Change Ripples Thru Merchant Trading, Energy & Power Sectors

Abstract: Energy merchant traders and power generators promised investors change in the late 1990s. It now seems that change in the form of restructuring is coming to those who made the promises.

Analysis: This is not another Enron story, although it is a tale about how the fallout from Enron has impacted the structure of both the oil and gas industry and the energy and power sector.

There are two nonpublicized results emanating from the collapse of the high-flying Houston firm that once billed itself "on the side of angels" during the California energy crisis two years ago. The first has been degradation of the energy merchant trading sector. It took less than a year post-Enron for the existing natural gas marketing infrastructure to collapse in the United States. More than 10,000 people lost jobs in energy trading. Liquidity declined in gas markets as trading platforms and counterparties exited the natural gas marketing business while pricing information became difficult to determine in exchanges distant from the major commodity hubs.

Before November 2001, oil and gas companies could produce gas and sell it at the wellhead without much effort. Now oil and gas producers have been forced into the marketing end of natural gas production after the decline of the middleman role that the energy merchant firms supplied.

Those energy merchant trading firms were often criticized for conducting a phantom business by trading as much as 10 times the actual volume of existing gas in the market. Still, those trades provided a platform for commodities to change hands and also created easy liquidity within the gas marketing industry. That benefited gas producers, though the benefits are now gone.

While the major commodity exchanges still provide liquidity to the market, there are problems in price discovery in markets distant from the large hubs. Indeed, pricing power in remote markets has devolved toward the gathering and pipeline operating segments of the industry once the large merchant trading firms exited the business. Many of these entities are intra-state and therefore not subject to Federal Energy Regulatory Commission rules. The local gathering systems levy surcharges for metering, maintenance, interconnect installations, or other processing activities, which means a lower effective gas price for operators at the wellhead.

This in turn impacts operator cash flow and slows the cycling of capital back to field work, retarding the industry's ability to add production. While producers get less money for their product, they must spend more money on creating an outlet for that product as they redirect manpower to the marketing end of the business or build relationships with endusers. Furthermore, producers are now responsible for many of the administrative processes that marketers formerly provided. It amounts to a decline in productivity since the commodity generates less top line revenue and entails greater costs in marketing and administration. This is one reason operators say they now need $3.35 gas to be economical.

The repercussions extend beyond the wellhead. When it comes to risk protection or hedging, producers now must fall back to the New York Mercantile Exchange (NYMEX). Proof this is happening is evident by looking at volume on the NYMEX. Gas contracts currently exceed 100,000 daily, or 20 times the actual physical gas traded in the market. There are no guarantees in this strategy, however. Reliant Resources is the latest gas marketer to exit proprietary trading after the company lost $80 million from hedging exposures during the natural gas price spike gyrations in February.

The second example of post-Enron structural change in energy has also generated scant publicity even though it has the potential to devastate financial markets. This involves repercussions from dysfunctional balance sheets, primarily in the energy and power sectors.

Standard & Poors estimates the sector must refinance $40 billion in short-term obligations in 2003 alone. The figure grows to $100 billion by 2006. Similarly, a Financial Times article estimated U.S. gas and power sector debt at more than $450 billion at the end of 2001 even before adding the off-balance-sheet numbers. This sector saw debt-to-capital ratios balloon to 60 percent when the cycle peaked in 2001. Today, energy and power sector companies represent 20 percent of all capital market debt due by 2010.

It is fascinating to review how that came about. Lenders were seduced by profit potentials in adding new power generation capacity in the late 1990s. Those expectations were reflected in the May 2001 national energy policy, which spoke of the need for a new power plant every week over the next 20 years. The blowback from those inflated expectations has not been kind, nor has it been confined to the energy sector. Commercial banks are now facing significant writedowns from monies loaned to the energy and power sector.

The impacts are also evident in field work. Balance sheet considerations are prompting El Paso Corp. to lay down drilling rigs just when the natural gas produced from those rigs would help the revenue stream during a high commodity price event. El Paso Corp. is the latest company to join the axis of balance-sheet-challenged energy firms who are jettisoning assets under distress while scrambling to assemble bridge financial packages to buy enough time to restructure debt.

So far, short-term financial packages have provided the additional time, but little in the way of permanent solutions. The Williams Companies last year put together a $900 million one-year loan agreement in an attempt to extricate itself from financial disaster. As collateral, the company pledged its Barrett Resources Wyoming gas properties, which it bought for $2.4 billion when things looked far rosier a few years back. The short-term agreement carries effective interest of nearly 34 percent when it comes due this summer. The window for solving the problem is narrow and the news is not good. Williams announced it was selling another $2.5 billion in assets after it lost three-quarters of a billion dollars during the 4th quarter 2002.

Reliant Resources faces a March 28 deadline to restructure $2.9 billion in loans. This comes after the company lost $900 million on the sale of its electricity-generating business in the Netherlands. The company carries $7.5 billion in debt.

Texas-based TXU also wrote down $4 billion in early 2003 from the distressed sale of its European power segment.

At first glance, the steady stream of individual headlines concerning asset sales and refinancing activities at El Paso, Duke, Williams, Dynegy, and a host of other companies in the energy and power sector seem like isolated events. The reality is they indicate how financial pressures are forcing structural change in a post-Enron environment. Those financial pressures are growing, and could migrate from the energy sector to the financial industry, which aggressively underwrote expansion of a business model that, in retrospect, was based on flawed assumptions.