The Utility Sector: A Wall Street Takeover?

Financial players bring credit depth to energy markets, but will they play by the rules?
Fortnightly Magazine - January 2004

Financial players bring credit depth to energy markets, but will they play by the rules?

The center of gravity for energy marketing and trading activity is moving from Houston to Wall Street. Some major financial institutions already have plunged into the market, while others are testing the waters, gearing up to participate in a bigger way. Already their impact is being felt, and it is most definitely welcome.

"Financial players are providing a significant portion of the liquidity in the market-on the order of 30 to 40 percent," says Richard Hunter, managing director with Fitch Ratings in New York.

Financial companies that are trading gas and electricity contracts include commercial banks like ABN Amro, Bank of America, Citigroup, Deutsche Bank, JP Morgan, and UBS; hedge funds, including Citadel Investment Group, DE Shaw & Co., and Susquehanna International Group; and investment banks, like Goldman Sachs, Morgan Stanley, and even Merrill Lynch (which sold off its energy trading organization to Allegheny Energy in 2001 and was sanctioned by the Securities and Exchange Commission for its Enron dealings). According to sources at Merrill, the firm established an oil and gas trading desk in April 2003, and hired several people to conduct trades.

While some firms are taking tentative steps into the energy markets, others are making bigger investments. Goldman Sachs and Morgan Stanley, in particular, are putting money in the ground by acquiring hard assets in fuel and electricity. Most recently, in October 2003, Goldman Sachs agreed to acquire Cogentrix Inc. in a $2.4 billion deal that includes 26 power plants generating 3.3 GW of capacity.

"Our strategy is to have a balance between physical and pure financial activity," says Doug Kimmelman, a partner and managing director with the Goldman Sachs Commodities group in New York. "We believe that owning a modest amount of physical assets will help give us credibility and stability in the marketplace. It will also help to educate us on market dynamics that will benefit our trading activities."

The facilities acquired by the company all sell power under long-term contracts-a sharp contrast to the merchant plant concept (though some excess capacity remains, which Golman says it will sell at wholesale.)

"Merchant plants still face some significant valuation hurdles," Kimmelman says, pointing to the negative spark spreads that have submerged the merchant power industry. "We'd prefer not to take the price risk associated with a merchant plant, and we think we can meet our strategic objectives of building our power marketing and trading business through ownership of contracted assets."

Goldman's strategy won't help the ailing merchant power business, but it does represent a bright spot in the otherwise gloomy wholesale power market. "Buying up contracted plants is just monetizing contracts. But financial players are getting into energy marketing and trading, and that is something to watch," says Peter Rigby, a director with Standard & Poor's. "They have the balance sheets and expertise necessary to succeed."

To the degree these and other well-financed companies enter the energy trading business in a significant way, the market's long, dry spell could be coming to an end.

Deep Pockets

As 2004 begins, U.S. wholesale power markets are illiquid and opaque.

"Liquidity dries up fast if you go out more than a couple of years," says Ted Murphy, senior vice president and chief risk officer with Cinergy Corp. "If you are looking for a customized product, or anything further down the curve, there are a lot fewer players out there than there were a couple of years ago."

Because discovering accurate prices depends on liquidity, the thin market makes hedging more difficult. At the same time, credit worries have driven up demand for collateral, pushing all but the strongest companies out of the market. Debt refinancing and restructuring activities during 2003 have helped, but a credit drought persists.

"The top 10 energy marketers from a few years ago still have very poor credit," says Mark Williams, an executive in residence at Boston University. "Credit is the lifeblood of trading. The market is very leery about these counterparties, which means there isn't much volume being traded, and it is being done by a narrow group."

For example, as few as 20 traders conduct virtually all the trading activity for electricity futures in PJM. Compare that to some 200 traders for natural gas futures on the NYMEX. While this shortage leaves a lot of room for new entrants, it also makes it difficult for the newcomers to assess risk. Many of the most active traders do much of their business over-the-counter; a large share of the market's price information may not be publicly recorded.

"Those that are taking advantage of the inefficiencies in the market have proprietary models and better access to information," Williams says. "The market and the smaller counterparty can't benefit from that information."

All these trends tend to favor the players with world-class risk-management capabilities and balance sheets. That gives them greater flexibility than leveraged merchant players would have.

"There is clearly an opportunity in the market for entities that have a stronger balance sheet and higher credit rating," says Dan Gates, a managing director with Moody's Investors Service in New York. "In some cases they may be able to get more out of the same asset than an entity that is financially stressed. They can enter long-term contracts and do things from a trading perspective that a weaker entity cannot do."

Nevertheless, this situation could spark two positive trends for the industry. First, it could prompt more plant sales, as deep-pocket players develop comprehensive trading strategies and seek hard assets to back their positions. "You'll see more assets change hands because they will be more valuable in the hands of a better-financed player," Gates says.

Second, it could serve eventually to expand the tenor and terms of contracts available in the market. Companies that enjoy a stronger credit position are better able to manage risks further out on the curve. "Financial players can bring some flexibility on the risk spectrum and might be able to provide specialized and exotic products, such as load-following contracts or other options," Murphy says.

Not all financial players in the market are necessarily willing participants, however. Specifically, some banks are taking possession of merchant power plants when their original owners default on senior debt obligations. In the past year, Exelon, NRG Energy, and PG&E's National Energy Group together surrendered nearly 10 GW of generating capacity to lenders BNP Paribas, SocGen, Citibank, and ABN Amro. More such defaults are likely to follow in the next year, through loan write-downs and bankruptcy proceedings.

Given the current depressed market for merchant assets, banks seem likely to hold on to such facilities until such time as they can liquidate them in a more favorable market. Some banks are trying to negotiate long-term power sales contracts, but that will prove difficult for merchant plants facing a negative spark spread. How banks will manage such plants in the meantime remains to be seen.

"The previous owners might have been in the business for cash, but the banks could take a more sophisticated view," Hunter says. "Their balance sheets give them the flexibility, for example, to take plants off line if they think it will lead to better prices in the market for their overall portfolios." That is what happened in the United Kingdom and Spain, Hunter explains, when better-financed buyers acquired power plants but then faced a negative spark spread.

The degree to which a plant owner could employ such a strategy in this country, however, is another question. In issuing its market behavior rules in November, the Federal Energy Regulatory Commission (FERC) said that causing or attempting to cause an "artificial shortage by physically withholding sufficient and otherwise available power from the market for the purpose of raising the sales price obtainable by other units participating in the market" would be considered forbidden market manipulation.

Legal Limbo

In some sense FERC's market-manipulation rule is unfortunate, because it may discourage speculators from trading around price imbalances-a basic function in an efficient, liquid market. Listen to Sharon Brown-Hruska, a commissioner with the Commodities Futures Trading Commission (CFTC):

"In our effort to squelch manipulative behavior, we may end up unwittingly nurturing it by encouraging noncompetitive, illiquid markets," she said in an address given in October. "The true enemy of manipulation is competition and liquid markets."

Not only does overly broad regulation discourage competition. The mere prospect a federal agency bringing charges of market manipulation can add uncertainty to the already frail wholesale power business.

"A FERC investigation can go on for weeks and months. The impact on ratings can be more significant than the penalties might be, because it creates uncertainty," Hunter says. "That gives us cause for concern."

Uncertainty, of course, is the enemy that risk managers are always struggling to defeat. So the banks and financial houses must learn to navigate the industry's shifting regulatory landscape, along with everyone else. Several key features of this landscape remain in flux as the new year begins:

  • Little Experience. FERC's market behavior rules are brand new, and have yet to be tested in either the real world or the courts. The commission waded through comments from more than 60 companies during the review period, and not everyone was satisfied that the final rules addressed their concerns satisfactorily.
  • Slow Progress. Delay in forming regional transmission organizations (RTOs) contributes to a sense of unease over the industry's long-term future.
  • Environmental Risk. Emissions rules could skew prices for power. Under the Clean Air Act, many coal-fired power plants will face the choice of installing selective catalytic reduction equipment, buying emissions credits, or mothballing.

"Companies potentially will be turning off coal-fired machines that they might otherwise turn on, and that will cause more volatility," Murphy says.

On the other hand, if changes to the Environmental Protection Agency's New Source Review policies survive the current federal court battles, the mandate to clean up or shut down may not be as pressing in 2004 and 2005 as it would have under the old rules. This factor, combined with the Bush administration's Clear Skies initiative and corresponding efforts to enact global warming legislation, make environmental regulation a decidedly unknown quantity.

Congress spawns even more uncertainty. When Senate Democrats blocked the omnibus energy bill (H.R. 6) with a filibuster in November, they left many questions unanswered-including such politically safe questions as tighter reliability standards for utilities and extended tax credits for renewable energy. But perhaps more importantly, the industry is left wondering what will happen with the Public Utility Holding Company Act (PUHCA), which H.R. 6 would have repealed.

"PUHCA is an arbitrary trade barrier, frankly," says Doug Dunn, a partner with Milbank, Tweed, Hadley & McCloy in New York, and chair of the firm's power and energy practice. Large foreign utilities have largely stayed out of the U.S. power market, he says, because they feared the effects of PUHCA regulation.

Repealing PUHCA would open the market not only to foreign utilities, but also to "other potential players, whether financial firms or big oil companies, that have deep pockets but haven't wanted to become ensnared in utility regulation," Gates says.

Whether or not PUHCA's repeal would open up new opportunities for financial players, its current state of limbo represents a stumbling block for possible market entrants

At this writing, Senate leadership was planning to revive the energy bill in early 2004, in hopes of defusing opposition by stripping out the controversial section on liability for the MTBE fuel additive. Thus PUHCA repeal may retain good chances for passage in the new year.

Merchant Makeover

Despite lingering uncertainties, current trends seem to favor the participation of well-capitalized energy traders. With any luck, these firms will help to revitalize the anemic markets with greater credit depth, trading volume, and price transparency.

That's good news for traders, but it brings little hope to decimated merchant power companies, which are caught between a looming debt load and a negative spark spread. Debt restructuring offers a reasonable short-term solution for some, but in the long run the real solutions may prove more dramatic. Think bankruptcy and asset liquidation.

"We're not seeing the consolidation that might help the industry," says Rigby of Standard & Poor's. "Until plants start getting knocked down, you'll still have this capacity problem. Almost every report on reserve margins says this problem stays with us, possibly to the end of the decade. It's hard to see merchant companies climbing back out of the debt hole and into investment-grade ratings."

That leaves the question of whether the only successful merchant power model will be one that involves large-scale financial firms and multinationals. "The cyclical and capital-intensive nature of this business has not gone away," says Cinergy's Murphy. "It has been transformed with deregulation and trading, but you still need a strong capital structure to ride through those cycles."

The next phase in the evolution of the merchant power industry might be here already, as financial firms take ownership of distressed merchant plants-willingly or otherwise. Perhaps they can develop a new merchant business model that is built on a foundation of capital management-not just cash flow-and backed by a balance sheet that can endure the ups and downs of a volatile market.

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