New mega-marketers, niche players emphasize opportunity.
The natural gas trading business has been on a roll since the mid-1980s, when the Federal Energy Regulatory Commission (FERC) issued Order 436, giving birth to the concept of gas marketing companies. Even when the calendar flipped to 2001 and much of the energy industry was swept into the turmoil surrounding the California electric industry restructuring fiasco, gas marketers continued to thrive in the low-supply, high-demand environment. Gas traders pounded out deals that earned record profits for their companies.
California's woes invited increased regulatory and political scrutiny of energy trading companies, especially those headquartered in downtown Houston. But the ethos of deregulation was too firmly entrenched for even a public relations disaster such as California to turn back the clock on wholesale gas trading competition.
"It's hard to put the genie back in the bottle," says Steve Weiler, head of the Washington, D.C., energy office of the law firm of Leonard, Street and Deinard. "The invisible hand of competition will continue to govern the market."
In her recent book on gas trading, Ann O'Hara, president of the consulting division of O'Hara & Associates, emphasizes the staying power of gas competition: "One thing will remain constant through all current and future FERC activities-the U.S. natural gas industry will not return to the former days of total regulation from wellhead to burnertip."
Indeed, the fallout from California never included serious discussion about a return to the old days of gas price control. No politician or regulator proposed putting a wrecking ball to wholesale gas industry deregulation. Resistance to such chatter was a testament to how entrenched gas marketing had become over the past 15 years.
On the electric side, there was the constant bickering over refunds to power customers in the West. And there was a vigorous battle waged by San Francisco activists against Pacific Gas and Electric to municipalize the utility's assets in the city. Despite a year of pronouncements by citizen groups blasting PG&E for poor management, liberal San Franciscans still failed to pass the referendum. The referendum's defeat not only reaffirmed PG&E's clout in Sacramento and in San Francisco's city hall, it also highlighted the energy industry's resolve to rally public opinion behind the perceived benefits of private control of utility assets versus the supposed waste incurred when government grabs control of yet another public service.
Energy companies understood California political figures needed to play to their constituencies. Expressing dismay at what they called price gouging, politicians attempted to stir up public support, including threatening to lock up certain Houston energy company executives if they stepped foot in the state. There was the ongoing El Paso imbroglio at FERC, which centered on accusations that the company exercised market control over gas supplies headed to California and favored its marketing affiliate in pipeline contracts. The new administration in Washington even shoved aside the nation's top energy regulatory cop because he embraced too strongly the values of the free market at the expense of political realities.
Gas industry officials viewed these as controllable events that could be isolated, thereby avoiding spillover into unwanted discussions about re-regulation. Industry players were confident that any reasonable person who took the time to examine the overall picture would find that today's gas industry offered a shining example of how a formerly tightly regulated commodity market could function with little government intervention.
But then the trading community was hit by the meltdown of Enron, the biggest and most flamboyant company in the energy marketing business. Many traders were stunned at how the company's financial standing could wither in such a short period of time. At the same time, as Enron grew at a torrid pace during the past 15 years, many traders inside and outside of Enron often found it difficult to determine exactly how the company generated all of its revenue.
"What has happened is perhaps vindication to my theory that it wasn't all real anyway," a trader with a competing marketer says. Another trader said he always thought of Enron as a solid company and was surprised by the severity of the company's downturn. "You're now seeing their dirty laundry," he says. Neither trader wished to be identified, reflecting a trend among marketing officials who are declining to comment for attribution about Enron's misfortunes.
While few competitors are shedding tears over its sudden reversal of fortune, Enron's saga is certain to force other top energy marketing companies to ensure risk management mechanisms are in place that allow them to avoid a similar fate. Based on the reported scope of the Securities and Exchange Commission's investigation into Enron, these other companies must contend with the specter of their trading operations facing closer scrutiny by government officials.
Ron Barone, an analyst with UBS Warburg, speculates that aside from harm to Enron and its shareholders, the Enron debacle could lead to "trading losses beyond VaR [value-at-risk] limits and unfavorable changes in the regulatory environment of the natural gas/power industries."
Once again, though, the Enron saga-combined with all of the other events of 2001 and their potential negative consequences-failed to dampen the optimistic mood that has fueled the gas marketing business since the founding of Natural Gas Clearinghouse (now known as Dynegy) in the mid-1980s. In fact, gas trading companies, especially those with production assets backing them up, had little time for worrying in 2001 because they were busy counting their record profits from last winter's sky-high gas prices.
Conoco Rising: A Gas Trader's Vision
Take a look at a list of the top gas marketers in North America and you won't find many names associated with the upstream end of the business. Most of the high-volume trading companies are the market-maker types who don't have production assets to back up their futures and swap contracts.
One heavy hitter in the exploration and production sector, though, is trying to make a play for the upper echelon currently dominated by financial service-oriented marketers. Conoco-the integrated oil and gas company, linked at different times during the previous hundred years to the Rockefeller and DuPont family fortunes-is enacting a strategy to join the barons of the 21st century energy-marketing world.
With its U.S. gas production totaling almost 300 Bcf in 2000, Conoco believes it has a strong foundation to make a rapid ascent into the mega-marketer echelon. The scope of its production assets promises to grow even larger following the completion of its mergers with Gulf Canada Resources and Phillips Petroleum.
What sets Conoco apart from other major upstream players, though, is its expertise with managing financial instruments and transportation and storage capacity, says Mike Stice, president of Conoco Energy Solutions (CES). "Conoco has developed a level of commercial sophistication," explains Stice, whose tenure at Conoco totals 20 years. On his previous assignment, as president of Conoco Gas and Power Marketing, a unit of CES, Stice managed the company's trading operations during which time the company's marketed gas volumes grew by more than 50 percent.
Today, Conoco markets 7 Bcf/day of gas, still far behind the super-mega-marketers, each of which markets at least 13 Bcf/day. If there's a slowdown in the expansion of the gas market from the projected 30 Tcf market by 2010, though, Stice believes the size of a company's trading book will determine whether it survives a shakeout. "We want to be one of the top five energy marketers. We want to be talked about in the same vein as Dynegy and Duke," Stice says.
For many upstream companies, the expertise ends at the wellhead. But during the past year, marketers have needed to tap deeply into their ingenuity to address the rapidly changing needs of their customers as prices fluctuated from the high end to the low end of the spectrum. "Last year, they were sweating reliability. This year, they are sweating getting rid of the gas," Stice says, referring to the transition from limited supply last winter to an abundance of gas this winter. In the current contango market, customers want to know "if you can make this [gas] go away in an economic way," Stice says.
Conoco can succeed in either type of trading environment, he argues, based on its flexible trading book. A winning strategy involves maintaining a "large portfolio," with a balance of industrial and local distribution company customers, Stice explains. "You should be able to make money in all markets," he says, alluding to the need for companies to succeed in both the record price environment of last winter and the "choppy market" that characterized trading during the last couple of months of 2001.
In order to leap from its current position outside the top-10 gas marketer club into the realm of the heavy hitters, Conoco will need to ensure all systems in its trading division are running smoothly. "Growth can be a double-edged sword," Stice says, explaining that the mid- and back-office functions inside a marketing unit must keep up with the dealmakers in the front-office part of the company.
Conoco doesn't believe other top trading players need to fade from the marketing space for it to join the mega-marketer club. In fact, Stice had hoped Enron's trading presence would survive in one form or another. "They provide[d] so much liquidity in the market," he says. "The Enron credit risk wake-up call was probably good for the industry."
Conoco isn't alone among affiliates of producers expanding marketed gas volumes. BP Energy's gas trading unit has made great strides in the past year with its parent company's emphasis on the "gas economy," and Coral Energy, a subsidiary of Shell, has a natural advantage with its task to market all of Shell's North American natural gas production.
And, of course, there's ChevronTexaco, which owns 26 percent of Dynegy and appears keenly supportive of Dynegy's efforts. In committing $2.6 billion of cash to Dynegy's short-lived takeover of Enron, ChevronTexaco Chairman and CEO David O'Reilly said his company's additional investment "underscores our belief in the long-term value potential" of the energy-marketing sector.
Stice still believes Conoco has an upper hand on many of its producer counterparts. "We steward gas from the wellhead to the customer," he says. He's also optimistic about the marketing business as a whole. "I do not believe this industry will suffer [from Enron's fall]," he predicts. "Gas and power marketing will be a healthy business model. ... Gas will continue to be the fuel of choice."
In announcing his company's decision to call off its merger with Enron, Dynegy Chairman and CEO Chuck Watson said, "While it is regrettable to see a leading industry player in difficulties, this does not reflect a failure of the energy merchant business."
A Long Way To Consolidation
Among the mega-marketers, a shift in power is occurring. Some are focusing on increasing the scale of their business while others are developing new products and improving the "service marketing" aspects of their business. Reliant Energy, American Electric Power, Mirant and BP Energy all have taken dramatic strides in expanding the volume of gas they trade and have joined the league of mega-marketers. Mirant and BP Energy, for example, recently acquired portions of TransCanada PipeLines' significant gas marketing and trading assets.
With the crash of Enron, a scramble promises to ensue for control of the market space left behind. For the third-quarter of 2001, Enron marketed a daily average of 26.7 billion cubic feet (Bcf) of gas. Next in the rankings for the quarter was Reliant Energy, with marketed gas volumes of 15.4 Bcf.
Whether there's consolidation in the marketplace or not, industry players say the rest of the market remains large enough for both mega-marketers and regional players to enjoy a piece of the pie. "There's always room for people who create value for their customers," says Eric Larson, senior vice president of marketing and trading for Entergy-Koch Trading, the marketing partnership established by the merging of certain assets of Entergy and Koch Industries last February.
"We're not anywhere close to an unhealthy consolidation," says Derek Porter, vice president of software products for Henwood Energy Services, a California consulting and software company. "Niche players will not get merged out." If the number of players did shrink considerably, the operating costs would climb too high and other smaller players would be able to enter the market and undercut the major players, Porter says.
"You'll continue to see regional marketers purchased, especially on the electricity side," says Joe Ewing, an associate with consultant Market Reach Strategies in Columbus, Ohio, and the former strategic sourcing manager of energy for Procter & Gamble. But regional marketers always will come back, Ewing explains. "Business is regional," he says. "It's not a national market."
Niche Players Alive and Kicking
One mid-sized marketer, Tenaska of Omaha, Neb., agrees with the philosophy that it's best to think regionally in developing your business. Tenaska, a name derived from "tenacity" and "Nebraska," was formed in 1987 by a group of former executives with Omaha's InterNorth, the pipeline company that merged with Houston Pipe Line in 1985 to create Enron.
Despite growing into a top-25 gas marketer, Tenaska remains a "regional marketer," says Fred Hunzeker, president of two Tenaska subsidiaries, Tenaska Marketing Ventures and Tenaska Marketing Canada. Hunzeker says he views his company as one that operates in the three distinct markets of Texas/Oklahoma, the Midwest and Canada, with a trading office in each.
Tenaska foresees East Coast gas pipelines and clients in that region as a possible growth area for the company, Hunzeker says. Any expansion into that region, though, would be gradual, he adds.
Tenaska also doesn't view consolidation as a negative development for the smaller trading houses because of its belief that many gas utilities and industrial customers prefer to do business with regional marketers. "We are seeing penetration into our client base increase because of the consolidation," Hunzeker notes, referring to customers who want to do business with a marketer that has an understanding of a particular market.
As for the plight of Enron, Hunzeker believes "someone else will play the role of market-maker."
Aquila, the large energy marketing company in Kansas City, already is seeing business swing its way due to Enron's downfall. "We're anticipating we'll see a lot more business than usual," says Mark Gurley, senior vice president and general manager of trading for Aquila.
Among the changes this winter, Gurley says Aquila will be working with local distribution companies on finding buyers for their large inventories of storage in a market already saturated with gas. During the summer, utilities refilled their contracted storage to near-full levels in order to avoid the price run-up and regulatory scrutiny that occurred last winter when production was low and demand was high.
"This winter, utilities are more worried about getting rid of gas," Gurley notes. Many state regulators blamed utilities for not adequately preparing for last winter's price run-up, a situation about which forecasters and analysts had sounded the alarm all during the summer of 2000.
For California, supply fundamentals indicate this winter will be much different than the last. The state should see adequate supply and stable electricity prices because of robust gas storage levels, much-improved hydroelectric capacity in the Pacific Northwest and softer demand due to the downturn in the economy, Gurley explains.
Despite the optimistic projections for this winter's gas and power supply in the state, some Californians still haven't forgiven marketers for their alleged profiteering last winter. And California consumer activists also aren't celebrating Enron's perceived comeuppance.
"The energy cartel already has done so much damage in California, and the only thing worse than that would be a more tightly controlled energy cartel," Doug Heller of the Foundation for Taxpayer and Consumer Rights in Santa Monica told the in reference to the short-lived merger proposal between Enron and Dynegy. "These [were] two lawless cowboys forming a single bandit."
Industrials Beat a Different Drum
For the end-user, consolidation also is a prime concern. "As mergers have occurred, you have had a real change of focus, with marketers focusing on their internal corporate structure and the customer has been forgotten," says Ewing.
Industrial end-users often build loyalty with a particular marketing sales representative and will show more allegiance to a representative rather than a company, Ewing says. When corporate consolidation leads to a sales representative leaving the newly merged company, end-users often will follow their old marketing rep to his or her new company.
During his tenure at Proctor & Gamble, Ewing noticed that FERC Order 636 led end-users to reassess other types of relationships. "Eight years ago, industrial end-users had close relationships with producers and their relationships with pipelines were adversarial," he says. That dynamic has changed today, with the producers abandoning end-users in many cases and pipelines offering more flexibility to industrials that hold capacity rights on pipelines, Ewing explains.
End-users also have grown more knowledgeable of the market in recent years, especially since last winter in response to the price spikes. "There's an urgency that they must control their own destiny," Ewing says. "They are significantly increasing their market intelligence," he says. They're not necessarily relying on their marketers or producer contacts for all of their information.
O'Hara contends large consumers of natural gas generally don't want to be a part of the gas industry and don't want to know every facet of the gas industry in order to purchase fuel at a reasonable price. "They just want to deal with someone they can trust," she says. "[M]any suppliers trying to sell gas to industrials felt that these customers, because they don't always understand the gas industry, don't necessarily appreciate that not all things are possible, and there are limits on what any organization in the gas industry can do."
Some large end-users are deciding to go with the total outsourcing of their energy buying needs because they believe it's more efficient to let knowledgeable third parties handle a task that's not part of their core business. But Ewing argues that end-users who separate themselves from energy procurement risk letting the marketers take advantage of them. "That's the worst decision they could make," Ewing says. These gas consumers tend to be those companies with cash-flow problem, he explains.
Ewing believes large industrial companies need to keep at least a portion of the energy procurement duties in house in order to ensure some form of oversight of costs and reliability of service. "I'm very concerned with one industrial that had an outstanding energy procurement department and then turned it loose," he says.
Risk Management Before the Fall of Enron
While end-users are advised to keep an eye on the conduct of their suppliers, analysts are urging trading companies to assess the financial standing of their trading partners. To facilitate futures and swaps transactions, energy trading companies extend credit to one another. The agreements are contingent on a partner maintaining an adequate credit rating. Aquila Energy, for instance, significantly lowered its exposure to Enron as soon as the company took a credit ratings plunge.
Entergy-Koch's Larson says his company has been "very diligent about managing risk" and that it focused on credit risk long before Enron's troubles. "We monitor who we do business with. We have a strong risk management culture at Entergy-Koch."
Henwood's Porter agrees that industry players were prepared for what happened with Enron based on the turmoil in Midwest power markets during the summer of 1998. "When Federal Energy Sales defaulted, they [marketers] said,
'Wow, this can happen.'" Federal Energy, a Rocky River, Ohio, power marketer failed to pay on a series of wholesale power contracts during a June 1998 heat wave and later filed for bankruptcy.
That summer's power shortage had a ripple effect on several companies in the Midwest, including FirstEnergy Trading and Power Marketing and Springfield (Ill.) City Water, Light and Power.
Despite claims by marketers that Enron's troubles have had little impact on the functioning of the overall North American gas market, some are blaming concerns about Enron's credit for higher-than-expected gas prices that hit the market in October. Apprehension about conducting a deal with a company that controls 25 percent of the market certainly could diminish liquidity in the market, analysts say.
Prior to rumors circulating in early November that Dynegy would come to Enron's rescue, cash prices at Henry Hub hovered in the $3.05/mmBtu range. After the Dynegy story began circulating, cash prices at Henry Hub had retreated to the $1.95/mmBtu range by the end of November. "Any time you lose a major marketer, there are concerns about liquidity," Gurley says.
Enron's downfall could have far-reaching effects beyond market liquidity, explains Will McNamara, an energy analyst with Scientech. "There is a larger issue at play here as well, and that is Enron's impact on the energy market as a whole," McNamara says.
As the major player in the trading sector since the mid-1990s, and one of the primary pushers for deregulation across the country, Enron's fall is having ripple effects across many sectors. "I've seen new reports that suggest Enron's problems will cause states that already had questioned the prudence of deregulation to further delay or terminate their plans to commence with electric competition," he added.
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