Michigan Green - Trading Will Survive

October 08, 2008

Lehman Brothers' demise may lead to the rise of new and powerful players in the energy trading sector. Just as the investment banks stepped in to fill the void left by such unregulated energy trading organizations as Enron, newly-aligned financial institutions that understand risk management will likely participate.

The uncertainty now in financial markets makes it imprudent to speculate on what the future may hold for energy trading. In general, the pace of such commerce will slow in the near term but will likely resume to typical levels over time as nerves settle. The financial trading sector could possibly be a profitable one in the $400 billion a year electricity and natural gas industry. Meantime, carbon markets are another potentially rewarding venture for traders.

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 have been the investment banks with the hedge funds right on their heels.

But fate has caught up. A revolution is occurring, culminating most recently with Bank of America scooping up Merrill Lynch. Now discussions persist that the lynchpins of the investment banking community, Goldman Sachs and Morgan Stanley, might pair up with others to endure in today's environment. The ongoing volatility has led to questions about which, if any, major conglomerates will be the next to fall and whether the U.S. government will step in to save them.

Burgeoning carbon markets are among the first trading segments to feel the financial disorder. Right after Lehman Brothers announced it was declaring bankruptcy and closed its carbon trading operations, the price of European carbon futures is reported to have fallen 4 percent. December futures were trading at 23 Euros a ton. While the dip is probably temporary, the goal is to get the price higher -- all to create a threshold whereby companies have less incentive to release carbon emissions. Installing environmen! tal controls, for example, might be cheaper than buying carbon credits.

Europe and Japan have been hotbeds for such carbon markets, but the United States will likely join the fold. Lawmakers here have been discussing ways to reduce greenhouse gas emissions and the creation of a cap-and-trade system that mandates companies meet certain limits or buy credits to allow the companies to exceed them. Last year the value of those credits is reported to have been $60 billion. As markets mature and as more countries participate in the system, carbon markets could reach $1 trillion by 2020, say traders.

Market Liquidity

That's why the financially stronger investment banks are trying to attract new sources of capital and to reposition themselves for the future. It's not just to capture a share of potentially lucrative carbon markets. It's also to thrive in the trading of commodities and specifically electricity and natural gas.

Carbon markets are not just playin! g host to investment banking firms. They are also welcoming hedge fund s and utilities, which ironically seem relatively strong when compared to other participants. Much of the investment banking crop, meantime, has also been working to diversify their commodities positions and to sell electricity products to their institutional and industrial clients.

To the extent that these firms are much weaker than they have been, it is bound to affect the level of their participation in commodities trading. That, in turn, will hurt liquidity that is the lifeblood of such markets. Following the collapse of Enron in December 2001, trading volume industry-wide was said to be off by 70 percent.

Just how did we get to this point? Following the September 11, 2001 tragedy, the Federal Reserve sought to reassure financial markets by significantly reducing interest rates. The goal had been to keep the economy flush with money so as to maintain consumer confidence and to motivate businesses to expand.

But such low rates also prompted investment banks to create complicated financial products and commercial banks to make riskier loans. For their part, many consumers bought expensive homes that they could not afford. When the bubble ultimately burst, calamity spread throughout the financial sector. The collapse of Lehman Brothers, among others, is a manifestation of this phenomenon.

Now it will take time to rebuild. Consumer and investor confidence are paramount, but so is the remaking of the investment banking world that has provided critical financing and which has been so vital in recent years to commodities trading. The electricity and natural gas trading evolution will continue. What once began with utilities marketing around their physical assets will carry on.

Investment banks will stay involved, but they will seek partners. They will combine their knowledge of financial markets and hedging instruments with the capital and know-how provided by other entities t! hat want a piece of the action.

Trading organizations are staples of the energy economy. As long as wholesale markets for both power and gas are open, a need to pair up buyers and sellers will exist. The goal is to augment the market by involving financially solid participants. If trading activity increases, credit difficulties could ease, market liquidity would jump and prices could stabilize. Risks must still be managed, necessitating that sellers and buyers of power and lock in prices. Dominant traders have come and gone. But trading will survive.

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Ken Silverstein EnergyBiz Insider Editor-in-Chief
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