Online trading moves forward

Online energy trading seems to have a bright future, despite the two biggest players – Dynegy Direct and EnronOnline – leaving the market, finds Catherine Lacoursière

Despite a major industry shake-out, the future looks promising for online energy trading, although the online exchange model may need some tweaking. Of dozens of electronic energy exchanges in the US just two years ago, only a handful are still in business. The void has left traders scrambling for price quotes and creditworthy counterparties. Amid the mayhem, however, several major trends have unfolded.

One is that multilateral exchanges have faired better than market-making exchanges. Online exchanges that weathered the Enron bankruptcy and ensuing drop in trading volumes were bid-offer or many-to-many exchanges such as Canada-based Natural Gas Exchange (NGX), an electronic wholesale market for natural gas; commodity market-place IntercontinentalExchange (Ice); HoustonStreet, a market for physical, domestic crude oil and refined products; and TradeSpark, a hybrid exchange offering both brokered and online over-the-counter (OTC) energy trading.

Market-making or one-to-many exchanges were not so fortunate. Most notably, the two biggest such exchanges – EnronOnline and Dynegy Direct – closed down. And while UBS Warburg took over EnronOnline and its 600 staff, the firm now says it is reappraising the business model, laying off 130 employees.

A second trend is that wholesale exchanges did better than retail exchanges, with two major retail exchanges, aggregator and reseller of energy products and services Essential.com and discount energy provider Utility.com now out of business. Online trading volume is clearly linked to deregulation. Analysts do not expect retail exchanges to really take off until retail markets are more fully deregulated.

And finally, online trading has faired better in the established oil and natural gas markets than in the nascent electricity markets.

With this newfound wisdom, companies are retooling the next-generation electronic energy exchange. “To be competitive, you have to create an integrated trading environment from front-end through to settlement. The company that can do that most efficiently either through a completely in-house product or through a partnership is going to create very high value for customers,” says Michael Rucker, director, Western Electricity Co-ordinating Council (WECC) Region for APX, a transaction processing company for wholesale electric markets, based in Santa Clara, California.

Analysts say any new architecture will have to address all facets of the transaction chain from order entry to clearance and settlement to physical delivery. All told, the OTC online energy exchange is starting to look more like the regulated exchange model.

Meanwhile, straight match-to-match exchanges – that is, those that bring buyers and sellers together but do not offer related services such as clearance and settlement or delivery – are out of favour. And in the current environment, so are exchanges that lack strong credit supports. Dan Zastawny, vice-president of operations at the NGX in Calgary, Alberta, says: “Most important is the clearing facility – particularly of late, with capital constraints being high and everyone worried about counterparty risk.”

Such concerns, says Zastawny, are behind the exodus to exchanges with established clearing and settlement services, such as NGX and the New York Mercantile Exchange (Nymex). In the year-to-date, NGX’s sales are up 40% to 2.7 billion mmBtu over the comparable period in 2002. Many of its customers are subsidiaries of US companies. And other exchanges, such as Ice, are quickly adding clearance services.

Instant gratification
The new breed of electronic energy market may also seek to offer physical as well as financial products. The holy grail in e-commerce is instant gratification – for instance, executing a spark spread between the electricity hub at Palo Verde, California and the El Paso Permian natural gas pool in Texas with one mouse click, the exchange facilitating delivery of the power. However, many e-commerce companies ran out of money while trying to build out the the infrastructure for physical delivery.

As in other e-commerce sectors, the ‘bricks and mortar’ firms – those with the physical infrastructure and industry backers – did better than the independents. The most liquid online energy exchange, with the strongest product and regional breadth, is Atlanta-based Ice, which is backed by leading energy market participants and financial institutions. Ice was launched in 2000, just before independent company and early mover Altra Energy started selling off its virtual natural gas exchange in parcels. Launched in 1996, AltraTrade was starting to put in place the infrastructure that many exchanges are aspiring to today, including adding an electricity product, scheduling and delivery.

Double-edged sword
The double-edged sword of the internet market crash and the US energy crisis has left a less fragmented market to fewer, but better-capitalised players. Still, due to the high cost of expanding the virtual energy exchange model, the question has become whether to buy, build or partner.

Ice, for one, has been fast ramping up its global electronic energy exchange through alliances and acquisitions. It recently added to its platform for both physical and financial contracts for energy, with the purchase of the London-based International Petroleum Exchange (IPE).

Ice is connecting its virtual energy market to the IPE’s futures and options contracts through an electronic trading platform it has licensed from trading technology developer eSpeed, a New York-based subsidiary of broker Cantor Fitzgerald that makes software for electronic exchanges. It has since added clearing facilities and, in July, announced clearing services for its OTC power products. Initially settled at two hubs, Pennsylvania-New Jersey-Maryland West and Cinergy, Ice expects to extend clearing services to at least five more hubs.

And NGX is moving closer to instant gratification by scaling its technology in-house. NGX operates the most liquid electronic gas trading hub in Canada, the Intra-Alberta Market Centre and in 2000 added two more Canadian natural gas hubs, the NGX Eastern Marketplace and the NGX Niagara Market Centre.

In October, the company plans to extend its virtual exchange across the border, opening its first US exchange in Chicago at the Nicor natural gas hub. NGX’s Zastawny says: “All will run through the same central facility from clearing and trading and a central control perspective.”

Zastawny says the move will provide the firm’s customers – a lot of whom buy gas in Chicago and sell into Alberta – the opportunity to better hedge their position and lower their collateral requirements through cross-margining, whereby the difference between offsetting open positions in related products is used to reduce margin.

NGX also has plans to provide financial contracts for the major US natural gas indexes over the next 6 to 12 months.

Level playing field
Meanwhile, Nymex says it is pursuing an open architecture and a “level playing field”. Nymex’s model might be more closely aligned than the proprietary exchange model with the electronic communications network (ECN) model. Nymex’s electronic order-matching services provide the financial markets equal access to order books and execution on Nasdaq and other listed and OTC stocks.

Nymex president Robert Collins says: “Our intention is to become the main technology mechanism for other people to play on. We will allow anyone out there with a front-end to use our networks and clearing services for them to facilitate their market.” For example, a market-making exchange such as UBSW Energy, currently eschewed due to concentrated risk and a lack of risk-transference mechanisms, could plug into Nymex and start trading and clearing through its secure and liquid network.

In a separate online venture, Nymex has aligned with leading futures and options exchange the Chicago Mercantile Exchange to sell fractional products of its popular crude oil and natural gas contracts. The new instruments are known as e-miNYs (see box).

But despite the continuing development of a new model, two obstacles to the electronic energy exchange have been technology and regulation. When technology-buying decisions were made a few years back, not all planned for an always-on, iron-clad, globally-linked virtual energy trading regime.

Interoperability, open architectures and scalability have all become big issues. Tom Allbee, president of HoustonStreet, based in Portsmouth, New Hampshire, says the early technology the exchange built in 1999 is now out-of-date. In August, the firm announced a more scalable technology platform based on Microsoft’s .Net technology.

The platform is allowing the company to expand its physical delivery points for crude oil barrels beyond a handful of major hubs. “The newer technology is very scalable,” says Allbee. “We can add commodities, as well as services to pick up any additional bandwidth or processing load we incur.”

Alongside the bigger energy exchanges, niche exchanges such as HoustonStreet’s have carved out viable virtual markets. Following two profitable quarters, HoustonStreet is also considering partnering with other companies for back-office and possibly clearance-and-settlement services.

Straight-through processing
Demand for straight-through processing is c ertainly growing. And many firms are considering partnering as the most economical way of achieving it. APX’s Rucker says that to remain competitive, the independent exchange will have to consider a different model for different parts of the transaction chain.

APX runs its own energy exchanges, including its newly launched electricity exchange in Palo Verde, California. But, in an inversion of the usual business model, APX says the power exchange is a complement to its larger transaction processing business. “For us, the magic bullet has been providing a seamless back-office service for those who don’t have one,” adds Rucker.

APX has also found success in the niche exchange market. It administers the Renewable Energy Credit Exchange, which has been operating in California since 1998. The exchange saw volumes fall during the energy crisis, and the primary buyers – energy service providers – were driven out of business. But it is still a very viable market. In addition, APX administers a number of markets for the California Power Authority, the New England Power Pool and others.

Yet conspicuously absent from the online trading realm are the internet power plays, at least in the electricity markets. But Nymex says electricity may be offered as part of the e-miNY contracts in the future. Most of the trading activity in electricity resided in now-defunct one-to-many exchanges.

Uniform rules
What’s more, US interstate energy regulator the Federal Energy Regulatory Commission’s (Ferc) July 31 ruling on a standard market design has just infused new life into the wholesale power markets. Uniform electricity rules across all states are widely expected to increase interstate transaction volume, remove interstate transmission constraints and provide clearer price signals.

However, setting uniform rules in the retail markets – where the rules for the buying and selling of electricity are made by 50 individual states rather than one standard setting body such as Ferc – is proving to be a bigger challenge.

The Ferc wholesale rules are expected to be fully implemented by 2004. Jim Walker, a senior analyst at Cambridge, Massachusetts-based technology research firm Forrester Research, says: “It may take three to five years for electricity to be a robust, highly liquid, tradable risk management product such as Nymex Henry Hub for natural gas contracts or the Nymex West Texas Intermediate crude oil contract.”

Oil and natural gas trading will remain the frontrunners in electronic energy markets until liquidity picks up in the electricity markets. Analysts are divided over whether that will be two, three or five years away. What is certain is that while the industry maintains its ambitious quest to link multiple energy products, trading hubs and services, consolidation and alliance building will continue unabated.

Nymex’s mini futures contracts

Launched in June in conjunction with futures and options exchange the Chicago Mercantile Exchange (CME), the New York Mercantile Exchange’s (Nymex) e-miNY energy futures are 40% the size of a standard futures contract. This model is the “third way”, says Felix Carabello, associate director, industrial commodities at the CME. “It is the idea that you have an electronic product trading against or with the open-outcry model. Some folks or groups are trying to launch an exchange that is fully electronic with nothing to leverage, and that is pretty difficult.” CME launched e-miNY contracts in 1997 on the S&P 500 and on the Nasdaq 100 in 1999. The fractional contracts are now available on a variety of index products. Introduced into the slow summer trading months, the futures are increasing both the volume and speed of trading in crude oil and natural gas contracts. The exchange is averaging around 2,700 e-miNY contracts a day, which are cleared through Nymex. E-miNY futures also bring liquidity to the standard contract. The product is too small to provide a hedging vehicle for bigger energy players. But the opportunity to arbitrage between the e-miNY contracts and standard floor contracts, and to trade the volatility in these contracts, is attracting traditional energy traders, day traders and the retail market.