In commodity markets that have traditionally been dominated by two firms, Morgan Stanley and Goldman Sachs, two dealers have now clearly emerged as leading challengers to the pair's hegemony. Alongside this year's Energy Derivatives House of the Year winner, JP Morgan (see page 38), Barclays Capital continues to consolidate its market standing and earn plaudits from clients for its sophistication and breadth of service.
Nonetheless, while it is likely that Morgan Stanley's 15% increase in client-related business revenues last year was eclipsed in percentage terms by some of its competitors, the firm's sheer scale and deep expertise in both derivatives and physical products across most underlyings marks it out from the pack.
One high-profile client that values the bank's risk management expertise is the Arab Republic of Egypt. "They have assisted us greatly with all aspects of our first pre-paid forward sale agreement," says Khaled El Ghazaly Harb, undersecretary for financial and economic affairs in the Egyptian Ministry Of Petroleum. "Morgan Stanley not only helped us implement the hedge with more competitive pricing, they take physical delivery of our production and get it to our clients." The undersecretary is also a board member of the Egyptian General Petroleum Corporation (EGPC), the Cairo-based government-owned company that entered into the huge forward sale.
For Egypt, the original $1.55 billion pre-paid forward deal in July 2005, along with a follow-up $378 million transaction in February 2006 that monetises a significant proportion of the EGPC's stake in the original transaction, was an innovative way of tapping into the capital markets.
Marc Mourre, global head of commodities marketing at Morgan Stanley in London, says the financing transaction illustrates the breadth of the commodity group's strengths. "The sovereign didn't want to incur more debt, but we were still able to structure a non-debt deal that met their needs," he explains. "The notes allowed Egypt to monetise future exports of crude oil and naphtha for seven years, while retaining control of marketing."
Under the pre-paid forward, EGPC sells forward fixed volumes of crude oil and naphtha to a special purpose vehicle (SPV); Morgan Stanley agrees to buy those volumes over the course of the deal at market price. Meanwhile, the SPV enters into a hedging transaction with the dealer, which ensures a floor price for the crude oil and naphtha.
The initial forward sale is funded via notes issued by the SPV. The proceeds made by the SPV from the so-called off-take agreement with the dealer, plus any profit from the hedge, are used to service the debt issued. And it's the surplus cashflow, beyond that earmarked for servicing the original $1.55 billion of notes, which is being used to service the debt of the follow-up transaction from last February.
"This deal was a one-of-a-kind. There have been some prepaid forwards against African exports of crude oil, for instance, but very few of that size and none against oil products," says Xavier Trabia, executive director in the marketing group at Morgan Stanley in London. "They were also done as bank syndications and very few were hedged, which could be problematic for exporters."
Morgan Stanley created the SPV, which in turn captures the oil exports and buys the put options from the dealer to secure the issued notes' future cashflow. The dealer also distributed the various tranches. Half the notes issued had an AAA rating - the result of a monoline insurance wrapper on two tranches. The SPV itself was structured so that it achieved a Baa1/BBB rating, which is one-and-a-half notches above Egypt's sovereign ratings from Moody's Investors Service and Standard & Poor's, respectively.
"We were required to initially warehouse a very large amount of market risk - after all, this is a long-dated transaction that involves around 100 million barrel-equivalents of options," says Mourre. "We were able to execute the hedge underlying the deal in less than two weeks and without the market noticing."
The dealer was able to get a handle on the pricing of the hedge well before execution, which helped when putting the deal together. "We had already sourced around 60-70% of the required liquidity from clients prior to taking on the large short volatility position that needed to be hedged," he says. For example, the firm entered into long-term extendible option structures with some of its end-user clients, where it bought the embedded optionality.
This kind of creativity has won plaudits from customers. Jonathon Barrett, a New York-based managing director at LS Power Equity Advisors, a private equity management company focused on the power sector, says Morgan Stanley exhibits great ingenuity, both in terms of structuring and in dealing with the credit risk associated with large deals. When LS Power entered into a $1.65 billion deal to purchase some of Duke Energy North America's power generation assets in January last year, for example, Morgan Stanley played a vital role. "We basically sold a very large heat rate call option to them on power plants in three different markets," says Barrett. "This was a state-of-the-art deal across three geographical markets, where the financing and the hedge were dependent on each other."
As one of the largest power traders in the western US, Morgan Stanley was one of only a handful of firms that could have taken on such a large deal, says Simon Greenshields, managing director and global head of power, associated power fuels and carbon/emissions trading and structuring, at Morgan Stanley. "These are fairly substantial volumes. The hedge associated with the assets in California alone amounted to 753 megawatts," he says. "These markets are not liquid, so such deals can involve warehousing a fair amount of risk. Morgan Stanley is in the flow of a lot of tactical hedgers, and that obviously helps," Greenshields adds, referring to the benefit of having a large, diversified client base.
Having a large balance sheet and in-market financing capacity, as well as an ability to hedge the most complex underlyings over the long term and the capability to market products, are now the qualities required of top-tier commodity and energy houses, says Mourre.
As is the case with most of its competitors, Morgan Stanley is taking the burgeoning emission trading market very seriously. It plans to invest a total of nearly $3 billion in carbon and emissions credits, projects and other initiatives related to greenhouse gas emissions reduction over the next five years.
Having a breadth of capabilities is serving the firm well. Alongside strong results in oil and oil-related products, electricity and natural gas due to strong client activity, proceeds achieved on a few large structured transactions helped drive record fixed-income sales and trading net revenues of $2.2 billion during the third quarter of 2006, the banks says.
A number of other commodity houses have undoubtedly stolen a march on Morgan Stanley when it comes to creating structured products for investors. The firm is now putting resources into this business line and hopes to triple its revenues this year. But in terms of building a presence in the physical market, it has historically been ahead of the pack.
One of the standout acquisitions last year occurred when it bought Denver-based Transmontaigne. The large refined petroleum products marketing and distribution company has operations across the Gulf coast, east coast and midwest regions of the US.
In September last year, Morgan Stanley also bought Heidmar Group, a Connecticut-based shipping management company. "This increased the number of tankers we own by 85. At any given time, we may be chartering around 50 vessels," says Mourre. Maybe his office should now also be referred to as the captain's cabin.