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White Paper
Emerging Trends in Wholesale Power Marketing and Trading
WRITTEN BY F. Mitchell Davidson Uday Narang Chris Madland Entergy Power Marketing Corporation http://davidson.UtilitiesProject.com
F. Mitchell Davidson is senior vice
The power industry is undergoing rapid structural changes. The nonstorability, fragmented transmission, and volatile supply and demand characteristics of power combine to yield an exceptionally volatile commodity. The broad range of successes and failures among industry participants, as well as advantages of scale, are spurring rapid consolidation, a trend that will likely continue until full competition across the domestic market. The financial complexity of transacting instruments with price ranges spanning two orders of magnitude is spawning a wide and growing variety of structured transactions. Power shops are evolving into Wall Street-style trading concerns, with professional risk analysts and managers in nearly every operational function and personnel rosters heavy with quantitative expertise. The power trading business – a concept that required extensive explanation as recently as 1998 – is rapidly transforming from “emerging market” status to a fully developed sector of the global commodities industry.
president of Trading, Marketing, and Risk Management at Entergy Power Marketing Corporation. Mr. Davidson worked previously at Enron, Union Carbide, and Allied Signal. Uday Narang is vice president of Commodities Trading at Entergy and worked previously at Cinergy Corp., Metallgesellschaft, and J.P. Morgan. Chris Madland is a derivatives trader at Entergy and worked previously at Morgan Stanley and Andersen Consulting.
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Background The physical nature of electricity imposes market constraints quite unlike those seen in other energy markets. With today’s technology, electricity storage is impractical and uneconomic. This creates a market that is bounded by end users and generators; storage players and holding investors are precluded from the physical power market. Residential power demand is currently priceinelastic and grid managers are reluctant to interrupt delivery. When supply is constrained, excess demand enables long players to charge prices that are many multiples of generation cost. Transmission limitations can isolate certain regions, leading to price spikes in the island region while adjacent regions enjoy normal prices. Some power trading shops that were established as branches of existing crude or natural gas shops have encountered powerspecific obstacles they have been unequipped to overcome. As a result, the market has seen some shops exit and others consolidate. The recent wave of consolidation will most likely continue. Power traders and marketers face difficult analytical problems in spot price estimation, forward price and volatility curve construction, option pricing, and structured transaction valuation. Successfully solving these problems requires techniques and skill sets
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somewhat different from those used in the crude, products, and natural gas markets. Sophisticated structured deals are becoming more prevalent as trading shops adapt to the market’s risk characteristics. Risk management is now a key component of every aspect of dealmaking and quantitative analysts are enjoying a boom in employment demand. The power market’s ongoing adaptation to electricity’s unique demands is observable through several trends: the consolidation of industry players continues; structured transaction volume is growing; risk management is now a process-wide activity; and trading shops are demanding quantitativelytrained analysts as never before. We describe the development of these trends.
Introduction The power market exhibits interesting and unique characteristics. Electricity is a perishable commodity, market price is highly volatile, price distributions are usually not lognormal as observed in capital and equity markets, supply and demand dynamics are abrupt and volatile, transmission capabilities and constraints are intermittent, and contract liquidity suffers dramatically from a relatively small number of market participants. Because of these market characteristics, success in trading and hedging demands
U.S. Quarterly Power Sales and Marketers Population
S A L E S million MWh
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MARKETERS
600 500
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Figure 1
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Growth in quarterly power sales and marketers population in the United States
price forecasting techniques, sophisticated financial risk management, and advanced quantitative analysis heretofore unseen in traditional energy markets such as crude, products, and natural gas. Some power trading shops have failed and exited the industry. Others have consolidated to survive adverse financial impacts arising from failure to manage these difficult problems. The industry is rapidly adjusting. Market players continue to both consolidate and exit the industry. Structured product usage is increasing and is indeed essential for producers. Risk management is now an essential role within trading, credit, and physical per formance as well as the traditional risk management and financial reporting functions. Finally, quantitatively trained personnel are in record demand on the energy job market. We highlight aspects of these ongoing trends.
Consolidation in the Power Industry McGraw-Hill’s Power Markets Week has tracked and ranked power marketers by volume (megawatt-hour) sales since 1995. Since the emergence of broad wholesale trading in 1997, the list of significant marketers (i.e., large enough to be tracked) has grown from 56 players in Q1-1997, to a peak population of 144 marketers in Q3-1999, to the most recent total of 117 in Q1-2000 1. While the population mix of marketers has changed dra-
matically through the rankings, both the growth rate and total number of marketers have peaked and are currently declining. Over the same period the volume of power traded has grown steadily. The Power Report, an industry analysis newsletter, calculated that 80 percent of the growth in U.S. energy demand since 1990 has been met by electricity2. Figure 1 illustrates the evolution of the power marketer population and volume of power traded since Q1-1997. To provide some insight into the changing mix of power marketers, Table 2 (included in the Web edition of this white paper) lists current and past mergers on file with the Federal Energy Regulatory Commission. The classical economic consolidation phase of a growing industry, with the accompanying entrance and exit of firms, is clearly underway. The broker services market reflects consolidation as well; Table 1 lists broker shops that have merged or exited the power trading business. Common reasons for recent power marketer mergers are cited in the industry press. These include reducing costs, increasing earnings, improving competitive position, and simply growing in size in order to compete when retail competition ensues. Less frequently cited but prevalent of late are instances of poor trading results and consequent industry exit or merger with a stronger partner. The current environment is somewhat different from that in 1998 and 1999, when many marketers were willing to
sacrifice profits in return for larger market share. Navigant Consulting, a Chicagobased energy analysis firm, studied profit margins and volumes traded for the top ten marketers and electric utilities and found that firms were valuing the establishment of firm name and identity more than profit margins during that period 3. Fur ther, Navigant forecast that by 2004, only about a dozen large marketers would sur vive the industry shakeout. An earlier study for the U.S. Department of Energy by Policy Assessment Corporation4 forecast as few as five large survivors following the industry’s transition to retail competition. The volatile price, supply and demand, and liquidity problems in electricity trading are undoubtedly contributory factors to loss-driven consolidation – many firms have been simply unequipped to manage these technical challenges. The recent wave of consolidation activity will continue until the physical market’s characteristics change markedly – that is, until significantly more generation is installed, transmission assets are expanded and constraints relieved, and market inefficiencies due to incomplete deregulation are eliminated.
Structured Product Necessity and Development It is worth noting that since the volume of power traded is growing while the number of marketers is nearly flat or declining (Figure 1), the volume share of incumbents is growing. In other words, the number of active shops is falling but the volume handled by each shop is growing. Larger volumes magnify the financial impact of adverse market moves on an organization. This fact necessitates an increased focus on structurally managing exposure via shaped transactions, as well as improved risk management functions and stronger quantitative analysis. Power traders who transacted in 1997 recall that the $100/MWh price level was commonly accepted as a practical market ceiling. Only a year later, dayahead prices as high as $4,000/MWh and hourly prices near $10,000/MWh
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shocked market expectations and shuttered a number of shops who were exposed to short positions. Several marketers also defaulted on their contractual delivery obligations, propagating the damage to downstream trading partners. Lawsuits are still ongoing from the price events of June 1998. Similar price events occurred throughout the summers of 1998 and 1999. While 2000 has been unseasonably cool, prudent power marketers are more risk averse in their trading practices due to the continuing possibility of similar price spikes. Ordinary long and short positions expose the position holder to unlimited rising price risk (for short positions) and large, but limited, falling price risk (for long positions). Against forward contracts prior to delivery, vanilla European options on swaps provide collar mechanisms. Against forward contracts taken to delivery, “daily” options provide collar mechanisms. A daily option for a particular month is a portfolio of European options, one option for each delivery day in the month’s contract, where each option is exercised on the prior business day. There are two major problems using these elementary option strategies to manage the risk of forward contracts. The first problem is liquidity; relatively few marketers actively trade power options and fewer still make markets in them. One prominent power option broker estimated that the volume of options transacted has tripled annually since 1998, but added that days can pass with only a few trades across all Eastern Interconnect markets. The second problem is market incompleteness. When forW E B L I N K
The intricacies of hedging are addressed by Rusty Braziel (Altra Energy), David W. Haley (Aquila Energy), and Neal Shumway (Aquila Energy) in their white papers in this book and on the Utilities Project website, www.UtilitiesProject.com.
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Comparison of June Forward Contracts and Cash Prices: TVA $120
$5.00 $4.50 TVA
$100
T V A
Forward June 2000
$4.00 Henry Hub NG Cash
$3.50
$80 NYMEX NG
$3.00
June 2000
P o w e r
$60
$2.50 TVA Daily Cash
$2.00
$40
$1.50
H E N R Y H U B N G
$1.00
$20
$0.50 $0
$0 5/1 00
Figure 2
5/5 00
5/9 00
5/13 00
5/17 00
5/21 00
5/25 00
5/29 00
6/2 00
6/7 00
6/11 00
6/15 00
6/20 00
Forward power prices for the June Into TVA power contract reflected the possibility of daily price spikes, but daily physical delivery prices failed to meet that expectation, resulting in a severe forward/daily price disconnect. The corresponding natural gas situation lacks such a disconnect.
ward option contracts are written, the underlying security is actually a basket of individual daily physical power contracts, one obligation for each delivery day in the month of the contract. However, the market does not trade the individual delivery days until the month of delivery. Technically, this means the basis set of these securities is incomplete. What this means is that traders cannot fully hedge daily options on a forward basis, and also cannot fully hedge individual daily physical power contracts on a forward basis. Since the largest determinant of a single day’s price spike occurring is short-term weather, which at present can’t be reliably forecast more than a few days in advance, this particular imper fection in market structure will likely remain. As an example of the difficulty in hedging these contracts, consider a trader who enters into a shor t for ward contract for June deliver y, selling the contract for $50/MWh in April, two months prior to deliver y. If taken to deliver y, the position will lose money each day in June that the daily physical power contract trades above $50/MWh and will make money when the dailies trade below $50/MWh. A single day’s price spike at $2,000/MWh could prove disastrous, but the only for ward hedging mechanism available is to purchase a daily call
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option to limit price increase exposure. Given the price spikes seen in recent summers, such daily options are priced by the market to reflect the possibility of many days in the thousand-dollar price regime. As a result, the premium demanded for such options is a significant liability for all days during June deliver y when prices don’t increase beyond the option’s strike price. As an example of the for ward/daily physical price independence, consider Figure 2 which illustrates the per formance of the into TVA power contract for June 2000 deliver y. The behavior of the for ward contract price exhibits the market’s expectation of possible price spikes, but the daily prices for June deliver y reflect cool weather, weak demand, sufficient generation capability, and the lack of transmission constraints – i.e. low prices. Marketers who took long June TVA positions into daily deliver y incurred heavy financial losses. To contrast with another energy commodity, compare the for ward natural gas contract price levels seen in Figure 2 with the daily gas deliver y prices. The daily volatility and for ward/daily price disconnects seen in the power market are generally absent in the more mature, efficient, and complete natural gas market.
Entergy Power, Henry Hub Natural Gas, and WTI Cushing Crude Daily Volatility 1600%
100% 90%
1400% 80% 1200%
70%
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60%
HH Natural Gas
Cinergy
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50%
(right scale)
(left scale)
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Figure 3
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7/13 7/20 99 99
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8/3 99
8/10 8/17 99 99
8/24 8/31 99 99
Volatility comparison between power, crude, and natural gas
Some marketers have tried to address these hedging problems by introducing exotic options from the capital and equity markets: Asian, Bermudan, and barrier options have been floated in the broker market but have been thinly traded, if at all. Again, liquidity is a major constraint. Since derivatives such as these have not yet solved such hedging problems, many marketers have turned to more elaborate structured, or shaped transactions. Structured “one-off” agreements are customized to the parties’ specific needs and risk tolerances, but require lengthy valuation, negotiation, and contract legal review cycles. Fuel tolling, must-take/optional-take, capped and floored volume, capped and floored price, and weather-dependent payment terms are examples of features currently seen in structured power transactions. Such sophisticated structured contracts will continue to increase in volume, especially as domestic markets proceed to full deregulation and retail competition.
Proliferation of Risk Management Roles Across Trading Functions A risk manager’s job in power trading used to entail producing a daily position report for trading management. Events such as $4,000/MWh spot prices, defaulting counterparties, failing genera-
tion units, and incorrectly marked positions have stimulated broader applications for risk management across trading organizations. We highlight a few key roles: Market price risk: Spot power price volatility5 approaching 1,600 percent has occurred in summer months and forward price volatility lies in the 40 percent to 60 percent range. Traders manage this price risk with forward, daily, option, and structured contracts. Payoff shaping with caps, floors, and collars is common. Daily determination of outright power position (forward and spot contracts) and derivative positions requires a risk team knowledgeable in determining forward-equivalent positions for options (delta-equivalent) and capable of managing a wide assortment of books across locations and delivery terms. Correctly pricing the derivative components of a book is another complex task necessary for daily mark-to-market reporting and Value-at-Risk exposure reporting. In some shops the risk reporting team is larger than the trading team; this is reasonable if many locations and products are traded. This functional area is growing as fast as product types emerge. Credit risk: The events of June 1998, which featured massive defaults, resulted in the immediate executive review of the credit management function in nearly ever y power shop. Since the power market today is dominated by
over-the-counter, phone-brokered trades, there is no per formance guarantee mechanism as seen in exchange markets6. In addition to standard OTC trading credit mechanisms such as letters of credit, corporate guarantees, and netting agreements, a prudent shop should now have real-time counterpar ty exposure tracking. As traders enter deals into computer systems, net counterpar ty exposure is monitored and automatically compared to trigger levels. When exposure reaches defined trigger limits, credit action is usually immediate: trading with the par ticular counterpar ty is halted until additional credit is posted or outstanding balances are wired. Financial review of prospective trading par tners now occurs ever y quar ter, typically, and a group of credit professionals are wholly dedicated to counterpar ty selection and rejection. This area is undergoing continual refinement. Operational risk: Basing a summer trading por tfolio upon flawless operation of a generation asset could be catastrophic in the event of plant failure. Power marketers with a large por tfolio of generation assets may choose to selfinsure. Alternatively, power plant unit insurance is now a viable product available from several large insurance concerns. This insurance function is growing rapidly. Accounting risk: An active power trading firm may trade positions spanning 10 to 20 deliver y locations, with corresponding transmission positions and aligned fuel positions. These products may trade in monthly contracts ranging from the current month out to two years, and in summer contracts or calendar contracts out to five years. Fur ther, the current month contract is divided into ad-hoc deliver y segments that change daily: next-day, balance-ofweek, next-week, and balance-of-month deals. Many packaged and customized software systems are now offered to suppor t financial trading, trade capture, credit approval, position tracking, markto-market, Value-at-Risk, exception
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repor ting and on-demand data mining. However, capturing the physical aspect of the industr y remains a customized solution. Use and suppor t of these systems is an ongoing challenge, and crossfunctional systems integration will continue to evolve. Power trading demands an increasingly broad skill base in these areas of risk management and the industry will undoubtedly see ongoing refinement of these roles.
BROKER FIRM
DISPOSITION
Amerex, BTU
acquisition / merger
APB, Chapel Hill
acquisition / merger
Choice!
exit
Continental Power Exchange
exit
ED & F Man
exit
ENC
exit
Eurobrokers
exit
Exco, Prebon
acquisition / merger
Quantitative Requirements and Staff Demands
Garban
exit
Gerald, SDI, TFS
acquisition / merger
The Power Marketing Association compiles a weekly online directory (www.powermarketers.com) of power industry employment opportunities. Recently (07/31/00) the directory listed 205 job openings of which fully 33 percent (67 openings) were for quantitative analyst or risk analyst positions. In contrast, only 10 percent (21 openings) were for trading or trading-related (e.g. trading management) positions. This sampling of openings is reflective of the industry’s collective realization that successfully trading power and managing the associated risk is a highly technical endeavor. Power trading staff who were in the industry in 1996 and 1997 recognize the staff transformation that has occurred. While personal industry relationships and a fat Rolodex are still helpful tools, entire quantitative analysis groups are now common on most power trading floors. Figure 3 illustrates the volatility time series for the Into Cinergy spot power, WTI Cushing prompt month, and Henry Hub spot natural gas daily prices during the summer of 1999. The enormous
Great Dane
exit
Optima
exit
PVM
exit
Spectron
exit
W E B L I N K
The Power Marketing Association (PMA) maintains a valuable online resource for the “new competitive electric power industry.” PMA OnLine features a wealth of news, information, and features about the deregulating, competitive electric power industry. Visit the site at www.powermarketers.com. vices are provided free-of-charge for PMA members as well as nonmembers, too. 130
Ta b l e 1
Broker shops exiting power trading or merging with other broker shops. (Source: Industry survey of power brokers and traders; not intended to be a comprehensive list.)
volatility in spot power is evident: the realized volatility for power in August approached 1,600 percent, compared to 30 percent to 40 percent for crude and natural gas. Interestingly, those hydrocarbon products are avoided by many commercial money managers due to their “extreme” volatility, which is dramatically dominated by that of power. The volatility inherent in power prices necessitates serious analytical firepower on the trading floor. There are several other major analytical problems: Spot price estimation: Spot prices during non-spike pricing periods (usually non-summer months) are dependent upon the marginal cost of generation. At each generation unit, this depends upon the characteristics of the particular plant (heat rate, or amount of fuel required to produce one megawatt-hour of power) and fuel costs (for fuel oil, natural gas, coal, hydro motion, or nuclear energy). Forecasting the prevailing spot price in a particular region then depends upon determining which plants are on the margin, which is a difficult information problem by itself. Assessing which regional plants are on the margin depends upon
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accurately modeling load (power demand), which requires precise weather forecasts. It is also necessary to forecast the price of fuel used by plants in the generation stack. Unexpected events such as unplanned power plant outages and transmission curtailment also play a large role. Accurately estimating spot prices is not a trivial problem. Forward price estimation/forecasting: Forward price forecasting is another challenging problem. Forward prices depend upon forward fuel prices, perceived future capacity/demand imbalances, and climate forecasting. The power market is inefficient enough that a few large marketers can also move prices in their favor, at least temporarily. Option pricing: The payoff of daily options depends primarily upon shortterm weather phenomena, which are largely unknown on a forward basis. Estimating the payoff of daily options is analytically similar to estimating spot prices and estimating the payoff of monthly options is analytically similar to estimating forward prices. Estimating the pre-delivery value of such options, for forward trading purposes, also depends
upon correctly modeling implied volatility. Volumetric estimation: Many types of physical structured transactions involve a varying volume of delivered power. Pricebased instruments cannot hedge volume risk, since volume risk depends upon consumption demand, which is at present almost perfectly price-inelastic. Demand in power, being weather-driven, can be hedged with weather-linked instruments. Newer structures such as cumulative coolingdegree day (CDD) and cumulative heatingdegree day (HDD) swaps, and options on those swaps, are directly applicable to volume-related hedging problems. The quantitative problems associated with historical and future weather analysis, prerequisite to transacting such weather-related instruments, warrant a small team of analysts wholly dedicated to the task. As the variety of structured transactions and derivative instruments grows, the demand for quantitatively trained analysts and traders will increase commensurately. Much like the personnel evolution seen on Wall Street in the 1990s, it is increasingly common to find doctorates from the math, science, and engineering disciplines on the power trading floor.
Conclusion The power industry is undergoing rapid structural changes. The nonstorability, fragmented transmission, and volatile supply and demand characteristics of power combine to yield an exceptionally
with professional risk analysts and managers in nearly every operational function and personnel rosters heavy with quantitative expertise. The power trading business – a concept that required extensive explanation as recently as 1998 – is
The volatile price, supply and demand, and liquidity problems in electricity trading are undoubtedly contributory factors to loss-driven consolidation – many firms have been simply unequipped to manage these technical challenges. volatile commodity. The broad range of successes and failures among industry participants, as well as advantages of scale, are spurring rapid consolidation, a trend that will likely continue until full competition across the domestic market. The financial complexity of transacting instruments with price ranges spanning two orders of magnitude is spawning a wide and growing variety of structured transactions. Power shops are evolving into Wall Street-style trading concerns,
rapidly transforming from “emerging market” status to a fully developed sector of the global commodities industry.
Footnotes 1
Power Marketer rankings and data provided courtesy of McGraw-Hill Energy’s Power Markets Week.
2
Mark P. Mills in The Power Report, published by Gilder Technology, February 2000.
3
As reported in Power Markets Week, August 9, 1999.
4
The Dynamics of U.S. Deregulation, October 1998, Policy Assessment Corporation, for the U.S. Dept. of Energy.
5
All volatility referred to herein is annualized, percentage price change volatility.
6
Several electricity futures contracts have been introduced on NYMEX and CBOT; only three are currently traded. NYMEX Palo Verde and COB futures trade fairly liquidly. NYMEX PJM futures trade sporadically.
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