The primary business function of an energy company or utility is the supply of energy. It is not trading. Herein lies one of the major problems in the fast liberalising energy markets. Companies have increasingly been driven by the opportunity of wealth creation through speculative trading, but in the aftermath of Enron a number of companies have started to scale back trading and refocus on the core company business of supply.
That the above scenario is from the US market should be of little surprise. Speculative commodity trading as a business asset developed in the US and has spread across the world. Of concern should be Europe following in the footsteps of the US, but this is one scenario that is increasingly unlikely. European electricity trading has not taken off to the extent that it has in the US and has liquidity issues in some of the forward markets. Somewhat ironically the lack of market liquidity is directly related to the absence of speculative trading and the limited involvement of financial houses and funds. Also, many of the energy companies in financial difficulty in the US have European business divisions and it is these that are likely to exit the European market first.
In the face of plummeting share prices and falling credit ratings the first line of employees to be shown the door are the traders, the rationale being that trading losses are the major contributor to overall business loses. The next action is to impose limits on risk exposure. And if this doesn't stem the financial woes then the sale of trading and other businesses will be on the agenda. But why does it take a major wake up call to start adopting sensible trading and risk management procedures? Trading may not be the primary business function of an energy company but it is an important business function. Competitive energy markets give rise to volatile prices and thereby increase the price risk faced by market participants. Trading in derivatives can offset this risk, ensuring that both business margins are protected and the supply business to customers remains competitive.
What is important is the relationship between the supply and trading businesses. Trading should support the supply business, ensuring that the supplier can remain competitive. Trades are implemented in response to actual or forecast customer demand patterns, and to micro-manage longer-term deals where the market price has changed since the trade was initially struck. This form of trading is anything but speculative but can still lead to losses if the trade positions are not properly managed.
One of the questions that energy companies need to address is whether they see trading as a way of increasing revenue or protecting revenue. The former approach is speculation and high risk while the second approach is more akin to hedging and is small risk. Another question to be addressed is the risk reward scenario of the company. Higher risks generally provide higher rewards, but does the high risk justify the reward? The experience of some US energy companies would tend to support this view and should act as a warning for the European market.
Clear way to liquidity
On the day that Aquila closed its London office the Intercontinental Exchange (ICE) announced the provision of clearing for its European OTC gas and electricity contracts. The irony is that Aquila regarded itself as one of the more aggressive traders of the European market and ICE is rolling out its cleared service to help develop the market.
The rationale in introducing clearing, according to its supporters, is it will help resolve credit issues in the short-term and increase liquidity in the long-term. Certainly a cleared market will resolve credit issues, providing the market chooses to use the cleared service, but it is doubtful that, on its own, a clearing service will promote long-term market liquidity. For liquidity to improve, more participants have to trade but the reality is the UK and, to a lesser degree European, market is primarily a short-term market. Longer-term liquidity will improve with greater speculative participation from the banks and funds but in light of the US experience this may be some time off.
The benefits of centrally cleared OTC contracts are compelling: reduced reliance on bilateral credit lines, greater number of prices to hit and the ability to cross-margin between the IPE futures and ICE OTC contracts in NBP gas. And there are also potential negatives: companies that have built up a portfolio of counterparts may want to keep the bilateral credit lines in place, and may also object to the cost of initial and variation margin calls to ensure that the default of any member does not impact on other members.
The challenge from the new clearing services will not necessarily be to the remainder of the OTC market — which is quickly being carved up between the brokerages and ICE — but to the fledgling futures market. By adding on clearing to standardised OTC contracts the differentiation between OTC and futures is minimised.
With liquidity the key factor in European market development the argument for a centralised European gas and electricity futures exchange becomes more compelling. This process has started in Germany with EEX and LPX and the next logical merger should be in the UK between UKPX and APX, and the consolidation process should continue until Europe has one liquid and transparent futures exchange.
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