State of Energy Trading &
Markets After Enron
EIM Conference
Tarpon Springs, Florida
February 24, 2003
Peter Fusaro
Global Change Associates
New York, New York
212-333-4979
www.global-change.com
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GCA Products & Services
• Books:
– New York Times bestseller What Went Wrong
at Enron (John Wiley, July 2002)
– Energy Convergence (John Wiley, May 2002)
– Energy Derivatives:Trading Emerging
Markets (2000)
– Energy Risk Management (McGraw-Hill, 1998)
• Customized consulting for energy & financial
service companies in energy & environmental
risk management advisory, competitive
intelligence and business strategy
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Energy Market Changes
• Evolution of Energy Trading:
– Overview of energy trading
– Energy futures and OTC trading
– New market developments and instruments
such as weather and emissions
– The Enron disaster’s impact on markets
– What’s to come
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Evolution of Energy Trading
• Historically high price volatilities for oil,
gas and electricity
• More volatility coming
• Risk shifting not elimination: no silver
bullet
• More futures contracts failing
• OTC markets in crisis
• Electronic trading & price discovery
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Historical Overview of
Energy Trading
• Need for viable cash markets:
– crude oil
– heating oil
– gasoline
– propane
– fuel oil and bunkers
– natural gas
– coal
– electricity
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Historical Overview of Energy
Trading
• Exchange-traded Futures Contacts:
– Transparency, clearing, and performance
– Crude oil (Headline contracts)
– Gasoline
– Propane
– Home heating oil
– Natural gas (Benchmarks created)
– Electricity
– Coal
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Historical Overview of Energy
Trading
• The Over-the-Counter Markets:
– Flexibility & customization
– Longer-term
– No regulation, more risk
– Forward Contracts
– Price Swaps
– OTC options
– Current market collapse
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Historical Overview of
Energy Trading
• Multicommodity Trading Takes Off:
– Oil & Petroleum Products
– Natural Gas
– Electric Power
– Emissions
– Weather
– Shipping
– LNG
– Coal
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Energy is a Risky Business
• The Risks:
– Price
– Fuel
– Operational
– Regulatory
– Liquidity
– Credit
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Why These Tools Emerged
• Oil, gas, power and emissions are now
commoditized
• Unprecedented price volatility
• Coal becoming a commodity
• Securitizes future sales and receivables
• Energy price risk management becomes a
fiduciary responsibility of energy
companies
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Why These Tools are Emerging
• Deregulation, privatization and risk of
competitive markets
• Conservative industry on the brink of
fundamental change
• Financial leverage is now more important
• More risk endemic in a market economy
but more risk mitigation techniques now
exist
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Evolution of Power Trading
• Energy Policy Act of 1992
• Long-term contracts die (10 to 20 years)
• No building except IPP
• Spot markets are created
• Price discovery commences
• NYMEX & others fail at creating futures
• Financial instruments for power fail
• Market breaks down in 2002
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Evolution of Power Trading
• Advantages of Merchant Power
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Wholesale trading essential in deregulated markets
No retail load nor obligation to serve
Act like a trader
Greater arbitrage opportunities
Can turn off equipment
More flexibility
Cash flow becomes king
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Evolution of Power Trading
• Disadvantages of Merchant Power
– No retail load (i.e. no cash flow)
– Incumbent retail clients can be served and
maintain cash flow
– Market collapse: oversupply
– Weather still the key variable
– Too much financial leverage (debt)
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Why is this Happening Now?
• Greed and incompetence have to lead to market
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failure
Wrong incentives in place for traders
Quarterly profits and quarterly bonuses
Senior management knew: no rogue traders
Need for oversight both internally and externally
Replication of financial template throughout the
energy complex: not just Enron
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Why is This Happening Now?
• Financial leverage became paramount
• Hiding debt became the game
• Lying became endemic
• Perversion of financial engineering
• The energy companies, banks,
accountants, lawyers and regulators are all
to blame
• Government asleep at the wheel
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Not Just Enron
• Major energy market makers in gas, electric and
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bandwidth failed
More off balance sheet financing schemes to be
further exposed
Arthur Andersen auditors replaced with rigorous
scrutiny of MTM and other deals
More red ink to be disclosed in next 2 quarters
Market bottom coming
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Rebuilding the Market
• May take rest of the decade
• NYMEX wins by doing nothing: oil and gas
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futures work, are regulated, and business as
usual. OTC Clearing is a great success!
ICE in trouble, salvation is IPE
Liquidity crisis brewing: $90+ billion needed to
shore up balance sheets
Potential power shortages in some areas of the
US in the future
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Rebuilding the Market
• New gas-fired combined cycle turbines are
not dual fuel capable (a new risk)
• Loss of generation build out
• Environmental compliance could be
overridden by power shortages
• Load growth still going up
• Guess what: the digital economy uses
power
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State of Electricity Markets
• The dispatch queue: nuclear, hydro & coal with
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gas for peaking
Microturbines as peakers
Distributed gen can’t get off the ground
Reserve margins are not a bad thing i.e. peak
vs. off peak
Spark spreads now under water
Conventional wisdom in unconventional times
does not work
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The State of Financial Electricity
• Too much price volatility: 1998, 1998, 2000,
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2001 etc.
2002: Collapse of financial trading
Result: real-time hourly market and next day
market
Relaunch of electricity futures by NYMEX:
– NYISO and PJM West
• ISO indexes and ICE
• Mark to model
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The State of Electricity Markets
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Little speculation
Supply balancing
Short-term oriented
Destruction of forward price curve
Price volatility continues (real-time commodity)
At least 2 more years to rebuild trading
Electricity becomes a “strategic commodity”
just like oil; i.e. it will never be fully deregulated
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Electronic Trading and the
OTC Markets (Setback also)
• Over 60 Internet energy platforms have
failed
• Over hyped and just starting to be used
• The Internet is just one more marketing
channel and information tool
• Consumers are slow to change behavior
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What’s left of Electronic Energy
Trading and Exchanges
• NYMEX ACCESS
• Automated Power Exchange
• Natural Gas Exchange (NGX)
• Intercontinental Exchange (ICE)
• TradeSpark
• Where’s the EnronOnline business?
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What’s To Come?
• Supply balancing rather than speculative
trading
• Less trade volumes for gas as well
• Weather derivatives: not a fungible
commodity, really a reinsurance product
• Movement to new markets
• Green trading markets are real,
government mandated and protected
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What’s To Come?
• Heavy heavy regulatory intervention in markets
• FERC “Standard Market Design” is California all
over again (economists and engineers can’t
make markets)
– Launch is September 2004
• Traders are much smarter than government
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regulators
More and honest financial disclosure necessary
Wall Street Banks are not energy companies and
can’t replace the loss of liquidity
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The Government Reaction
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Investigations
FERC’s SMD (Sept 2004) and RTOs
State Commissions focused on wrong ball
CFTC is six months to a year behind markets
Overregulation is imminent
This will not produce one MW of power or one
molecule of gas
No federal energy policy except bones to ethanol
and coal lobbies
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Environmental Market Evolution
• Biggest financial challenge of energy industry
• The Beginning: Today
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Opaque prices
Little trading and poor liquidity
Few participants
Wide arbitrage opportunities and fat margins
Tremendous inefficiency
Regulatory uncertainty
Cross commodity plays with weather and coal
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The Next Market: Environmental
Trading
– Environmental markets emerge (1995)
– SO2 (volatility and options)
– NOX in 1999
– CO2 (100+ trades and growing globally)
– Bush moves on GHG are confusing
– In North America, we make markets
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The Next Market: Environmental
Trading
• GHG is ready to roll
• Energy & agricultural industries are heavily
impacted and have liabilities
• CO2 trades already starting at state level
and will be grandfathered in
• Renewable portfolio standards in 14
states: started in Texas last year
• Negawatt market under development
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The Next Market: Environmental
Trading
• Green Trading markets may be $3 trillion
market opportunity globally compared to
$5 billion in SO2 and NOX trading today
• A North American Market, European and
Asian
• Carbon is a fungible commodity just like
oil, and therefore a global market is
emerging with cross border opportunities
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Bundling All the Risks: The Future
of Carbon Trading
• John Hancock Natural Resource Trade in
Australia:
– Reforestation Play
– Water Play
– Renewable Energy Play
– Carbon Play
– Real Estate Play
– Backed by Zurich Re
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Visions of the Future: Post
Enron
• The Emerging Trading World:
– Energy hedging still in its infancy 25 years
after first futures contract
– Application of financial engineering to
environmental structured and project
finance
– Globalization will accelerate trading
solution (Rest of the world is hot about
energy trading and risk management)
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Visions of the Future: Post
Enron
– Enron’s loss mostly confined to gas and
electricity
– Loss of market maker and risk taker in gas
and power (25-30% of gas markets) more
significant
– Largest gas & power market maker and
others gone
– Set back for energy hedging for at least
two years for gas and power
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Visions of the Future: Post
Enron
– More physical vs. financial trading
especially for power devolving
– Opportunities in coal, emissions, and oil
trading
– Loss of EnronOnline
– Loss of aggressive deregulation advocate
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Visions of the Future: Post
Enron
• Deregulation politicized and dead (i.e. Gray
Davis in California)
• More regulation coming in energy and
financial markets
• Don’t meet more laws, need proper
enforcement
• More financial disclosure
• Markets work, Enron didn’t
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Visions of the Future: Post Enron
• Debunking of all Enron/McKinsey
propaganda:
– Asset light
– Disintegration of energy industry
– Telecommunications bigger than energy
– Virtual utility
– Etc., Etc. Etc: Common sense is important!
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Visions of the Future: Post Enron
• The loss of responsibility in the energy patch
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Phantom trading
Sleeving
Market manipulation
Bonuses not tied to real financial performance
Traders are too young, arrogant and stupid to have
this much responsibility
– Risk controls are preeminent: market-to-market
windows based straight through processing
– Volatilities are growing
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Visions of the Future: Post
Enron
– More volatility coming due to cancellation
of projects
– Companies in trouble: AES, Calpine,
Dynegy, CMS, Panda, Mirant, Williams,
Reliant, Aquila and others to join the list
– Movement back to coal due to increased
gas production and deliverability problems
• Create more emissions activity
– More consolidation: Bigger Globalized
Utilities and Big Oil Waiting in the Wings
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Visions of the Future: Post Enron
• Heavy handed government regulation and
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investigation underway
Strangulation of markets in the near-term
FERC and SEC will lead the charge
Only the Fed can protect the financial markets
Death of the financial electricity market is not
overstated
Liquidity crisis brewing: migration of OTC gas to
NYMEX accounts for doubling of volumes in past
year and now NYMEX has OTC Clearing
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Visions of the Future: Post Enron
• Accelerating energy market consolidation
• Wellhead to wires: Big oil learns the power
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business slowly
European and to a lesser extent Japanese &
Korean utilities enter the US market
Fewer global players with mega portfolios of
generation assets (70,000 -100,000 MW)
Energy will always be an asset heavy business
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Visions of the Future: Post
Enron
• More volatilities coming and more cross
commodity arbitrage:
• emissions and coal
• emissions and weather
• coal and other fuels
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Visions of the Future: Post
Enron
• The markets will be rebuilt
• Talent will migrate from energy trading
to environmental trading
• Financial controls will be better
• Less liquidity in all markets now
• Accelerated consolidation and
globalization
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