company for leadership on overall wholesale market development, design and innovation.
"We continue to believe that wholesale deregulation needs to happen in this country and think that it is a good thing for ratepayers and consumers," says Harvey Padewer, Duke Energy's Group President, Energy Services, who says his company has consistently lobbied and will continue to be an advocate for competitive markets. Could Duke Energy be that leader?
In terms of revenues in 2000, Fortune's list of America's top companies ranked Duke Energy at No. 17, which was the next largest power and gas trading concern after Enron (at No. 7 before its bankruptcy) and excluding the oil majors whose earnings are still the largest in the energy space.
Duke Energy generated revenues of more than $49 billion in 2000, has $58 billion in assets, and is the largest producer of natural gas liquids (NGLs) in the United States. Duke Energy has long believed that its corporate structure-having regulated and unregulated operations under one umbrella-is one of the reasons for its success. It's a corporate structure that many in the industry have recently shown a preference for (see , December 2000 issue, Frontlines).
"I think people before thought they could be a pure play generator and a pure play trader. We have recognized for years now [that] a better strategy is balancing assets, trading and growing our business across regions, not only in the U.S., but also across the world, and across commodities," says Padewer.
He believes people are recognizing that Duke Energy's strategy is more robust and can withstand a lot of different economic impacts. "As a consequence, I see a trend going back in that direction," Padewer says.
"Look at Constellation and look at Aquila. Even Enron said before they had trouble that they wanted to go back to assets. That is a general recognition in the industry," he says.
Padewer believes that one of the advantages of having a trading operation with generation assets allows the company to capture the extrinsic and intrinsic values of the plants.
"We call that the intrinsic value or the gross margin of the power plant which is simply the difference between the cost of fuel and the price of power. If you had enough gross margin, you justified building the plant. But over time we have found that we create a huge amount of value from the extrinsic value, not only the intrinsic value," he says.
"Remember, a power plant is a spark spread option. Any option has intrinsic value. The extrinsic value is trading the volatility. We see volatility still remaining strong. That component has become a larger component in the earnings of our generation. So, extrinsic value in our component still gives us the ability to justify building power plants going forward," he says, explaining how his company hopes to insulate itself from a possible overcapacity market in the next few years.
"[Furthermore], one of the issues that separate the pure plays and people like Duke is that a pure play generator-that doesn't have strong trading operations and doesn't understand the markets in a way a trading company does-can't extract that extrinsic value, by definition. That is the reason that some of the pure plays are getting into trouble." It appears a leader is born.
For example, Calpine is basically short natural gas and long turbines. In an environment where natural gas prices keep going up and there is overcapacity in various markets, Calpine is not going to do well, Williams says.
"The scenario that does not work for their business model is high gas prices and low power prices and overcapacity. There is a lot more focus on business strategy. Where does that company fit? Are they asset light or asset heavy? The talent that is being hired on the credit side is getting much more sophisticated. You are seeing more former banker types that are not only familiar with good credit, but more importantly bad credits that haven't worked out. They know what it is like to make a loan and have it go south. A lot of the credit officers in the power industry are brand new and they haven't worked through a situation like that."
As a result of Enron's now famous losses from its off-balance sheet transactions-which when reported, caused an investor backlash and reversed the company's fortunes-risk managers are now concentrating their attention on these sort of off-balance sheet deals by other counterparts, Williams says.
"A perfect example is, two weeks ago El Paso went to the market and said, 'Hey, we don't have very many off-balance sheet transactions, but this is what we do have.' They are very transparent to Wall Street. They said, 'Hey look at us,' " Williams says.
Furthermore, questions of what percentage of earnings are being generated as steel in the ground versus trading operations, which are a less predictable revenue stream, are being asked. "That is an important question. That is the question that wasn't being asked just six months ago," he says.
"With Enron, the majority of their revenues came from trading operations. Take a shop like Reliant, and a much smaller percentage comes from trading operations and the rest come from owning steel in the ground. Look at Calpine. How much of its revenue is trading related versus steel in the ground? [It has] a lot of projections of phantom plants that they are going to be putting up in the next 3 to 5 years. But clearly trading revenue is a very small percentage of their overall revenue. The quality of their revenues as it relates to trading revenue is less in question."
Brett Humphreys, a principal consultant at Risk Capital Management, explains that an outgrowth of the Enron credit issue is that good credit risk managers are not simply taking the ratings from the ratings agencies for granted. "They are doing their internal analysis. They are looking at the financial statements. They are looking at the company and saying, 'Is there anything that I should be concerned about?'" he says.
"The problem that many of these companies face is that Enron was the only counterpart. You had a choice: You could not trade, not get into or out of these positions, or take on more credit risk with Enron. If you could negotiate deals with Enron to give yourself some collateral or credit protection, that was great. But, a lot of companies didn't."
Diversification: Is It the Key?
The Enron debacle made one thing quite clear: the power industry had too much exposure to one counterpart-Enron. Going forward, the industry is taking steps to participate in markets where financial exposure to counterparts is diversified. "I feel the markets can function without Enron, but I feel that there will be massive pains. [Of course], you have a number of other players like Dynegy, Duke, Mirant, Williams, Koch/Entergy, which are as capable as Enron and willing to fill in that vacuum, take up that liquidity and grow and survive," says Risk Capital Management's Humphreys.
Williams explains that a new trend will emerge where dominant players will still exist, but more second-tier players will get more business. The reason for this trend, he says, is that people feel more comfortable spreading out the risk. Williams says he would rather, for example, have $5 million in exposure with 20 counterparts than have $10 million with 10 counterparts, adding that the market is encouraging business with counterparts that normally the market didn't focus on doing business with.
"What's going to happen in the next nine months is that Enron's volume is going down. The volumes will be dispersed among various players," he predicts.
"People went to EnronOnline because it was the first medium that really had good transparency and quick trade execution. It was useful because it provided pricing information for forward deals. No one thought it would take off last year because of the lack of diversification but it provided good price discovery. The trend is going towards a broader platform with multiple counterparts. The Intercontinental Exchange [ICE is an online exchange funded by several investment banks and energy companies] provides greater counterpart diversification."
Padewer, whose company has an investment in ICE, explains the diversification comes from the fact that the owners of ICE are seven separate companies (Duke, American Electric Power, Aquila, El Paso, Reliant, Mirant, and British Petroleum, or BP) that represent 40 percent of the market.
"Volumes have really taken off. ICE is becoming the dominant trading platform. But clearly we are seeing more liquidity, more counterparts, [and] we are seeing growth in that business. We are very excited about it. These two things go hand-in-hand," Padewer says.
"I think that the larger players will migrate to primarily online types of trading. I think the smaller, less sophisticated players are going to deal with brokers. I think brokers will still be an important part of the business," he says.
Of course, not all will be strictly online. "I can't see long-term contracts being done online. It will be done by relationships and by sophisticated structuring of optionality. Those are the things that we like to do for customers as part of our business. It will never be purely one or the other."
Price Spikes, Defaults, Financial Meltdowns: A Cry for More Regulation?
Kenneth Raisler, partner at the law firm Sullivan & Cromwell, rejects the notion that the Enron meltdown should invite regulation from a regulatory body such as the Commodities Futures & Trading Commission or FERC to regulate the over-the-counter and online OTC energy markets.
He does not believe that such bodies should set reserve limits for energy market players in much the same way the 1988 Basel Accords set bank capital standards for market risk (the risk that a bank's value may be adversely affected by price movements in financial markets).
"Fundamentally I don't think the government ought to restrict innovation and progress and fundamentally all these systems are the next generation of communication," he says, adding that while the speed of transaction and the cost of transaction comes down, the issue of counterpart credit is the same.
"The notion of the government regulating the way that government extends credit to another counterpart, or the way in which lending is performed, is something the government has seen fit not to do and would not be appropriate," he says.
Furthermore, he explains, in a clearing structure (which ICE has proposed) where you have mutualization of risk among a variety of parties, there is no meaningful capital obligation imposed by the CFTC.
In addition, anyone who trades with anyone else ought to be comfortable with the credit of its counterpart. "Where is the federal government providing value in that discussion? I don't think it does," he says.
He explains there are a lot of reasons why banks have to have capital requirements associated with their business because of the functions they perform and the central role they have in the U.S. economy.
"General Motors does not have a capital requirement. Dupont does not have a capital requirement. So, what is the value added of imposing that? It basically means that you are restricting the freewheeling, free enterprise economy for reasons that cannot be justified. If you decide to do business with another company, you take the risk of that company's default. That has always been true. That is inherent in any contractual relationship. The notion that the federal government is there to protect the company or to protect you, or to protect the safety and soundness of that deal that you have done, that layers into the equation a cost."
Raisler concludes that the fact that the commodity is highly volatile only emphasizes the need for state-of-the-art risk management, or a lot of capital. "I don't think that there is anything that distinguishes trading in one volatile commodity versus another commodity."
Paper or Physical? Energy Markets Get More Physical
In the wake of the Enron situation, energy traders and risk managers say they prefer pure power, rather than a check, to back a deal.
"I think a lot of players don't want the bank and a lot of non-physical players getting into this business. It is not in their interest to divorce physical from financial. It helps to erode their competitive advantage. Going back to Enron as an organization that pushed things in the direction of paper or financial deals. As a result, there is a push back from that. There is a natural regrouping," Shimko says.
"What we have learned is that you can't use paper to manage your risks. A classic example is when the Olympic Committee was looking for power suppliers for Atlanta, they had two bids to consider. A bid from Southern Co, the incumbent, if you will, and a bid from Enron that was lower.
"Had they gone for the paper transaction for lower priced power, it would have seemed to make sense for them and would have in some sense given them a better risk profile because they would have a better pricing structure as a result. But the physical risk was too great. What if Enron, for whatever reason couldn't get power to the Olympics? It would be a global disaster. You can't solve all your problems with paper," Shimko says.
PG&E's Maddox, describes the current mix between physical and financial by saying, "In gas, it is 90 percent financial and 10 percent physical. In power, it is the exact opposite. Why is that? With power, we have a lot of financial settlements and not necessarily a lot of physical delivery but they all originate as a physical deal. That is why you see the differences there."
Maddox believes the New York Mercantile Exchange contract has helped natural gas, but it has not developed in power. He believes that the industry continues to head toward increased specialization in the type of deals that it does-which is not complementary to a standardized financial product traded on a futures exchange.
"It is the specialized products where money is being made that it helps with load factors such as load shaping, depending on how states regulate. Until you get liquidity that is standardized from state to state and ISO to ISO, you are going to have products that are unique to those areas that are going to be unique to the weather patterns of those regions," he says.
Maddox says trading companies are looking for new products that solve the real problems by segment. "I think you will see differentiation by industrial product, muni product, and weather products. The real world will have a structured type of commodity product."
Of course, fundamental products such as 5x16s (trading 5 days, 16 hour pre-scheduled deals) are things that a machine could trade, he says, adding that you could program a computer to trade it. He says many trading companies are looking into program trading of this standardized product that would execute in the market at a pre-selected price, as energy companies are over-burdened sometimes with the high volumes that are associated with typical daily business. While there are more specialized products offered by online trading markets, Maddox says his customers are looking for more non-standard type of products.
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