Ken Silverstein EnergyBiz Insider Editor-in-Chief

Trading organizations will always have a place in energy markets. As long as wholesale markets for both power and gas are open, companies will still need to mitigate risks and there will always be a need to match buyers and sellers. Some entity will be required to aggregate the energy and schedule its delivery. While the traders in the 1990s were typically part of an unregulated utility operation, the dominant ones today are the investment banks with the hedge funds right on their heels.

"I'm very optimistic," says Jay Lindgren, quantitative analyst for consulting firm R.W. Beck in Denver. "Of course, there will be bubbles because markets are imperfect. But markets are efficient. We need more liquidity, different counterparties and new products and investment banks and hedge funds provide that. The brutal efficiencies of the market are better than the waste that is generated through regulation."

Trading has evolved. It actually began with utilities marketing around their physical assets -- or, selling excess power to those that wanted it on the "spot" or "forward" markets. As markets pried open, speculators entered who bet on long-term prices to make bigger profits. But the pressure to increase revenues and profits intensified. That's when those markets collapsed after it was discovered that some traders had been gaming the system and power and gas prices skyrocketed as a result.

Many energy companies or their counterparties have therefore witnessed the downgrading of their debt, which would make it difficult for them to fulfill their credit worthiness obligations. That led to fewer market participants and sharply reduced volumes. Less liquidity means more volatility and a greater price spread between spot and future prices -- harmful for wholesale buyers of power that try to hedge risks.

Unlike Enron's "asset light" way of thinking that promoted trading without the benefit of hard assets, most utility trading organizations today have retrenched to market around their power plants or pipelines--tools to minimize risks, control costs and help predict more accurately what margins may be. In essence, they sell their excess power to other utilities or industrials. That's called "physical trading."

But that's left a void. There is still room for the trading of financial derivatives, or products that might pay an independent power producer the difference between an agreed upon price and what the current pricing indices show. And now that clearing houses such as NYMEX are participating in these markets, counterparties are provided more assurances -- bringing more well-heeled parties into the fray.

Efficient Markets

That market opening in the financial trading sector could potentially be a profitable one in the $400 billion a year electricity and natural gas industry. The banks are looking to make up for reduced trading revenues in their equity and bond businesses and the power sector does appear ready to accommodate a growing economy. Moreover, volatility in the oil and natural gas businesses provides for even better opportunities. Barclays, Citibank, Deutsche Bank, Goldman Sachs, Merrill Lynch and Morgan Stanley are among those that are working to diversify their commodities positions and to sell electricity products to their institutional and industrial clients.

At the same time, hedge funds that typically trade over-the-counter in private deals have lots of cash and are participating in this market segment at ever increasing rates. According to consulting firm UtiliPoint International, there are as many as 300 energy funds now -- all focused on the entire energy complex and all ripe with risks and rewards.

Such hedge funds are unregulated private investment funds and are comprised of sophisticated investors that range from wealthy individuals to institutional investors such as pension funds. Investment banks oftentimes finance them. In essence, such funds seek to find "arbitrage" opportunities whereby they might buy power low in one part of the country and sell it for a higher price in another region.

"Without a commitment by the asset-based trading operations embedded in large energy companies to increase liquidity and product innovation, the hedge funds look to be the most likely catalyst for redevelopment of efficient, effective energy markets," says Peter Stockman, a member of PA Management Group for financial services. "There's a dearth of liquidity now and under those conditions, they can make a lot of money."

Success is not guaranteed even for those with deep pockets. Take Merrill Lynch, which re-entered the energy commodities last year when it bought Entergy-Koch. In 2001, though, it sold its energy commodities to Allegheny Energy because it took some huge losses. Ditto for energy trading fund Enchanted Rock Capital, which just closed because of natural gas price volatility.

The skepticism is compounded by the California debacle and subsequent pricing scams that wreaked havoc on the market. All speculators run the risk of getting tarred with the "Enron" brush and are even being blamed for the current high energy prices.

"The hedge funds see the writing on the wall as a result of the lack of real investment in the energy complex combined with increasing demand," write Gary Vasey and Peter Fusaro in UtiliPoint's IssueAlert. "They are armed with ever increasing amounts of investors' cash looking for a market." Indeed, the consulting firm says that energy hedge funds earned 40 percent and up for the period ending November 2004.

As hedge funds expand, however, the greater the odds of investors losing money. All energy traders must understand their exposure and the risks that lie in wait, says John D'Aleo, managing director of New York-based OpenLink that handles software for the trading industry. But he insists that proper risk management and innovative contracts can be tailored to assist energy traders dealing with uncommon commodities.

In the span of less than a decade, the face of energy trading has dramatically changed. The once-powerful have been dealt deathblows. But the market apparently yearns for the products and services that traders can provide -- all leading to the entrance of sophisticated market participants such as investment banks and hedge funds. If they are successful, the benefits could translate into a more efficient marketplace that provides superior products and better rates.