ENERGY TRADING: IS THE
TURNAROUND IN SIGHT?
SECOND ANNUAL ENERGY
TRADING AND MARKETING
CONFERENCE
GEMI
Vincent Kaminski
Houston, January 22, 2004
© 1999 VK-9060359-1
Outline
General conclusion: very optimistic long-term but one has to
be realistic and cautious in the short and medium-term
 One should rather talk about the crisis of the merchant
energy business and the contagion effect that undermined
energy trading
 The preconditions for the recovery of energy trading
business
© 1999 VK-9060359-2
ENERGY TRADING:
WHAT WENT WRONG?
© 1999 VK-9060359-3
The Incredibly Shrinking Energy
Market
 Collapse of energy trading
 Shutdown or drastic reduction of the size and scope of most
energy trading operations
 Sharp drop in trading volumes and liquidity at most locations
 The breakdown of the infrastructure of energy markets
 Price discovery issues – lack of confidence in price indices
 Dissolution of trading teams and research units
 Regulatory uncertainty
 Unrealistic perceptions of profitability of energy trading and
marketing during 200-2001 and over expansion in terms of
headcount
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Merchant Energy Business
Short-term Price
Fluctuations
Market
Making
RISK FACTORS
Hedging
And Asset
Optimization
Proprietary
Speculative
Trading
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Long-term
Price Trends
Asset
Development
Long-term
Structured
Transactions
Contagion Effect
 Energy trading was affected primarily by adverse
developments related to fixed assets and long-term structured
transactions decisions
 Weak balance sheets of merchant energy companies
 Weak cash flows
 Flawed business models
 Excessive expansion of long-term transactions and
overinvestment in fixed assets was caused by
 Abuses of mark-to-market and fair value accounting
 The incentive system rewarding originators and asset
developers for concluded deals, not for profitable deals
Credit downgrades undermined energy trading
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Profitability of Energy Trading
Sources of profits in energy trading
 Bid-offer spreads
 Proprietary, directional trading
 Sales of risk management tools
 Stand alone derivatives
 Management of the supply chain on customers’ behalf
 Support of physical operations (trading around assets)
 The perceptions of energy trading profitability were distorted
by a combination of unique historical circumstances
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Bid-Offer Spreads
 A market maker: contractual or implied commitment to post bid –
offer spreads and to take either side of a transaction
 Bid – offer spreads in the short-term and medium-term transactions
were reduced to unsustainably low level due to excess capital
allocated to energy trading
 A hypothetical example
 5,000 transactions a day
 250 trading days per year
 5,000 MMBtus per transaction
 $0.005 bid – offer spread per MMBtu
 Total profit: 5000 x 5000 x 250 x 0.005 / 2 = $15,625,000
 The spreads were too low to support a trading operation based on
the pure market making activities, given over brokering of the industry
© 1999 VK-9060359-8
Other Sources of Trading Profits
 Proprietary trading: taking directional positions, based on
the traders’ intuition, research contributions (weather forecasts,
fundamental models), information flow from the market making
activities
 Proprietary trading can be a very profitable operation for a
specific company. A zero-sum game operation cannot support
the entire energy trading industry.
 Growth of profits from year to year requires very aggressive
escalation of trading operations and acceptable risks
 Strong temptation to influence the market outcomes through
artificial and often illegal actions
© 1999 VK-9060359-9
Preconditions of Recovery of
Energy Trading
 A diversified universe of players, including energy majors and
independent producers, big industrial users, regulated utilities and
financial institutions
 Rebuilding of the infrastructure of the energy trading business
 The trust in published energy price indices is a critical condition
of market recovery and future growth
 Last scale energy trading is a very expensive operation, given
fragmentation of the physical and institutional infrastructure of
the energy industry
 The
industry will have to streamline the procedures for
handling physical flows
Outsourcing of physical operations will become increasingly
popular
© 1999 VK-9060359-10
Contact information:
Vkaminski@aol.com
© 1999 VK-9060359-11