Peter Fusaro Global Change Associates New York, New York 212-333-4979 global-change

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State of Energy Trading & State of Energy Trading & Markets After EnronMarkets After Enron

EIM CEIM Conference onference Tarpon Springs, FloridaTarpon Springs, Florida

February 24, 2003February 24, 2003

Peter Fusaro Peter Fusaro

Global Change AssociatesGlobal Change Associates

New York, New YorkNew York, New York

212-333-4979212-333-4979

www.global-change.comwww.global-change.com

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GCA Products & ServicesGCA Products & Services• Books: Books:

– New York Times bestsellerNew York Times bestseller What Went Wrong at What Went Wrong at Enron Enron (John Wiley, July 2002(John Wiley, July 2002))

– Energy Convergence Energy Convergence (John Wiley, May 2002)(John Wiley, May 2002)– Energy Derivatives:Trading Emerging Markets Energy Derivatives:Trading Emerging Markets

(2000)(2000)– Energy Risk Management Energy Risk Management (McGraw-Hill, 1998)(McGraw-Hill, 1998)

• Customized consulting for energy & financial Customized consulting for energy & financial service companies in energy & environmental service companies in energy & environmental risk management advisory, competitive risk management advisory, competitive intelligence and business strategyintelligence and business strategy

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Energy Market ChangesEnergy Market Changes

• Evolution of Energy Trading:Evolution of Energy Trading:– Overview of energy tradingOverview of energy trading– Energy futures and OTC tradingEnergy futures and OTC trading– New market developments and New market developments and

instruments such as weather and instruments such as weather and emissionsemissions

– The Enron disaster’s impact on The Enron disaster’s impact on marketsmarkets

– What’s to comeWhat’s to come

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Evolution of Energy TradingEvolution of Energy Trading

• Historically high price volatilities for oil, Historically high price volatilities for oil, gas and electricitygas and electricity

• More volatility comingMore volatility coming

• Risk shifting not elimination: no silver Risk shifting not elimination: no silver bulletbullet

• More futures contracts failingMore futures contracts failing

• OTC markets in crisisOTC markets in crisis

• Electronic trading & price discoveryElectronic trading & price discovery

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Historical Overview of Historical Overview of Energy TradingEnergy Trading• Need for viable cash markets:Need for viable cash markets:

– crude oilcrude oil– heating oilheating oil– gasolinegasoline– propanepropane– fuel oil and bunkers fuel oil and bunkers – natural gasnatural gas– coalcoal– electricityelectricity

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Historical Overview of Historical Overview of Energy TradingEnergy Trading

• Exchange-traded Futures Contacts:Exchange-traded Futures Contacts:– Transparency, clearing, and performanceTransparency, clearing, and performance– Crude oil (Headline contracts)Crude oil (Headline contracts)– GasolineGasoline– PropanePropane– Home heating oilHome heating oil– Natural gas (Benchmarks created)Natural gas (Benchmarks created)– Electricity Electricity – CoalCoal

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• The Over-the-Counter Markets:The Over-the-Counter Markets:– Flexibility & customizationFlexibility & customization– Longer-termLonger-term– No regulation, more riskNo regulation, more risk– Forward ContractsForward Contracts– Price SwapsPrice Swaps– OTC optionsOTC options– Current market collapseCurrent market collapse

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• Multicommodity Trading Takes Off:Multicommodity Trading Takes Off:– Oil & Petroleum ProductsOil & Petroleum Products– Natural GasNatural Gas– Electric PowerElectric Power– EmissionsEmissions– WeatherWeather– ShippingShipping– LNGLNG

– CoalCoal

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Energy is a Risky BusinessEnergy is a Risky Business

• The Risks:The Risks:– PricePrice– FuelFuel– OperationalOperational– RegulatoryRegulatory– LiquidityLiquidity– CreditCredit

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Why These Tools EmergedWhy These Tools Emerged

• Oil, gas, power and emissions are now Oil, gas, power and emissions are now commoditizedcommoditized

• Unprecedented price volatilityUnprecedented price volatility• Coal becoming a commodityCoal becoming a commodity• Securitizes future sales and Securitizes future sales and

receivablesreceivables• Energy price risk management Energy price risk management

becomes a becomes a fiduciary responsibilityfiduciary responsibility of energy companiesof energy companies

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Why These Tools are Why These Tools are EmergingEmerging

• Deregulation, privatization and risk of Deregulation, privatization and risk of competitive marketscompetitive markets

• Conservative industry on the brink of Conservative industry on the brink of fundamental changefundamental change

• Financial leverage is now more importantFinancial leverage is now more important

• More risk endemic in a market economy More risk endemic in a market economy but more risk mitigation techniques now but more risk mitigation techniques now existexist

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Evolution of Power TradingEvolution of Power Trading

• Energy Policy Act of 1992Energy Policy Act of 1992

• Long-term contracts die (10 to 20 years)Long-term contracts die (10 to 20 years)

• No building except IPPNo building except IPP

• Spot markets are createdSpot markets are created

• Price discovery commencesPrice discovery commences

• NYMEX & others fail at creating futuresNYMEX & others fail at creating futures

• Financial instruments for power failFinancial instruments for power fail

• Market breaks down in 2002Market breaks down in 2002

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• Advantages of Merchant PowerAdvantages of Merchant Power– Wholesale trading essential in deregulated Wholesale trading essential in deregulated

marketsmarkets– No retail load nor obligation to serveNo retail load nor obligation to serve– Act like a traderAct like a trader– Greater arbitrage opportunitiesGreater arbitrage opportunities– Can turn off equipmentCan turn off equipment– More flexibilityMore flexibility– Cash flow becomes kingCash flow becomes king

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• Disadvantages of Merchant PowerDisadvantages of Merchant Power– No retail load (i.e. no cash flow)No retail load (i.e. no cash flow)– Incumbent retail clients can be served Incumbent retail clients can be served

and maintain cash flowand maintain cash flow– Market collapse: oversupplyMarket collapse: oversupply– Weather still the key variableWeather still the key variable– Too much financial leverage (debt)Too much financial leverage (debt)

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Why is this Happening Now?Why is this Happening Now?

• Greed and incompetence have to lead to Greed and incompetence have to lead to market failuremarket failure

• Wrong incentives in place for tradersWrong incentives in place for traders

• Quarterly profits and quarterly bonusesQuarterly profits and quarterly bonuses

• Senior management knew: no rogue tradersSenior management knew: no rogue traders

• Need for oversight both internally and Need for oversight both internally and externallyexternally

• Replication of financial template throughout Replication of financial template throughout the energy complex: not just Enronthe energy complex: not just Enron

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Why is This Happening Why is This Happening Now?Now?• Financial leverage became paramountFinancial leverage became paramount• Hiding debt became the gameHiding debt became the game• Lying became endemicLying became endemic• Perversion of financial engineeringPerversion of financial engineering• The energy companies, banks, The energy companies, banks,

accountants, lawyers and regulators accountants, lawyers and regulators are all to blameare all to blame

• Government asleep at the wheelGovernment asleep at the wheel

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Not Just EnronNot Just Enron

• Major energy market makers in gas, electric Major energy market makers in gas, electric and bandwidth failedand bandwidth failed

• More off balance sheet financing schemes More off balance sheet financing schemes to be further exposedto be further exposed

• Arthur Andersen auditors replaced with Arthur Andersen auditors replaced with rigorous scrutiny of MTM and other dealsrigorous scrutiny of MTM and other deals

• More red ink to be disclosed in next 2 More red ink to be disclosed in next 2 quartersquarters

• Market bottom comingMarket bottom coming

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Rebuilding the MarketRebuilding the Market

• May take rest of the decadeMay take rest of the decade• NYMEX wins by doing nothing: oil and gas NYMEX wins by doing nothing: oil and gas

futures work, are regulated, and business futures work, are regulated, and business as usual. OTC Clearing is a great success!as usual. OTC Clearing is a great success!

• ICE in trouble, salvation is IPEICE in trouble, salvation is IPE• Liquidity crisis brewing: $90+ billion Liquidity crisis brewing: $90+ billion

needed to shore up balance sheetsneeded to shore up balance sheets• Potential power shortages in some areas Potential power shortages in some areas

of the US in the futureof the US in the future

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Rebuilding the MarketRebuilding the Market

• New gas-fired combined cycle turbines New gas-fired combined cycle turbines are not dual fuel capable (a new risk)are not dual fuel capable (a new risk)

• Loss of generation build outLoss of generation build out• Environmental compliance could be Environmental compliance could be

overridden by power shortagesoverridden by power shortages• Load growth still going upLoad growth still going up• Guess what: the digital economy uses Guess what: the digital economy uses

powerpower

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State of Electricity MarketsState of Electricity Markets

• The dispatch queue: nuclear, hydro & coal The dispatch queue: nuclear, hydro & coal with gas for peakingwith gas for peaking

• Microturbines as peakersMicroturbines as peakers• Distributed gen can’t get off the groundDistributed gen can’t get off the ground• Reserve margins are not a bad thing i.e. Reserve margins are not a bad thing i.e.

peak vs. off peakpeak vs. off peak• Spark spreads now under waterSpark spreads now under water• Conventional wisdom in unconventional Conventional wisdom in unconventional

times does not worktimes does not work

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The State of Financial The State of Financial ElectricityElectricity

• Too much price volatility: 1998, 1998, Too much price volatility: 1998, 1998, 2000, 2001 etc.2000, 2001 etc.

• 2002: Collapse of financial trading2002: Collapse of financial trading• Result: real-time hourly market and next Result: real-time hourly market and next

day marketday market• Relaunch of electricity futures by NYMEX:Relaunch of electricity futures by NYMEX:

– NYISO and PJM WestNYISO and PJM West

• ISO indexes and ICEISO indexes and ICE• Mark to modelMark to model

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The State of Electricity The State of Electricity MarketsMarkets• Little speculationLittle speculation

• Supply balancingSupply balancing

• Short-term orientedShort-term oriented

• Destruction of forward price curveDestruction of forward price curve

• Price volatility continues (real-time commodity)Price volatility continues (real-time commodity)

• At least 2 more years to rebuild tradingAt least 2 more years to rebuild trading

• Electricity becomes a Electricity becomes a “strategic commodity”“strategic commodity” just like oil; i.e. it will never be fully deregulatedjust like oil; i.e. it will never be fully deregulated

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Electronic Trading and the Electronic Trading and the OTC Markets (Setback OTC Markets (Setback also)also)

• Over 60 Internet energy platforms Over 60 Internet energy platforms have failedhave failed

• Over hyped and just starting to be Over hyped and just starting to be usedused

• The Internet is just one more The Internet is just one more marketing channel and information marketing channel and information tooltool

• Consumers are slow to change Consumers are slow to change behaviorbehavior

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What’s left of Electronic Energy What’s left of Electronic Energy Trading and ExchangesTrading and Exchanges

• NYMEX ACCESSNYMEX ACCESS

• Automated Power ExchangeAutomated Power Exchange

• Natural Gas Exchange (NGX)Natural Gas Exchange (NGX)

• Intercontinental Exchange (ICE)Intercontinental Exchange (ICE)

• TradeSparkTradeSpark

• Where’s the EnronOnline business?Where’s the EnronOnline business?

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What’s To Come?What’s To Come?

• Supply balancing rather than Supply balancing rather than speculative tradingspeculative trading

• Less trade volumes for gas as wellLess trade volumes for gas as well• Weather derivatives: not a fungible Weather derivatives: not a fungible

commodity, really a reinsurance commodity, really a reinsurance productproduct

• Movement to new marketsMovement to new markets• Green trading markets are real, Green trading markets are real,

government mandated and protectedgovernment mandated and protected

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What’s To Come?What’s To Come?

• Heavy heavy regulatory intervention in Heavy heavy regulatory intervention in marketsmarkets

• FERC “Standard Market Design” is California FERC “Standard Market Design” is California all over again (economists and engineers can’t all over again (economists and engineers can’t make markets)make markets)– Launch is September 2004Launch is September 2004

• Traders are much smarter than government Traders are much smarter than government regulatorsregulators

• More and honest financial disclosure More and honest financial disclosure necessarynecessary

• Wall Street Banks are not energy companies Wall Street Banks are not energy companies and can’t replace the loss of liquidityand can’t replace the loss of liquidity

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The Government ReactionThe Government Reaction

• InvestigationsInvestigations• FERC’s SMD (Sept 2004) and RTOsFERC’s SMD (Sept 2004) and RTOs• State Commissions focused on wrong ballState Commissions focused on wrong ball• CFTC is six months to a year behind marketsCFTC is six months to a year behind markets• Overregulation is imminentOverregulation is imminent• This will not produce one MW of power or one This will not produce one MW of power or one

molecule of gasmolecule of gas• No federal energy policy except bones to No federal energy policy except bones to

ethanol and coal lobbiesethanol and coal lobbies

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Environmental Market Environmental Market EvolutionEvolution• Biggest financial challenge of energy industryBiggest financial challenge of energy industry

• The Beginning: TodayThe Beginning: Today– Opaque pricesOpaque prices– Little trading and poor liquidityLittle trading and poor liquidity– Few participantsFew participants– Wide arbitrage opportunities and fat marginsWide arbitrage opportunities and fat margins– Tremendous inefficiencyTremendous inefficiency– Regulatory uncertaintyRegulatory uncertainty– Cross commodity plays with weather and coalCross commodity plays with weather and coal

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The Next Market: The Next Market: Environmental TradingEnvironmental Trading

– Environmental markets emerge Environmental markets emerge (1995)(1995)

– SO2 (volatility and options)SO2 (volatility and options)– NOX in 1999NOX in 1999– CO2 (100+ trades and growing CO2 (100+ trades and growing

globally)globally)– Bush moves on GHG are confusingBush moves on GHG are confusing– In North America, we make marketsIn North America, we make markets

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• GHG is ready to rollGHG is ready to roll• Energy & agricultural industries are Energy & agricultural industries are

heavily impacted and have liabilitiesheavily impacted and have liabilities• CO2 trades already starting at state CO2 trades already starting at state

level and will be grandfathered inlevel and will be grandfathered in• Renewable portfolio standards in 14 Renewable portfolio standards in 14

states: started in Texas last yearstates: started in Texas last year• Negawatt market under developmentNegawatt market under development

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• Green Trading markets may be $3 trillion Green Trading markets may be $3 trillion market opportunity globally compared to market opportunity globally compared to $5 billion in SO2 and NOX trading today$5 billion in SO2 and NOX trading today

• A North American Market, European and A North American Market, European and AsianAsian

• Carbon is a fungible commodity just like Carbon is a fungible commodity just like oil, and therefore a global market is oil, and therefore a global market is emerging with cross border opportunitiesemerging with cross border opportunities

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Bundling All the Risks: The Bundling All the Risks: The Future of Carbon TradingFuture of Carbon Trading

• John Hancock Natural Resource John Hancock Natural Resource Trade in Australia:Trade in Australia:– Reforestation PlayReforestation Play– Water PlayWater Play– Renewable Energy PlayRenewable Energy Play– Carbon PlayCarbon Play– Real Estate PlayReal Estate Play– Backed by Zurich ReBacked by Zurich Re

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Visions of the Future: Visions of the Future: Post EnronPost Enron• The Emerging Trading World:The Emerging Trading World:

– Energy hedging still in its infancy 25 Energy hedging still in its infancy 25 years after first futures contractyears after first futures contract

– Application of financial engineering to Application of financial engineering to environmental structured and project environmental structured and project financefinance

– Globalization will accelerate trading Globalization will accelerate trading solution (Rest of the world is hot solution (Rest of the world is hot about energy trading and risk about energy trading and risk management)management)

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Visions of the Future: Post Visions of the Future: Post EnronEnron

– Enron’s loss mostly confined to gas Enron’s loss mostly confined to gas and electricityand electricity

– Loss of market maker and risk taker in Loss of market maker and risk taker in gas and power (25-30% of gas gas and power (25-30% of gas markets) more significantmarkets) more significant

– Largest gas & power market maker Largest gas & power market maker and others goneand others gone

– Set back for energy hedging for at Set back for energy hedging for at least two years for gas and powerleast two years for gas and power

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– More physical vs. financial trading More physical vs. financial trading especially for power devolvingespecially for power devolving

– Opportunities in coal, emissions, and oil Opportunities in coal, emissions, and oil tradingtrading

– Loss of EnronOnlineLoss of EnronOnline– Loss of aggressive deregulation advocateLoss of aggressive deregulation advocate

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Visions of the Future: Visions of the Future: Post EnronPost Enron

• Deregulation politicized and dead (i.e. Deregulation politicized and dead (i.e. Gray Davis in California)Gray Davis in California)

• More regulation coming in energy More regulation coming in energy and financial marketsand financial markets

• Don’t meet more laws, need proper Don’t meet more laws, need proper enforcementenforcement

• More financial disclosureMore financial disclosure

• Markets work, Enron didn’tMarkets work, Enron didn’t

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• Debunking of all Enron/McKinsey Debunking of all Enron/McKinsey propaganda:propaganda:– Asset lightAsset light– Disintegration of energy industryDisintegration of energy industry– Telecommunications bigger than energyTelecommunications bigger than energy– Virtual utilityVirtual utility– Etc., Etc. Etc: Common sense is Etc., Etc. Etc: Common sense is

important!important!

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• The loss of responsibility in the energy The loss of responsibility in the energy patchpatch– Phantom tradingPhantom trading– SleevingSleeving– Market manipulationMarket manipulation– Bonuses not tied to real financial performanceBonuses not tied to real financial performance– Traders are too young, arrogant and stupid to Traders are too young, arrogant and stupid to

have this much responsibilityhave this much responsibility– Risk controls are preeminent: market-to-market Risk controls are preeminent: market-to-market

windows based straight through processingwindows based straight through processing– Volatilities are growingVolatilities are growing

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– More volatility coming due to cancellation of More volatility coming due to cancellation of projectsprojects

– Companies in Companies in troubletrouble: AES, Calpine, Dynegy, : AES, Calpine, Dynegy, CMS, Panda, Mirant, Williams, Reliant, Aquila CMS, Panda, Mirant, Williams, Reliant, Aquila and others to join the list and others to join the list

– Movement back to coal due to increased gas Movement back to coal due to increased gas production and deliverability problemsproduction and deliverability problems•Create more emissions activityCreate more emissions activity

– More consolidation: Bigger Globalized Utilities More consolidation: Bigger Globalized Utilities and Big Oil Waiting in the Wingsand Big Oil Waiting in the Wings

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Visions of the Future: Post Visions of the Future: Post EnronEnron• Heavy handed government regulation and Heavy handed government regulation and

investigation underwayinvestigation underway• Strangulation of markets in the near-termStrangulation of markets in the near-term• FERC and SEC will lead the chargeFERC and SEC will lead the charge• Only the Fed can protect the financial Only the Fed can protect the financial

marketsmarkets• Death of the financial electricity market is not Death of the financial electricity market is not

overstatedoverstated• Liquidity crisis brewing: migration of OTC gas Liquidity crisis brewing: migration of OTC gas

to NYMEX accounts for doubling of volumes in to NYMEX accounts for doubling of volumes in past year and now NYMEX has OTC Clearingpast year and now NYMEX has OTC Clearing

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• Accelerating energy market consolidationAccelerating energy market consolidation

• Wellhead to wires: Big oil learns the power Wellhead to wires: Big oil learns the power business slowlybusiness slowly

• European and to a lesser extent Japanese & European and to a lesser extent Japanese & Korean utilities enter the US marketKorean utilities enter the US market

• Fewer global players with mega portfolios of Fewer global players with mega portfolios of generation assets (70,000 -100,000 MW)generation assets (70,000 -100,000 MW)

• Energy will always be an asset heavy Energy will always be an asset heavy businessbusiness

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• More volatilities coming and more More volatilities coming and more cross commodity arbitrage:cross commodity arbitrage:

•emissions and coalemissions and coal

•emissions and weatheremissions and weather

•coal and other fuelscoal and other fuels

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• The markets will be rebuiltThe markets will be rebuilt

• Talent will migrate from energy Talent will migrate from energy trading to environmental tradingtrading to environmental trading

• Financial controls will be betterFinancial controls will be better

• Less liquidity in all markets nowLess liquidity in all markets now

• Accelerated consolidation and Accelerated consolidation and globalizationglobalization

Documents

Peter Fusaro Global Change Associates New York, New York 212-333-4979 global-change