Merchant energy trading and marketing certainly has represented a valuable earnings growth vehicle to many utilities. That much is certain. But in the post-Enron world, many continue to question the legitimacy of the practice of inflating revenues through the trading business to bolster the company's financial picture. At least that's the view of the Petroleum Finance Company (PFC), which recently conducted a study called "Distorting Reality? Inflated Sales of Energy Traders."
A major concern of the PFC is that energy merchants do not follow uniformly stringent reporting standards for what they report as revenue for traded energy-booking the total value of the transaction as revenue, not just the net income of the transaction as investment banks do.
Of course, energy companies use what is now well known as mark-to-market accounting, which has the Financial Accounting Standards Board's (FASB's) blessing and comes into play at the end of each quarter.
That's the time when companies typically have their outstanding energy-related contracts on their balance sheets, either as assets or liabilities. CFOs then estimate the fair value of the contracts, based in part on their forecasts for market conditions. These quarterly changes in non-cash values subsequently show up on income statements.
Apparently, corporate managers have wide discretion in how they can interpret this rule, which has been one of the main sources of criticism of the approach.
In fact, FASB debated this technique for the past three years but ultimately decided to leave the interpretation to the individual companies, and so they have.
Many companies wanting to appear more transparent and more forthcoming than Enron have modified (only slightly) the way they report their mark-to-market earnings.
For example, in its first quarter earnings report, El Paso said it would no longer recognize trading book income on contracts going out beyond 10 years, resulting in a $61 million reduction in first quarter income from trading, marketing and customer activity.
Certainly, energy marketers are conscious of how this accounting is being perceived by outsiders, but they haven't abandoned the practice altogether, either.
To address this problem, S&P and Moody's are expected to impose new financial "metrics" with which to judge merchant energy companies, according to a senior industry executive.
Moody's is developing a new measure of a company's liquidity and will likely focus on the recurring cash-flow-to-debt ratio.
Meanwhile, some merchant trading firms have begun to report the value of their positions similarly, allowing investment bank Credit Suisse First Boston (CSFB) analysts more meaningful comparisons between companies.
CSFB has analyzed the value of the contracts entered into, changes in valuation techniques, and changes in the market movement of commodity prices.
In the critical areas of mark-to-market earnings, derivation of EBIT (earnings before interest and taxes) by the sub-sector of the merchant business, cash realization period, fair value calculations and credit profiles continues to evolve, CSFB said in its April 22 report.
Furthermore, mark-to-market EBIT is the dominant source of merchant EBIT for Williams, CSFB reported.
In addition, the bank assigned a discount for AEP and Duke, 47 percent and 40 percent, respectively, for their fair-value based on models and allowed a premium for El Paso due to its 91 percent of fair value based on active quotes.
The assignments were based on CSFB's opinion that the "most risky fair-value basis is mark-to-model, because of the subjectivity, and the most secure is prices based on active quotes in futures markets."
Also, the I-bank prefers to see relatively low-less than 20 percent-of EBIT derived from trading, because it is the most volatile.
But while high power clients of CSFB may glean new insights into the financial health of energy traders from highly intelligent equity research analysts, much of Main Street continues to be in the dark, preferring not to invest in anything that appears to be Enron-like.
Naturally, there is talk that the Emerging Issues Task Force (EITF) of FASB is looking again into whether to force energy companies to report their energy contract revenues on a net basis, rather than gross.
Meanwhile, like most industry watchers, I like to see the industry do well and get all the accolades it deserves. But I'd rather see those accolades bestowed on those who made it by reporting net.
Of course, that would mean that not everybody would make the Fortune 500 that made it in previous years using gross reporting. But isn't that the point? It should be a rating of all industries held to the same reporting standard.
Furthermore, energy companies might learn from some of the troubles Dynegy, Reliant and CMS Energy are experiencing from inflating their trading volumes.
Every quarter the energy trade press index newsletters have long published volume rankings to establish the so-called best-of-the-best in energy trading and marketing.
But when I have investigated this issue in the past, I have found that those very energy traders don't put much stock in it-as these marketers have readily admitted that volumes tell little as to the profitability of the trading concern.
And some marketers privately have admitted to inflating their volumes purposely to get a top ranking.
Even as traders publicly shrug off the volume rankings' significance, one finds those ranked highest promoting the fact in marketing material or on the trade floor to potential investors and clients. Even investment bankers that I know use those rankings in pitch books and presentations to potential clients.
That is probably why what has been a long-standing joke inside the industry is no laughing matter to a Securities and Exchange Commission wanting to protect investors from being duped-and already suspicious of power marketer accounting practices.
For example, U.S. financial regulators in mid-May put the microscope on electric-power trades by Dynegy that canceled each other out but appear to have boosted the energy company's trading volumes.
Dynegy's trades with a unit of CMS Energy were valued internally at a combined $1.7 billion and would have accounted for 13 percent of the total fourth-quarter value traded on Dynegydirect, according to the Wall Street Journal.
Experts generally agree that the prevalent reason is to create the perception of business being done, or at least create an illusion of volume.
But this illusion has cost Dynegy dearly. Its stock has tumbled more than 59 percent after revelations of the first SEC investigation into its now infamous Project Alpha, as well as a result of the investigation into its so-called volume deals.
In fact, Reliant Resources scrambled to pull a recently priced debt placement after deciding that some of its power transactions were a lot like those that had earned fellow power merchant Dynegy the scrutiny of regulators.
Trading of Reliant Resources' stock was halted on the New York Stock Exchange the same day of the announcing of the "Dynegy-like" deals, and the company witnessed its stock fall 17 percent to $12. Naturally, some of these volume deals might have been motivated simply to show how big a trader they were to the industry.
No doubt, after the millions lost in stock depreciation, after a drop in prestige, and along with an increased cost of capital due to impending or possible debt ratings downgrades, those marketers might be wishing they were a little more conservative in reporting volumes.
So too are the many shell-shocked investors who found out quite unexpectedly that ballooning trading volumes were full of hot air.