Why Do Energy Companies Trade? by Chris Trayhorn, Publisher of mThink Blue Book, November 15, 2000 Companies that trade – and trade well – have an advantage over companies that don’t, but typically that advantage is more subtle – and perhaps less fleeting – than successful commodity speculation. Companies that trade are able to: Clear the risks that are brought into their organizations Arbitrage Speculate Each of these advantages of trading is dependent on world-class risk management capability, information systems, and trading skills. Clearing Risk In a large energy merchant organization, the first and most important benefit of a trading function is to eliminate, not create, risk. This elimination of risk is called “clearing,” and it is done on a physical and financial basis. For example, an energy merchant company may offer to provide fixed-price natural gas for the balance of the year to a local distribution company. The risk of market price fluctuations is borne by the energy merchant company; if market prices rise throughout the year, the merchant company’s decision to sell fixed-price gas looks like a bad one. If market prices fall, the decision to sell fixed-price gas is clearly profitable to the merchant company. Suppose the merchant company decides to clear this risk financially. The merchant company takes an offsetting position (or a hedge) in the forward markets. In this example, the offsetting position is a purchase of gas, at the same delivery location and over the same time periods as the initial commitment to the local distribution company. The financial risk of the position is transferred, or cleared, via the market. As the delivery period for the natural gas approaches, the positions are physically cleared when the trading organization takes delivery of the gas purchased from the market and delivers the gas sold at fixed price to the local distribution company. The example mentioned above is simplified; risk clearing becomes much more complex with transactions that involve more than a single commodity, or more than a single type of risk. Common transactions in energy markets today can include risk from more than one commodity, weather, unit reliability, and so forth. Typically, transactions that contain these risks are brought into the company through the efforts of marketers, or “originators.” These originators are not traders; they are expert at analyzing a client’s energy and risk requirements and preferences. Successful originators also have a strong understanding of the energy merchant company’s capabilities to properly evaluate and manage the risk of these types of transactions. As these transactions are discussed with clients, a “structure” group intervenes to ensure that the valuation methodology of the transaction is correct and that the assumptions behind the valuation are consistent with current market price, volatility, and liquidity levels. The “structure” role also offers guidance to the trading organization about the structure of risks. Simple deals, like the example given above, are easy enough to hedge, or clear. But more complex deals, which may involve weather or reliability contingencies, can require several hedges made by different traders, or they may contain risks that can’t be financially cleared. Like the originator’s role, the “structure” role is not a trading activity; rather, it is a valuation activity that uses data gleaned from trading operations to assist in the valuation and partitioning of risks among traders who can clear them. The clearing function provides the trader, and therefore the organization, with information about current conditions in the market. In markets that are not transparent, such as the electricity market, the most reliable information about price levels and liquidity is obtained by trading. Two Special Cases of Risk Clearing: Asset “Leverage” and Market-Making Executives often claim that building and maintaining a trading organization is necessary to “leverage” their assets. While the phrase “leverage your assets” can mean many things, in the energy industry it is typically used to define the effort of maximizing the value of physical assets (gas pipelines, generating plants, etc.) through trades. An organization charged with leveraging an asset will identify significant risks associated with the asset (such as outages at a power plant or severe weather changes in a pipeline service area) and then make trades that reduce or eliminate those risks. Then the leveraging organization will physically clear the position either by selling it forward, by selling pieces of it on a contingent basis, or by selling it in the very near-term markets (daily for gas pipeline capacity or hourly for electricity). A “market maker” provides a commodity or a commodity-related service at a range of prices that allows both buyers and sellers to transact. As in the case of asset leverage, market-making is a special case of risk clearing. Rather than take in a risk and then seek to pass it back to the market, a market maker will try to identify the market price level that creates roughly an equal volume of buying interest and selling interest. Then the market maker bids and offers commodity at those prices, with the expectation of creating a balanced book and offering a service to market participants. There is significant benefit to all market participants when risks are cleared via trading. Most importantly, liquidity and price transparency are increased. Arbitrage The second benefit of maintaining a trading organization is the ability to arbitrage the market when a temporary misallocation of resources occurs. A trading organization that looks at national or regional markets can identify pricing relationships that do not make sense. For example, suppose that forward gas prices in the Northeast are $5.00 higher than forward prices on the Gulf Coast. Traders that understand pipeline transportation will know that $5.00 is significantly higher than the expected cost (or the forward cost) of transporting gas from the Gulf Coast to the Northeast. A trading company can arbitrage this differential without buying pipeline capacity and physically shipping the gas. A trading company that understands pipeline transportation can arbitrage the price differential, without buying pipeline space, simply by taking a short position in the Northeast and a long position on the Gulf Coast. This set of positions allows the trading company to profit as the price relationship between the Gulf Coast and the Northeast returns to a normal level. This example of arbitrage is extremely simple and is, therefore, a situation that is not likely to occur in the energy markets today. However, the principle applies – traders who continually watch the markets can see inconsistencies in pricing and can make relatively low-risk profits by arbitraging those inconsistencies. In today’s energy markets, most arbitrage opportunities occur either between regions (as in the example above), between delivery periods (such as gas delivered in the summer versus gas delivered in the winter), across different types of instruments (such as options to futures), or across a combination of these conditions. Many arbitrage opportunities are not perfect; that is, even though an arbitrage position looks like a “sure win,” there can be significant speculative elements involved with the position. In addition to providing a low-risk benefit to trading companies, arbitrage helps the market in two ways: Provides pressure on prices to move to rational or normal levels Maintains liquidity in the markets Speculation The third benefit of maintaining a trading organization is the opportunity for speculation. An organization that skillfully trades gains market knowledge and, over time, can become expert at predicting changes in prices, given changes in supply or demand. This is often the most difficult benefit of trading to maintain profitably, because the risks of speculation can be great and because the markets continually change, requiring traders to constantly update their knowledge. In large energy companies, a knowledge of the relationship between weather forecasts and energy demand can be at the root of profitable speculation. Other speculative opportunities occur when non-commodity markets (stock markets, bond markets, etc.) gain or lose participants, or when regulations or technologies change. As with risk clearing and arbitrage, speculation creates liquidity in the markets and keeps prices transparent. Risk Management and Control These three advantages provided by trading activities can be fleeting, or even prove to be disastrous, for companies that do not have a well-defined trading discipline. That discipline must include risk control, which requires traders individually and as a group to keep the aggregate risk of their positions within limits that are set and enforced by an independent risk-control group. A key part of setting proper limits is understanding the objectives and the risk tolerance of the company. Most companies that successfully trade have specific limits and rigorous enforcement of those limits. Filed under: White Papers Tagged under: Utilities About the Author Chris Trayhorn, Publisher of mThink Blue Book Chris Trayhorn is the Chairman of the Performance Marketing Industry Blue Ribbon Panel and the CEO of mThink.com, a leading online and content marketing agency. He has founded four successful marketing companies in London and San Francisco in the last 15 years, and is currently the founder and publisher of Revenue+Performance magazine, the magazine of the performance marketing industry since 2002.