Must-Have Technology

High commodity prices and volatility are driving growth in energy trading as
producers try to maximize their market share and profitability and buyers attempt
to control their energy costs and risks. Financial institutions have stepped
up both physical and financial trading, adding liquidity to the market and assuring
that volumes will stay high. In order to maintain their competitive edge, utilities
and independent power producers will need to invest in more sophisticated information
technology. However, that investment must be effective – reducing IT support
costs, while increasing the volume of deals per trader.

Energy Prices Will Remain High; It Is a Matter of Supply and Demand

In
recent years, the world has seen an unprecedented increase in the price of crude
oil, caused primarily by the narrowing of the gap between global supply and
demand. Specifically, surging demand in China coupled with supply disruptions
associated with the war in Iraq, multiple hurricanes in the Gulf of Mexico and
the oil workers’ strike in Venezuela have driven historically high oil prices.
It is expected that the supply/demand gap will continue to be tight into the
near future. The increase in oil has brought subsequent increases in the prices
of natural gas and electricity, where generated by gas-fired turbines (see Figure
1).

In North America, a similarly tight supply/demand situation for natural gas
is driving historically high wellhead gas prices. Granted there has been some
relief from a mild winter, but weather is an uncontrollable factor. Increasing
demand (driven in large part by the power generation business), declining production
from existing gas fields and the sluggish development of liquefied natural gas
(LNG) capacity, are contributing to forecasts of increasing prices and volatility
during the next five years.

The Pace of Energy Trading Is Quickening as the Markets Recover

Energy trading is increasing in importance. Trading volumes are up in almost
all of the markets for energy commodities, whether these are for liquid hydrocarbons
(crude oil, natural gas liquids, etc.), natural gas, power, coal or energy derivatives.
Trading exchanges such as Intercontinental Exchange (ICE) and the New York Mercantile
Exchange (NYMEX) have set records for numerous products. Despite the slowdown
in formation of new Regional Transmission Organizations (RTOs), volumes on existing
spot wholesale power markets are up. Brokerages also are reporting increased
activity in over-the-counter (OTC) energy.

The Enron Legacy Has Left Its Mark; Regulatory Scrutiny Remains High

Energy markets – especially power and natural gas – face challenges subsequent
to the collapse of Enron. That collapse decreased the liquidity of the energy
markets, as Enron as a market maker generated significant liquidity, especially
through Enron on Line (EOL). Investigations into shadow or wash trading practices
extended to other energy companies. About the same time, practices of price
reporting by gas traders were called into question, leaving the market with
doubts about the transparency and credibility of market reporting.

The response to corporate excesses has led to increased regulatory scrutiny
in North America.

  • Congress passed the Sarbanes-Oxley Act, requiring corporations to strengthen
    internal controls and audit procedures, as well as report to shareholders
    events likely to impact their financial performance;
  • The Commodity Futures Trace Commission (CFTC) has issued more than $50 million
    in fines to gas traders and companies for wash trades and manipulative price
    reporting to index publications; and
  • The Federal Energy Regulatory Commission (FERC) initiated actions against
    companies involved in the California energy crisis and also issued new regulations
    requiring quarterly wholesale trade reporting. FERC has also issued new sanctions
    for market manipulation.

In an effort at self-policing, the energy industry formed the Committee of
Chief Risk Officers (CCRO). That organization defined best practices in risk
management, including a common methodology for arriving at value-atrisk, in
addition to establishing disclosure standards for the industry.

Financial Institutions Supply Liquidity, But Have the Edge

The year 2005 saw a continuation of active participation by financial institutions
in not only financial but in physical trading. These institutions are acquiring
the assets to back trading to do just that. According to SNL Energy, financial
buyers made up over 80 percent of the nameplate capacity acquisitions in 2004
and 2005.

Not only do financial institutions have leverage, but they have years of experience
using sophisticated information technology to support their activities. These
companies have advanced technology for credit and currency risk, along with
well-developed straight-through-processing STP. STP is the ability to access
and track deal data through front, middle and back office. The idea is that
a system of record is created with role-based access for those needing the information.

Granted, financial institutions entered physical trading lacking requisite
technology for specifically assessing energy commodity risk and physical delivery,
such as scheduling, nominations and settlement. However, these institutions
are acquiring that technology quickly either through buying software or acquiring
the trading desk of energy companies outright. Witness the acquisition of Energy-Koch
by Merrill Lynch and the partnership between Calpine and Bear Stearns to form
CalBear.

The financial health of the utility industry is improving; however, there are
limited opportunities for growth. The traditional utility can look for growth
in only a few places – growing the customer base through mergers and acquisitions
or through acquiring more customers through retail competition. Since restructuring
has slowed significantly in North America, the second avenue is not an option.
Trading and arbitrage do provide opportunities for growth. Merchant generation
companies must be engaged in trading just to do business.

At the same time, Enron revealed just how exposed energy companies are in their
dealings with counterparties. Part of the difficulty lies in the inability to
identify deals across commodities. One company may be selling electricity to
another, but buying gas from that same company. Most companies are still not
equipped to understand their total exposure because deal information does not
flow between units responsible for trading each type of commodity. Add to that
the fact that for large deals there are relatively few counterparties, and credit
agencies have high capital adequacy requirements for this industry.

Trading requires information technology. According to one risk manager at an
independent power producer, “My business depends entirely on technology and
access to information.” In the sections that follow, the required capabilities
and the must-have technologies for competitive edge are described. However,
before setting out the case for technology, it is necessary to describe the
business process it supports.

The business process involves constant information flow between front, middle
and back offices. Although exchanges make the market, today emphasis is being
placed on what goes on within the enterprise. Trading and risk management functions
are performed by front, middle and back offices. Each has different needs for
data and analytics:

  • Front office – where all phases of deal execution occur. Front office
    is responsible for new product development, execution and price curve development.
    Front office typically requires near-real-time (within minutes) information
    (commodity prices, weather forecasts, forward price curves, transmission pricing,
    spot market pricing, emissions status, availability of credit and financing,
    etc.) from internal applications, sensors and external data feeds. Analytics
    tools must be easy for traders to use in calculating the best deals.
  • Middle office – where exposures and risk are examined and controlled.
    Middle office is responsible for forecasting, deal validation and risk management.
    Middle office typically builds limits into the traders’ systems, so real-time
    alerting capabilities are not as critical, but data streams from external
    sources are. Visibility to trading activity and available credit are critical.
    Middle office has a need to receive information that will impact financial
    performance within 48 hours. Middle office also requires the calculating capacity
    to process large volumes of data within hours, rather than days.
  • Back office – where settlement and accounting occur. The back office
    is responsible for reconciliation and compliance with accounting and disclosure
    requirements. Back office requires receipt of information into settlement
    and ERP systems on a timely basis, but does not require real-time information.
    However, the more quickly deals can be processed, the faster the next trade
    can be made.

Now,
most interaction between the offices (front, middle, back) occurs either via
face-to-face contact on the trading floor, phone or fax, not necessarily through
electronic alerting or transaction systems. Traders (front office), risk managers
(middle office) and schedulers (front office) typically are co-located on the
trading floor to facilitate communication. Personnel involved in settlement
(front office) and forecasting (front or middle office) are often housed separately.
As trading volumes increase, trading companies will rely more on portals to
gain role-based access to information and analysis.

In the early years, there was a common understanding about the business process
involved in energy trading and risk management, but this process was largely
undocumented. The CCRO has since documented the process and we use their outline
as a foundation for the process from new product development in the pre-deal
stage to final settlement in the post-deal stage. Supporting these business
processes are a set of applications and application development and deployment
tools (see Figures 2 and 3). We refer to these technologies as Energy Trading
and Risk Management (ETRM).

Must-Have Technologies Include Applications, Data Services and Supporting Technologies

The technology to support the information needs of a profitable business is
certainly mature. At the very least, utility companies need to invest in applications,
especially if they are on older legacy applications that are undocumented, costly
to support and do not provide accountability and traceability. The only decisions
now to be made by companies participating in trading is how much they are willing
spend. For the enterprise, capabilities required are:

  • Enterprise access to data, transactions and analytics. While some
    companies are still focused on putting together market information and trading
    tools on a portal for the front office, the more advanced companies are concentrating
    on building enterprise portals that provide role-based access not only to
    front, middle and back office, but also to operations and corporate. The most
    valuable portals will not just assemble streaming data, but will display graphics,
    use geomapping of price and other data and most importantly the ability to
    run analytics that provide business intelligence specific to ETRM. For the
    executive level, a portal alone is not enough; dashboards with key performance
    indicators are needed to support business performance management. For compliance
    purposes, traceability – the ability to replicate results and reporting –
    are essential just to do business.
  • Energy and credit risk analytics. Trading energy commodity is not
    like trading financial products. The commodity tends to be lumpy and for some
    commodities like power and natural gas, very tied to regional markets. In
    addition, there are regulations specific to these commodities. Generic analytics
    cannot be used to establish value – risk management applications specific
    to energy commodity are required. On the other hand, the industry can take
    advantage of more generic credit risk analytics used by the financial services
    industry for financial instruments.
  • Integration capabilities and service-oriented architecture. ETRM
    depends upon the integration of many applications, especially in oil and gas
    where IT organizations currently run hundreds of applications. Integration
    capabilities are essential for STP. While there are opportunities for consolidation
    of redundant systems, there is not one comprehensive integrated application
    that can handle all functions – niche applications are still required. Currently,
    the norm for integration is enterprise application integration (EAI) technology.
    Along with integration buses comes alerting capabilities, critical for companies
    that must be able to confirm deals quickly, so as not to lose opportunities.
  • Web services wrappers will be used in the utility industry to help
    integrate legacy applications, until these can be replaced. ETRM software
    vendors are already developing service-oriented architecture (SOA), enabling
    users to build integrated composite applications. Energy companies will want
    to have an SOA supporting the enterprise architecture as well, especially
    if these companies trade in multiple markets and commodities.
  • High-speed calculating capacity. The middle office needs to be able
    to run simulations, stress testing and optimization routines involving numerous
    variable and large data sets within hours rather than days. Analytics for
    ETRM are fairly complex, involving numerous variables operated on by sophisticated
    algorithms, requiring multiple iterations. Although long-term planning may
    allow waiting a day or two for a process to run, other activities require
    quick calculations performed in minutes rather than days. Particularly complex
    calculations may require at the very least mixed-integer linear programming
    and at best high-performance computing (HPC) capability provided via parallel
    processing.

Planning is required. As with other projects, investing in technologies for the
sake of maintaining competitive edge is not enough. It is important for the business
leaders in energy trading and risk management to work closely with IT to ensure
that the investment in technology results in increased capacity (deals per trader)
as well as decreased risk. Hiring additional IT personnel to build custom programs
is not a winning strategy in the long run.