To remedy the financial turmoil that exists for U.S. energy merchants still operating, an analyst with Standard & Poor’s Ratings Services (S&P) suggested Thursday that they should consider relying more on “trading around their assets” by hedging and other risk-management activities.

John Kennedy, who follows energy merchants for S&P, noted in a new report that energy marketing activities have long been viewed as having higher risk relative to regulated operations, reflected in merchants’ business and financial profiles. However, as the business model has been transformed in the past two years, pure speculative trading “has led to reduced cash flow, higher debt levels and a lack of confidence from investors and the capital markets.” He said, “the challenges now faced by these firms lie in repairing balance sheets, improving liquidity positions and restoring sustainable cash flows.”

Previously, said Kennedy, many merchants used speculative trading as a new source of profit, driven mostly by “market-making and long-shot strategies,” along with the underlying commodity price movements. Because of the “dynamic shift” in fundamentals, however, Kennedy noted the result is “less liquidity due 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.”

The strategy shift has caused some merchants to “retreat from riskier speculative trading practices and refocus 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.” S&P is classifying these risk-management activities as hedging, said Kennedy, because they are used to lock in a profit margin or limit losses.

Some companies are choosing to call this new hedging strategy “trading around assets,” said Kennedy, “but this 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. 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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