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.


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


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.