Economics: Energy Trading Success Factors
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By John R. Stephenson

Evolution of the natural gas and electricity market has created a significant new industry player: the wholesale gas and power marketer/trader.

Traditional natural gas pipeline and electric utility businesses sparked by regulatory changes have transitioned from a cost-plus basis of service to market-responsive (spot) pricing structure. Unregulated subsidiaries of these firms are now engaged in the wholesale marketing and trading of natural gas and electricity.

Today’s electricity trading markets are marked by deep corporate financial strength. Many participants in a recent gas and electric industry study commonly market both commodities. The study revealed:

• 33% have affiliations with a natural gas business
• 25% are affiliated with a nonutility generator or are wholly owned subsidiaries of an investor-owned utility (IOU)
• 20% are entrepreneurial by background: and
• 10% are associated with finance houses or investment banks

Though sales volumes drive revenue numbers, the maintenance of a solid margin is the most critical driver of success. Volumes are related in part to the scope of operations and in part to demand. A natural gas marketer in the high-cost Northeastern United States might have substantial revenues associated with its sold or delivered gas volumes. Volume by itself, however, says nothing about corporate margin performance.

Expenses for gas and power marketing and trading organizations are generally quite low. In fact, the largest marketing and trading organizations can be run with less than $150 million in annual general and administrative (G&A) expense. With the substantial volumes generated in this business, the total G&A levels per equivalent unit of volume (Bbtu) are relatively low. Research indicates range of total G&A per Bbtue from $3.75 to $52.50 with the average company hanging around $9.25. These organizations tend to have relatively small numbers of people considering the revenues and volumes involved. In order to structure and execute increasingly complex transaction, an extremely sophisticated type of new employee is needed, resulting in high compensation levels per employee.

Margins vary by commodity. Research shows that most gas marketing operations fall between 1.5% and 2.5% for gross margins. Top performing operations achieve as much as 3.5% gross margins in natural gas. Because of the relative immaturity of the power markets, power margins appear to be more random. For utility-affiliated organizations dispatching power solely in response to market spikes, gross margins can be as high as 20%. For companies actively trading the wholesale electricity market, gross margins typically fall between 0% and 4.5%. It appears difficult for most participants in the emerging electricity trading industry to outperform break-even. However, a firm’s presence in multiple commodities does tend to yield significantly better overall margin performance, even when power operations are negative. Near-term gross margin performance for companies with combined operations (gas and power) is anticipated in the 1.5% to 2.5% range.

Due to the very thin margins in this industry, net income levels, when measured as a percentage of revenue, are very modest for most companies. In fact, most organizations have net income as a percentage of revenue between 0.75% and 1.25%. Net income per dollar of total G&A expense tends to be fairly good. Most participant companies managed to return between 75 cents and $2 (net income per total dollar of G&A expense).

In general, while this business returns very little when measured on a volume or revenue basis, the returns are fantastic when measured on an invested capital basis. The reason is simple. As traded volumes are huge and margins per transaction are thin, profitability measured on a per-transaction basis may be very small indeed. However, the capital employed to manage these trading activities is relatively small, particularly when compared with traditional asset-backed businesses. Therefore, returns on an invested capital basis tend to be very large. A small amount of capital (that necessary to fund a trading floor) can control a large number of transactions (volume) and hence total profits.

One large, poorly executed trade could bring a firm to the verge of bankruptcy. Most industry participants tend to hedge (enter into offsetting transactions) their market position (s) to avoid the detrimental efforts of an adverse price move, hedging more than 99% of the transactions on their books.

KEY DRIVERS

Both core business and the business demands for the wholesale energy marketer and trader are very different than those of the traditional utility players. Industry analysis reveals seven critical energy trading success drivers.

First mover advantage. Marketing and trading organizations have downsized over the years in response to declining margins. As a result, a first mover advantage is important.

Knowledge-intensive. Knowledge-intensive gas and power marketing and trading differs from the traditional utility focus, which is asset-intensive. Intellectual capital is vastly more important than asset intensity. Most of the largest players are moving volumes of power or natural gas in considerable excess of their physical assets. In a sense, they are acting as virtual utilities. Hiring the best and brightest is the key to creating a marketing and trading organization. Many traditional utilities have tried to grow the marketing and trading business from within with poor results.

To match the skill set necessary for keen competition, companies and firms are prospecting from the top business schools, and competing with Wall Street and consulting firms for top graduates. This necessitates a significantly different approach and compensation structure than the practices in effect at utility companies. Even within the wholesale gas and power marketing and trading business, there are huge average pay package differentials between the most competitive firms, at which total pay may exceed $100,000.

Commodity mix. Companies engaged in delivering multiple commodities to the marketplace have performed better than their competitors as this creates both demand push and pull and operational synergies. Firms may be able to structure products and services best tailored to client situations. Lessons learned from dealing in one commodity can be used to structure and create better opportunities in another.

Ownership of strategic assets. Differing from other trading organizations, in many cases a physical energy commodity goes to delivery. By owning strategic assets at a critical system point (a futures settlement receipt and delivery point), vital trading information can be obtained and then relayed to a trader participating in the financial markets. This may create an advantage over a trader who may study a screen full of figures but who does not understand their interdependence with the physical backdrop at a particular trading location. For example, if a wholesale trading company owned a generating plant downstream of a critical transmission pathway that served a major market and was prone to congestion, there would be several advantages. A competitor without the physical assets in this market area would receive price signals solely from the financial marketplace. The supply and demand forces on the physical commodity are significant.

But since financial prices are linked to a physical commodity, there is the possibility for delivery. If a marketing firm controlling the generating station at a critical system point observes that the upstream transmission capability is fully used and yet the market need (demand) is still not served, then an opportunity arises that short-term prices for electricity in that market area may rise should demand exceed supply. Resultant arbitrage opportunities may arise. The firm with a physical asset at the strategic location may supply the physical peaking power into that market at a premium price.

Sophisticated transactions. Companies that have maintained the best margins relative to their peers have been able to originate transactions characterized as:

• long-dated;
• multiple-commodity oriented (e.g. gas and power tolling arrangements);
• financings linked to commodity transactions (the energy marketing and trading organization brings unique abilities to evaluate energy operations and structure creative financings); and
• complicated optionality (knockouts, knockins, and other complicated financial tools)

These are path-dependent options. The value of the option at its maturity date depends upon the path taken by the spot price over the life of such options. This complicated the valuation of such options. In the case of a knockin or knockout option, the option value depends upon whether the underlying spot price crosses some prespecified upper or lower bound. An example of a knockin option could be an at-the-money put option written on the S&P Index, which currently trades at around 1,375. The knockin (barrier condition) could be set at 1,100 for the option to be exercisable. Once 1,100 is breached on the S&P, the Gamma (the sensitivity of delta or hedge ratio to changes in the underlying asset) expands to its maximum value. Such hybrid options are difficult to value, so sophisticated players can benefit by more directly tailoring products to client circumstances and by arbitraging knowledge.

Operational scale. In a trading organization, the ability to achieve scale and become a market-maker offers the opportunity to make above-average returns. Increases in a trading organization’s size or scale means exposure to more transactions. This has several advantages: incremental business, opportunity for increased market knowledge and potential for structuring more sophisticated transactions. As an organization’s size increases, it becomes the counterparty of choice for other market participants who wish to lay off some of their own respective exposures. This company will have to become a market-maker able to influence prices to a greater degree than competition.

Margin focus. Many players have followed a volume strategy, because most public information uses volume rankings. With thin margins, this strategy could lead to financial distress. Successful companies concentrate on structured transactions that are thought out carefully in advance with the best human capital available.

John R. Stephenson, a chartered financial analyst, is vice president of Utility and Related Services practice at Sterling Consulting Group.