Dunham Cobb and Janette Whitehead,
Cap Gemini Ernst & Young
US energy companies are teetering on the brink of collapse following the trading scandals of 2002. As they try to restore confidence and rebuild their businesses, the energy company of tomorrow could look very different.
Figure 1. Energy companies will have to find a new way to feather their nests
The energy trading industry has been rocked by scandal for the past year. As investigations and indictments increase, many question the viability of this industry. Yet deregulated energy markets have existed in the US for nearly two decades and are continuing to develop in Europe. So what were the influences that forced the American market to begin this downward spiral? And more importantly what will align it again?
If we turned back the clock to the early 90s, would there be anything that would let us predict the state of the 2002 energy markets? Energy trading was an emerging business, which Wall Street was struggling to understand. The first movers in this market sold a specific message to Wall Street. They taught Wall Street to value energy merchants based on a model of high growth.
Figure 2. The traditional utility is less affected because the investor clearly understands what it does
Many companies were aggressively entering new markets and building large organizations without taking the time to build the necessary control infrastructure.
The marketplace now
With Enron toppled and Dynegy, Williams, and others crumbling, there is an increased focus on credit and a very active administration of collateral. This focus, combined with the drying up of financing sources, has resulted in severe cash flow and liquidity problems for many companies.
A vicious cycle is currently underway: due to their poor credit, companies are needing to post more collateral, which they can’t obtain, which precludes them from trading, which prevents companies from hitting their revenue targets, which results in downgrades for their credit ratings.
Historically in the wholesale market, traders would execute deals and only check credit afterwards. Now companies are taking a much more cautious approach. In many situations today, the industry requires prepayments.
Traditionally, the larger companies that were rated as creditworthy traded on the strength of their balance sheet. Less well-respected companies were forced to provide either parental guarantees or letters of credit. Now banks are hesitant and even unwilling to sell letters of credit on behalf of many companies.
Figure 3. New York: Nymex is offering OTC settlement products
Energy trading parties are requiring cash deposits up front for physical trading. Financial trading executed on exchanges, such as Nymex, have always required the posting of margins. There is now a movement in the physical and over-the-counter (OTC) financial markets to do something similar.
ICE and eSpeed have collateral that they are posting with a counter-party. Nymex is offering OTC settlement products. EnergyClear Corp, a new OTC energy clearinghouse backed by a $100 million credit facility from a group of commercial banks, is ready to begin clearing and settling trading in monthly forward contracts for 22 natural gas and 12 electricity points. It appears the whole industry is going into more of a margin-type mindset with the collateral that is being posted.
Who’s not at risk?
The industry today is a game of guilt by association. In the US public’s mind, ‘energy trading’ has become a four-letter word. The supermajors and utilities have done everything they can to distance themselves from trading, making statements that reassure the public that trading is not their core business.
Companies with more basic business models, such as utilities, are less affected because their businesses go on – the lights keep turning on, the air conditioning keeps running – and the basic investor clearly understands what a utility does and how it makes money. In many markets, there are still regulated rates of return.
For those utilities that saw the trading business as a way to generate more than a regulated rate of return, they may be punished for those projections because the trading industry is not delivering those rates of return right now. Utilities such as Reliant and TXU, that are generally viewed as ‘traders’, will be punished in the short term.
Over the long term, it is possible this shakeout will instil a much more sound business model. After all, most have solid retail and generation assets to rely on.
The turning point?
Turning the at-risk companies around will be a function of implementing behaviours and policies to help them weather this storm.
First and foremost, the companies have to get their numbers right, they must have correct financing going forward, and they must instil confidence in their balance sheets’ integrity.
With regard to mark-to-market (MtM) accounting, and ostensibly MtM accounting on a gross basis of revenues, the accounting rules need to be examined. For example, under MtM rules, PURPA restructuring requires revenues to be recognised all at once, up front. These are contracts with durations of more than 20 years in some cases. There’s possibly a need for some sort of grace period where a company would have a few years to bring those revenues forward and recognise them currently, but then hold off recognising revenues for the rest of the contract.
It’s conceivable that the SEC can take some steps to help companies mitigate some of the issues, particularly around MtM accounting. For instance, alternatives like limiting the term of the forward price curve, or setting national prices for every company to mark against, exist.
Another option could simply be a matter of greater disclosure in earnings reporting. That may also be part of the requirement of the analyst community, to become more educated and to ask the right questions.
Analysts need to be knowledgeable enough about the industry to be able to challenge some of these numbers. That was the case for Enron, where its status as a first mover allowed it to educate analysts as to how it wanted to be valued.
It remains to be seen whether the companies that are in trouble today can pull themselves out, or if they are going to need external assistance. Some fear the US government is going to artificially prop the industry up, giving it an artificial floor, allowing undercapitalized or unscrupulous players back in the game, only to let the industry drop again. The FERC’s recent proposals for Standard Market Designs should go a long way toward standardizing trading across regions where the market participants and RTO/ISOs are now comfortable with their ways of doing business.
Is there really gain?
The year 2002 will go down as one of the worst in the history of the energy industry. The question everyone has asked in its terrible wake is whether energy trading actually serves a vital function in the marketplace.
The energy marketing function can positively select and bundle the best of different offerings. For instance, if there are two different plants, energy marketing allows a company to take the best from both to offer it at a cheaper price to customers. Energy trading also benefits the marketplace by filling the gaps where specific products are needed or efficiencies could be realized.
The US government’s recent efforts to standardize rules across states and regions will have a stabilizing effect over time. Without overarching incentives in place to ensure a nationwide system, the individual states’ PUCs will continue setting their own rules. Under this scenario, deregulation is a destabilizing effort and is possibly not in the national interest of the USA. The California experience has already shown that people will find ways to take advantage of differing sets of rules.
National policies won’t end the need for trading. Utilities need to purchase fuel. They need to trade among themselves to help stabilize loads. Producers need to sell gas. Transacting is a natural byproduct of markets wanting to be efficient – whether from a profit standpoint or a reliability standpoint. Trading isn’t likely to ever go away.
A new breed
Tomorrow’s energy businesses will look very different from today’s. They will have a clearly communicable business model – they will not be all things to all people, as they were before. There will be fewer traders and the average quality of the trader will be higher. In other words, there will be analytical traders with the ability to identify value.
With respect to the balance sheet, working capital at risk and cash flow at risk will likely become as accepted as VaR. Because cash flow, working capital, and credit are now clearly recognized as limitations or constraints to trading, they will be factored into trading decisions and trading strategies. The investor community will require verifiable independence in order to mitigate concerns for accountability.
There’s also likely to be an increase in acquisitions of marketing assets. In the short term, more companies are going to shift their focus more into the marketing to end-use customers, where a regional presence is needed. Merchants will be required by the public sector to have stronger risk control, and procedural and systems processes in place. This will ensure that the public has more faith in the numbers they report. Overall, there will be fewer, well-capitalized companies that are better run, with much better sense of their data, their controls, and their systems.
Everything looks ugly at the bottom of a cycle but by taking appropriate steps, today’s energy companies can get the industry back on track after its flirtation with the brink.