For whom the bell tolls

Ridiculous as it may sound, a group of obese Americans are suing four fast food chains for selling food which they (the food outlets) knew was fattening and unhealthy. So what is the motive here? Perhaps it is part of a plan to secure enough funds for a supply of even more fattening food. A clever scheme. Or at least, when analysed closely, clever in its simplicity.

Yet the world is full of clever schemes and strategies to make ‘money’ and reduce risk. The likes of Enron and the other energy traders have been the ‘pioneers’ in the power business – pioneers who have come to grief as a result of their round trip trades. These are deals designed to increase trading volumes and thus boost share prices. Unfortunately, the negative speculation surrounding the likes of Enron and these deals is now having a knock-on effect to other types of companies and trading deals.

Both Royal Dutch/Shell and TXU have come under the spotlight in recent newspaper reports. Analysts raised concerns about Royal Dutch Shell’s decision to commit up to $7.4 billion to secure gas and power “tolling” deals in the US over the next 20 years. TXU, meanwhile, has a number of tolling deals in the UK which some industry observers claim could ‘lose’ the company billions of dollars on power contracts. Notably, it has a large tolling deal with International Power which it signed in June. It is, reportedly, a five-year contract under which TXU provides coal for the Rugely power station, and makes payments to sell three-quarters of that plant’s electricity output. The deal follows the sale of Rugely by TXU to International Power.

Commenting on analysts concerns, a TXU spokesperson said: “We aim to provide price and volume stability. We do this by spreading risk and locking in margins over time. Tolling contracts are standard energy trading deals. There is nothing exotic about them. They are a hedging tool.”

Under a tolling deal, a gas producer effectively ‘rents’ power generation plants, usually from third parties, to give it the option of turning its gas into electricity. The whole operation turns on arbitrage between the value of gas as gas and the value of it turned into electricity. This relationship between gas and electricity prices is known as the “spark spread”.

Tolling agreements are quite legal and have been around for many years, particularly when a trader wants to change the indexation on a commodity. For example, he will buy oil from somewhere, put it through a process and turn it into something else. He might then put it into a power plant and burn it to create electricity. This electricity could be put into other positions and he may even swap these positions with other commodities. You could get oil, for example, going through three or four trading positions and coming out the other end as aluminium. This essentially shifts risks across different commodities and therefore different markets.

A good trader needs to have freedom but with hindsight they have been given too much freedom. The problem that has now made tolling agreements questionable, is that theoretically they can be done in such a way so that they become ‘virtual’ i.e. when tied up with round trip trades. The fear is that tolling agreements can be used to cover round trip trades or similar activities.

Shell has made no secret of its tolling obligations, which are set out in its annual accounts, and analysts are unanimous in discounting any suggestion of Enron-style mis-accounting. They are, however, concerned that the departure from core business means exposure to more risk – especially in a market which is volatile and plagued by scandal.

Energy companies like TXU and oil companies like Shell, which are backed up by physical positions, are not in the same position as the pure energy trader.

The big problem is the current sensitivity of the power market. With current perceptions, any company – the big oil majors included – should not do anything which might set alarm bells ringing with their shareholders. This is not the end of cross-commodity trading and clever trading strategies, and I suspect the curtain has not yet fallen on this whole episode. Yet for many, “the Fat Lady” is singing.

And speaking of fat ladies, I hope their strategy to increase their personal volume is doomed. They say all good things come to an end, and sometimes quite rightly so. Even here, the bell has finally tolled for PEi as you know it. But don’t worry, we’ll be back next monthࢀ¦ with a new look.

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