S&P Analyst Claims Hedging Has Taken On New Role

As the energy market continues a metamorphosis that began two years ago, energy trading and marketing practices have had to adapt. While some companies in the energy sector are moving away from pure speculative trading and focusing more on hedging and risk mitigation, others are abandoning the business altogether, noted Standard & Poor's (S&P) analyst Jack Kennedy.

Kennedy pointed out that while many energy firms have attempted to reduce their risk profiles in an effort to maintain or increase credit quality, the previous business model has left many companies in a "financial bind." With the shift in the industry, marketing arms of companies are experiencing reduced cash flow, higher debt levels and a lack of confidence from investors and the capital markets.

"The challenges now faced by these firms lie in repairing balance sheets, improving liquidity positions and restoring sustainable cash flows," Kennedy said in an S&P report. "In theory, moving away from speculative trading and focusing on hedging and other risk-management techniques could help to reduce earnings volatility and stabilize cash flows."

The analyst pointed out that previously, many firms engaged in speculative trading as a new source of profit, adding that these profits were driven mostly by market-making -- buying and selling in the market to provide a two-sided market -- and long-shot strategies, as well as by the underlying commodity price movements.

"Market-making forces a firm to take on greater credit risk because the firm is providing credit to buyers and sellers," Kennedy said. "Also, market-making can be risky due to inventory management. These firms need to be efficient in managing inventories, which can be capital intensive. Furthermore, if a market dries up and a market-maker is holding inventory, this in turn could create a speculative position."

He added that while all trading activity is capital intensive, speculative trading "requires a greater capital cushion because speculating implies taking on more risk," which creates more volatility or uncertainty in earnings. This requires a "thicker capital structure" to withstand potential write-downs or losses.

Commenting on the current state of the energy trading and marketing industry, Kennedy said the segment has seen what some participants call a "dynamic shift" in fundamentals as a result of less liquidity. The lack of liquidity can be attributed to the collapse of some of the market-makers, thinner spark spreads because of converging gas and electricity prices, and a change in corporate strategy as firms have moved away from speculative transactions, Kennedy suggested.

As a result, firms are retreating from "riskier" speculative trading practices and refocusing on managing the risks associated with owning generation, transmission, and storage assets. "In other words, firms are not looking to the trading desk for increased profits or even as profit centers, but instead are counting on that unit to help mitigate risk and stabilize the cash flow associated with its assets."

Kennedy categorized this risk-management activity as hedging, which can be considered "trading around assets" by some firms' definition. However, he noted that hedging now appears to be a risk-management technique rather than what was considered trading in the past.

"Clearly, the success of firms using this type of strategy will depend on the quality of its risk-management practices and management's attentiveness," he said. "Successful controls should help smooth out market fluctuations and produce more stable earnings and cash flow. However, lacking controls, unexpected occurrences, and poor execution would be detrimental to the underlying credit quality."

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