Can the Merchant Sector Survive?

Within the energy industry, the merchant sector has gone from one of the most
promising areas to one of the most troubled. Indeed, many have questioned whether
portions of the merchant business can recover from the damage of the past two
years.

In this paper, we are focused on six persistent questions on the future of
energy marketing and trading:

1. What happened? Why did the merchant business model implode?
2. Is the merchant business model still valid?
3. Who will survive?
4. Is there a market to serve?
5. Can the market recover?
6. What are the signs of recovery?

What Happened?

The merchant model has had a fundamental shift with the exit of Enron, which
explains much of the current credit predicament. For all its faults, Enron was
the great liquidity provider and enabler in the power trading markets because
it was on the other side of most trades. Enron held a triple-B credit rating
and, as such, other merchants with similar credit profiles could trade with
Enron without posting onerous amounts of LOCs (letters of credit) or collateral.

However, in a post-Enron world, the liquidity function was transferred to the
banks and exchanges, which have far superior balance sheets and significantly
greater margin requirements. As such, power trading, with its intense volatility
and nascent liquidity, has become a function for big balance sheets. This explains
Aquila’s and El Paso’s decision to close shop or significantly limit their activity
in the power markets. We expect more exits to follow.

Trading up to higher credits and stiffer margin requirements lasted for a short
time, but simultaneously the credit rating agencies (in reaction to the Enron
meltdown) reduced the credit ratings of these companies thus deteriorating their
counterparty-credit profiles. So while liquidity requirements were rising, counterparty-credit
profiles were deteriorating, and the merchants got caught in the middle.

The result is that wholesale power markets have dried up, significantly impairing
merchant economics and dislocating the business model.

Is the Business Model Valid?

The merchant business model can be distilled down to two components: the physical
market and the financial market.

Due to the previously described events that led to the current credit crunch
for most merchants, we expect the model to remain valid but become increasingly
segmented with the merchants focusing on the physical model while financial
intermediaries increase their presence in the financial segment.

The physical market is the foundation of the merchant model and centers around
the logistics and delivery requirements of energy commodities. The physical
model includes procurement of natural gas for eventual delivery or for power
plant fuel, natural gas storage and transportation, electricity generation and
transmission, and multi-commodity and regional arbitrage.

The physical markets will remain an option for all financially feasible merchants;
however, the most successful physical players will incorporate a dynamic energy
infrastructure with regional strength. In other words, in order to maintain
the low-cost/higher-return position in this razor-thin margin business, successful
physical players will need the following:

• Dominant power generation market share in focus regions similar to other
low-margin businesses such as midstream services, whose participants typically
follow an “airline hub and spoke” strategy.

• The ability to source gas at the lowest cost, which necessitates a sophisticated
gas marketing and trading presence (we believe gas trading will remain available
to most merchants given the gas markets’ deep and liquid markets and resulting
reduced liquidity requirements). This is particularly important since fuel is
roughly 85 percent of the cost of running a plant. We believe a preferred profile
entails some ownership of natural gas reserves in combination with contractual
rights in order to offset sourcing/margin risk and being long power.

• A preferred profile also includes an energy sink (i.e., a customer base)
to help offset the natural long position in power. While commercial and industrial
clients are preferable due to the margin associated with structured transactions,
the churn rate is very high relative to residential customers. Furthermore,
regulated customers offer higher margin with lower turnover and commodity risk.
Unregulated retail customer services have not yet panned out as a desirable
business, given that customers are not easily lured away from the incumbent
utility — they also carry low margins and a meaningfully higher commodity
price risk.

• Logistical sophistication, including significant positions in transmission,
pipeline, and gas storage capacity to reach the lowest-cost fuel and highest-profit
end markets, as well as maintaining multi-regional and multi-fuel positions
in order to capture arbitrage opportunities.

• High credit standings as a lower cost of capital is key to returns in a low-margin
business and will also provide preference in capacity contract negotiations.

We believe that the merchant players, marred with excessive debt and limited
access to the capital markets, will have a difficult time surviving in their
current forms and will not be long-term winners in the new market environment.

The financial model is necessary in an open and competitive market. The financial
model includes providing liquidity (market making services), speculative trading
(a.k.a. proprietary trading), structured products (i.e., derivatives), and risk
management services (transferring price risk from large energy consumers to
their balance sheet and then ultimately to the market).

Financial market participants provide liquidity and depth to trading markets,
which allows physical players and large energy consumers to lay off risk through
hedges. Without market liquidity, physical players are forced to seek each other
out on a bilateral contract basis, which has proven extremely inefficient. Like
any other market, middlemen match buyers and sellers, which also supplies reliable
price signals on which economic decisions can be founded.

While we believe bilateral contracts will grow in application as a result of
financiers’ requirements and the recent breakdown in financial markets, our
channel checks overwhelmingly confirm the desire and need for liquid financial
markets in order to manage the significant risk associated with electricity
price volatility. We expect banks, brokerages, hedge funds, and other large
commodity houses to increase their role in the financial power markets.

More important to our thesis than power generation margins has been the outlook
for risk management demand growth. Energy marketing and trading starts with
marketing where long-term contracts and relationships are formed.

Trading for merchants, in our view, is a consequence of the origination business.
Because by definition risk management transfers consumers’ price risk to the
providers’ books, it is now a function for financial intermediaries such as
banks, which have specialized in similar services in other sectors. Only the
merchants with the strongest balance sheets will have the ability to participate
in this segment, which we believe offers the greatest growth and profit potential.
But, as we describe below, this is an area ripe for collaboration among the
financial and physical players.

Who Will Survive?

We continue to believe the merchant model works, albeit the number of companies
with the ability to participate in each step of the value chain has been significantly
reduced. So what does the future hold?

As mentioned, we expect financial institutions to fill the financial trading
void and, to this end, have been stepping up efforts (confirmed by UBS’s purchase
of Enron’s platform). Morgan-Stanley Dean Witter and other brokerages are already
forces in the market; in fact, Goldman Sachs already announced that it is re-upping
its power trading efforts. Foreign energy firms are increasing their presence
in the U.S. wholesale markets demonstrated by RWE’s opening of its trading floor.
Hedge funds such as Citadel and D.E. Shaw are said to have growing interest,
and commodity firms like Cargill and AIG are also mentioned as studying their
options. Domestic utilities and some of the major integrated oil companies have
also expressed interest in building on their participation.

We also see the logic behind joint ventures/partnerships/collaboration among
merchants and financial institutions. It is possible for a model to develop
similar to loan or mortgage origination wherein risk-management deals are underwritten
by the merchants and partner banks, then syndicated to other players, likely
in time tranches.

Merchants had rejected these types of arrangements in the past, wanting to
keep the spoils to themselves, but in today’s dismal reality this structure
offers a lifeline. Alternatively, it is of interest to financial institutions
as they typically lack the physical delivery capability. Moreover, merchants
bring to the table the customer relationships that are invaluable to origination.
The first such partnership was announced by CMS with Capstone Global Energy
and Harvard Management and is, in essence, a credit-support agreement enabling
CMS to pursue longer-term risk-management deals on which the partnership would
have to sign-off.

It is impossible for us to gauge the viability or economics of these structures
from the merchants’ standpoint, but we would assume merchants would be less
profitable than in the past as the financials have the upper hand and will likely
extract more than their pound of flesh. As such, it remains to be seen if the
merchants’ current capital structure can support a JV partnership. Nonetheless,
a JV partnership arrangement would likely save the day and significantly improve
the outlook for some companies as it would reduce the onerous collateral requirements
and provide additional flexibility to trade.

Is There a Market to Serve?

We start from the premise that the wholesale energy markets will survive and
grow from current levels going forward. Founding this belief is the Federal
Energy Regulatory Commission (FERC) accelerating efforts to pry open the wholesale
power arena with the goal of promoting open and competitive markets. FERC’s
ambitions were recently demonstrated by the issuance of its GIGA NOPR, which
is an effort to lay out the rules for an open wholesale power market.

To date, the process of opening power markets unleashed the underlying price
volatility inherent in electricity. While not always the case as demonstrated
in California, typically the end users (large wholesale customers) find themselves
subject to this volatility and, as such, power-risk management demand had begun
to flourish prior to the recent liquidity crisis.

Over the past several years, many utilities have been mandated or have elected
to divest their power generation assets, leaving many naked of power generation.
Without these assets, utilities have created a short position in the most volatile
commodity ever traded, which does not square with their inherently risk-averse
culture.

Furthermore, demand has outstripped supply for many co-ops and munis, and large
commercial and industrial customers have become more aggressive in seeking stable
energy supply deals. This is a huge new market for companies that specialize
in risk-management services.

Unlike many other commodities, power and gas pricing is highly correlated to
weather, which is difficult to predict. Weather has a particularly strong impact
on the price of power because the commodity cannot be stored. In addition, most
power plants are not designed to increase production rapidly to meet sudden
demand spikes.

Weather derivatives, a form of weather insurance for large energy consumers,
remains in a nascent stage. Consumers are offered price visibility within set
parameters for a given period of time. Risk does not disappear; rather, suppliers
transfer consumers’ pricing risk onto their books, which is then offset through
a series of “dirty hedges,” or hedging using highly correlated commodities.
To date, weather derivatives have proven less economic to consumers given their
relatively high cost compared to more standard risk-management methods. Moreover,
the large suppliers of weather derivatives were Enron and Aquila, which have
left the business.

However, weather derivatives could regain some momentum and become another
arrow in risk managers’ quivers if pricing is reduced, which should come with
scale.

The unpredictable nature of weather, combined with the inability to tightly
follow load, should sustain a relatively high level of volatility for the foreseeable
future, in our opinion, which should lead to steady risk-management origination
demand. Unfortunately, supply of this service dried up as providers’ credit
quality dwindled and the trading market evaporated.

We have confirmed through our contacts that demand is currently cocooned and
waiting for current events in the merchant arena to play out. As such, we expect
suppliers to meet the demand attracted by the high margins and profit potential.
The projected growing volume of origination deals implies healthy trading volume
growth given the trading markets’ multiplier effect (velocity).

Can the Market Recover?

While we start with the assumption that the market will redevelop and grow
from current levels, we have dramatically reduced our expectations for the potential
growth of the market and its ultimate size.

Previously, we had estimated the market to grow to $1 trillion-plus by 2005
from $285 billion in 2001 (includes nonregulated generation, gas and power marketing,
and trading). We now see the market growing to about $420 billion in 2007 (see
Figure 1). The primary factor in deflating our projections is an assumed slowdown
in power volume velocity, i.e., the financial-to-physical ratio. We had assumed
power velocity could reach the average for natural gas, which is roughly 10x
and, in fact, it was above trend to meet these expectations.


(See Larger Image)

Figure 1: Wholesale Industry Model                                                                  Source:
Company Reports and Banc of America Securities, LLC

However, given the upheaval in the wholesale power market, we now believe there
will be more reliance on bilateral contracts (direct from plant owner to end
user) and shorter-term deals of one to three years compared to the four to eight
years prior to the market downturn. Given that risk grows in the outer years,
there should be less risk to lay off in the markets. As such, while we see a
return to more liquid power markets, we expect depth only in the near-term market
of one to perhaps three years, thus reducing velocity from previous expectations.
The question remains: When will the recovery begin?

What Are the Signs of Recovery?

Volume growth is an important leading indicator of a recovery, but who or what
will prime the market? Key events we are watching that would imply a recovery
in the wholesale power markets include the following:

First Mover — We are watching to see which companies take
a leadership role in providing liquidity to the market and what platform is
preferred (i.e., NYMEX, Intercontinental Exchange, or EnronOnline now resident
at UBS). First signs here are Goldman’s efforts to enhance its power trading
efforts.

JV Announcements — A very strong endorsement of the viability
of this market would be a joint venture announcement from a financial player
with a merchant. The ultimate combination we can imagine would be a name brand
“smart money” player such as Goldman or Berkshire combining their efforts, or
backing the efforts of a top merchant such as Dynegy.

Smart Money Asset Acquisitions — Having credible acquirers
stepping in would help signal a bottom, in our judgment. While Berkshire Hathaway’s
purchases of pipelines are encouraging, they are “no brainers” in our view.
The real test is, when do parties step up to purchase trading books, tolling
deals, and merchant plants?

Overhang Resolutions — The largest overhangs facing the
sector and impeding new investment and new entrants, in our view, are the investigative
risks and uncertainties surrounding California. We believe that the resolution
of these issues would help reduce the sector’s taint and encourage new investment.

New Entrants — Looking for palpable signs of commitments
from those companies said to be building new power-trading operations such as
RWE and Citadel.

Deeper and Longer Markets — While we are watching for an
increase in volume, we are also monitoring volume in longer-term markets (two
to three years and beyond), which would signify a return of risk-management
origination.

Bottom Line

In conclusion, we believe the market will recover and grow from current levels,
albeit at a more measured pace. The business model remains intact, although
few companies will engage in the full-value chain. Those that are capable, or
desire to participate, are presented with a unique opportunity to expand their
presence on a lower cost basis.

A significant impetus to the recovery of the merchant business model would
be the reopening of the capital markets for the entities in the merchant space.
Over the past year, there has been a significant deterioration in both the market
capitalization and credit spreads of the merchant players.