Trading Floors, Alternative Approaches To Risk Management And The New Wave Of Convergence? by Chris Trayhorn, Publisher of mThink Blue Book, January 15, 2002 Why Do Energy Companies Trade? Trading operations appear to be a highly esteemed part of many energy companies. During the last two years, several companies have built trading floors, announced the creation of a wholesale trading organization, or hired trading expertise to build up such a capability. However, in many cases, it is not clear what the companies’ goals are. Many people assume that the primary value of a trading organization is to speculate in commodity markets. Others believe that a trading organization is necessary to “leverage assets,” to glean market information, or to provide credibility when negotiating transactions. Companies that 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: o Clear the risks that are brought into their organizations o Arbitrage o Speculate Each of these advantages of trading is dependent on sophisticated 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 minimize risk, not create it. Minimizing risk is called “clearing” and is done on a physical and financial basis. Risk clearing can become complex with transactions that involve more than a single commodity or 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. 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 Leveraging And Market Making Executives often claim that building and maintaining a trading organization is necessary to “leverage” their assets. That phrase 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. 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 difference 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, therefore, is 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, delivery periods, 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: o Provides pressure on prices to move to rational or normal levels o Maintains liquidity in the markets Speculation The third benefit of maintaining a trading organization is the opportunity for speculation. A skilled trading organization gains market knowledge and can become expert at predicting changes in prices, given changes in supply or demand. However, the risks of speculation can be great because the market continually changes, requiring traders to constantly update their knowledge. In large energy companies, knowledge of the relationship between weather forecasts and energy demand can result in 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. Non-Price Risk In Energy Markets Trading floors clear price-related risks through commodity markets. Commodity markets are not efficient, however, at clearing non-price risks. Non-price risks stem from many different sources, generally arising from the physical vagaries of machine performance and weather. This creates an alternative form of risk for which traditional hedging strategies are poorly designed. A traditional forward contract in electricity is “firm with liquidated damages” (firm LD). This means the supplier is obligated to deliver physical power. The failure to meet that obligation results in the buyer purchasing replacement electricity at prevailing market prices. That creates a liability for the seller. The alternative risk faced by producers is caused by the fact that physical assets do not always operate. An owner of a 500-megawatt generating plant may wish to mitigate price exposure by selling forward the power from the plant. Liquidity and price transparency in the electric forward markets are in the “firm LD” instrument. If the owner enters into a “firm LD” forward contract, the failure of the plant to operate at times when market prices are high creates a significant risk. An asset owner who enters into a 500 megawatt forward sell at $50 per megawatt hour faces liquidated damage charges of $975,000 per hour when the spot price of electricity reaches $2,000 per megawatt hour. This exposes the asset owner to volumetric risk if the plant does not perform. Retail aggregators face a similar type of volumetric risk. Traditional derivative contracts (futures, forwards, and options) are designed to manage price risk for a fixed quantity. Retail aggregators can hedge this exposure through traditional forward, futures and options contracts. However, energy price volatility is not solely determined by retail demand. A nuclear unit outage in a region might cause high prices with no accompanying increase in retail load. Traditional hedging instruments can be expensive, since it is the correlated volume and price risk the aggregator seeks to mitigate. The Role Of Reinsurance And Capital Markets In Managing Energy Risks Reinsurance and capital markets provide alternative methods to managing energy-related risks, particularly those risks that are event-related. Insurance products were developed centuries ago to manage event risks. Reinsurance markets aggregate uncorrelated risks. Since the events under which different policies pay out are statistically unlikely to occur at the same time, pooling of uncorrelated risks results in a portfolio with lower average variability or risks than the sum of the risks from the individual policies. Capital markets allocate risks by transferring those risks to the holder of financial securities. Bond yields are determined by the risk-free rate (the yield on a security with no default risk) and the default risk from a specific security. Event-related risks can be securitized and issued to the capital markets. Recently, weather-linked notes have been structured based on the realization of certain meteorological events. If the event occurs, the bond defaults. If the event does not occur, the principal is repaid in full. Commodity, Reinsurance And Capital Market Convergence Risks can be managed through a variety of means. Price risk is typically handled best via commodity markets through which the trading floor is the point of access. Non-price, or event risks, can be managed via reinsurance and capital markets’ products. Figure 1 describes the type of risk and expected losses than can be efficiently managed via the three markets. The management of enterprise-wide risk requires an energy company to consider a variety of risk-management instruments. For each of these types of risks, decisions are required that affect profitability. This has led to a convergence of reinsurance, commodity and capital market risk management and created hybrid organizations that manage those risks. 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.