State of Energy Trading

1
State of Energy Trading Markets After EnronEIM
Conference Tarpon Springs, FloridaFebruary 24,
2003

• Peter Fusaro
• Global Change Associates
• New York, New York
• 212-333-4979
• www.global-change.com

2
GCA Products Services

• Books
• New York Times bestseller What Went Wrong at
  Enron (John Wiley, July 2002)
• Energy Convergence (John Wiley, May 2002)
• Energy DerivativesTrading 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

3
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 disasters impact on markets
• Whats to come

4
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

5
Historical Overview of Energy Trading

• Need for viable cash markets
• crude oil
• heating oil
• gasoline
• propane
• fuel oil and bunkers
• natural gas
• coal
• electricity

6
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

7
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

8
Historical Overview of Energy Trading

• Multicommodity Trading Takes Off
• Oil Petroleum Products
• Natural Gas
• Electric Power
• Emissions
• Weather
• Shipping
• LNG
• Coal

9
Energy is a Risky Business

• The Risks
• Price
• Fuel
• Operational
• Regulatory
• Liquidity
• Credit

10
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

12
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

13
Evolution of Power Trading

• Advantages of Merchant Power
• 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

14
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
  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

16
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

17
Not Just Enron

• Major energy market makers in gas, electric and
  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

18
Rebuilding the Market

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

19
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

20
State of Electricity Markets

• The dispatch queue nuclear, hydro coal with
  gas for peaking
• Microturbines as peakers
• Distributed gen cant 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

21
The State of Financial Electricity

• Too much price volatility 1998, 1998, 2000, 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

22
The State of Electricity Markets

• 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

23
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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Whats left of Electronic Energy Trading and
Exchanges

• NYMEX ACCESS
• Automated Power Exchange
• Natural Gas Exchange (NGX)
• Intercontinental Exchange (ICE)
• TradeSpark
• Wheres the EnronOnline business?

25
Whats 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

26
Whats To Come?

• Heavy heavy regulatory intervention in markets
• FERC Standard Market Design is California all
  over again (economists and engineers cant make
  markets)
• Launch is September 2004
• Traders are much smarter than government
  regulators
• More and honest financial disclosure necessary
• Wall Street Banks are not energy companies and
  cant replace the loss of liquidity

27
The Government Reaction

• Investigations
• FERCs 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

28
Environmental Market Evolution

• Biggest financial challenge of energy industry
• The Beginning Today
• 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

29
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

30
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

31
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

32
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)

34
Visions of the Future Post Enron

• Enrons 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

35
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

36
Visions of the Future Post Enron

• Deregulation politicized and dead (i.e. Gray
  Davis in California)
• More regulation coming in energy and financial
  markets
• Dont meet more laws, need proper enforcement
• More financial disclosure
• Markets work, Enron didnt

37
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!

38
Visions of the Future Post Enron

• The loss of responsibility in the energy patch
• 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

39
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

40
Visions of the Future Post Enron

• Heavy handed government regulation and
  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

41
Visions of the Future Post Enron

• Accelerating energy market consolidation
• Wellhead to wires Big oil learns the power
  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

42
Visions of the Future Post Enron

• More volatilities coming and more cross commodity
  arbitrage
• emissions and coal
• emissions and weather
• coal and other fuels

43
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