Articles about CTRM software markets.
Energy Trading and Risk Management (ETRM) software providers have been enjoying considerable success over the last several years. With a market buoyed by higher commodity prices, high levels of volatility, new regulation and reporting requirements, and new market entrants, software vendors have been making some serious hay. These companies have been seeing new records for unit sales and revenues and have struggled to keep up with demand. However, at UtiliPoint, we've been projecting that the rapid market expansion, while not necessarily ending, would be slackening as there is only so much growth that's sustainable over the long term in a market of this type. In our recently released 2008 North American ETRM Market Analysis and Sizing Report (http://www.utilipoint.com/rci/details.asp?ProductID=1173) , we've forecast that slowing, projecting market growth this year to be substantially down from the double digit growth rates of 2006 and 2007. Our forecast has been based upon a number of dampening forces which started emerging in energy commodity markets in the first quarter and have reached a crescendo within the last week. These forces are now hammering many in the energy commodity markets and have started, and will continue, to impact sales of software products servicing those markets.
The Financial Services Crisis is Being Felt in the Physical Energy Markets
The dollar magnitude of the transactions in the energy commodity markets demand that players have ready access to credit, and by extension, a solid balance sheet. Credit is the oxygen that keeps this market alive. Consider a common sized transaction for natural gas: 10,000mmbtu/day for a month. At current market prices, that transaction is worth around $2.25 million. Small trading shops may be buying and selling up to a half of a BCF of gas per day, meaning their exposures will be north of $100million prior to the end of the month settlements. Mid-sized traders, those up to 1 BCF/day, will have exposures measured in the hundreds of millions of dollars, with the largest companies, those trading several BCF/day, having multiples of that. This is not a "cash on the barrelhead" business. These trading companies rely on ready access to quality credit reserves to provide assurance to their trading partners that they can meet their obligations despite any negative market developments. If market players start to doubt the credit worthiness of one of their trading partners, they will stop selling to that company in order to reduce their exposures, leaving that suspect company dead in the water and unable to meet their obligations to the companies they've sold product to.
Last week saw the crash of Constellation Energy for this very reason. Despite the fact that Constellation's energy trading group was successful, generating up to 80% of the parent's revenues, the markets were increasing uncomfortable with the quality of the firm's credit due to the failure of Lehman Bros. (who held a less than 6% stake in the company) and the suspect nature of a few banks who were proving relatively modest credit lines to the company. As a result of credit downgrades associated with Lehman's demise and the questionable credit lines, many of Constellation's trading partners started to pull back and the company's stock plunged 45% in a single day. Ultimately Constellation was salvaged via a fire sale to MidAmerican Energy at $26.50/share, less than half its price just 10 days ago.
When Enron collapsed over the period of a few days in Oct. 2000, most companies couldn't react in time to shield themselves from losses—they had already sold significant volumes to Enron based on credit ratings that were ill-informed and ultimately far too optimistic. These companies, unable to recoup their losses, took significant bad debt write-offs, ultimately contributing to the demise of many. It was only after banking and financial services firms stepped up and into the market did any semblance of confidence return. Not only did these financials enter the markets directly through acquisition of existing trading companies or expansion of their own subsidiary commodity trading groups, they also extended and backed credit lines for other players. The recovery of the energy markets, catalyzed by the entrance of the financial companies, brought the ETRM solutions market out of the doldrums and fueled significant market growth for a number of the larger vendors.
With the market taking several years to emerge from the damage caused by Enron, credit managers have, for good reason, increased their diligence, and in some cases have become hypersensitive when it comes to counter party credit exposures. However, until recently, if a counterparty had one or more solid lines of credit from one of the major banks or financial services companies, credit managers were pretty comfortable with the source and were more willing to extend credit. The source of the credit helped assure them that the transactions were adequately backstopped in case something bad happened.
However, the sub-prime lending crisis has changed all that. With three of the five largest financial services companies imploding and with major banks, like IndyMac, going under, there are few if any golden backstops these days. Credit managers are seeing the quality of their counterparties' credit being impacted as firms such as Bear Sterns, Lehman Brothers and Merrill Lynch have either gone under or have had to be rescued by larger entities.
Even for those energy trading companies that have been able to maintain sold credit, those credit lines are being exhausted more quickly as commodity prices have taken off. Simply put—a doubling of the price of a commodity will double the credit exposure for a same sized transaction. Credit has become a limiting factor for growth for many companies as commodity prices have continued their steady rise over the last 24 months.
With credit being impacted by the ongoing financial market crisis and higher commodity prices, the oxygen is clearly being sucked out of this market and ETRM system providers are starting to feel the impact.
Budgets Have Absorbed Higher Prices
Producers have always been a steady market for ETRM vendors, making up 10 to 20 percent or more of the system sales in any given year. With the run-up in commodity prices, many energy producers generated profits beyond their budgetary projections. This unexpected influx of cash enabled many to upgrade their systems earlier than they may have otherwise; improving their transaction management capabilities at a time they needed it the most.
Unfortunately, this accelerated replacement cycle in the producer space will create some hangovers for vendors. As UtiliPoint's research shows that the normal replacement cycle for these systems averages five to six years, pulling many of these future deals forward will take some license sales opportunities out of the market for the next couple of years.
For many of the energy companies that had stayed with their legacy systems through the period of rapidly escalating prices, the recent slump in commodity prices has them rethinking near-term system purchase plans. With budgets developed last year during the upswing in the market, the recent sell-offs in commodities are forcing a number of companies to re-examine and potentially delay planned expenditures for IT infrastructure.
Some Positives
Despite many troubling developments in the market, there are some positive trends that should provide opportunity for ETRM system providers.
With crude having traded close to $150/bbl recently and still hovering around $100/bbl, industrial scale consumers of crude-based products continue to adopt aggressive price hedging strategies. UtiliPoint is anticipating that these industrial-scale consumers, including transportation companies, railroads, and airlines, will continue to seek out ETRM system capabilities to better manage their energy purchases and hedging strategies.
We also expect to see continued growth in the market for systems servicing non-energy buyers, such as agricultural product producers and traders. This market has been emerging for the last 18 months and should continue to drive new sales for the vendors that have capabilities in the space.
An additional bright spot in the market is the widening acceptance of ASP or "Software as a Service" (SaaS) solutions. These solutions, delivered over the web, have been selling well in the last couple of year as they enable smaller market participants, such as municipals, to acquire ETRM capabilities at a lower price and with less implementation effort. Given their appeal to the lower tiers of the market (a segment likely to be lest affected by the credit crisis), we believe the ASP/SaaS software vendors will continue to see success and enjoy good market growth.
Some Vendors More Impacted Than Others
2006 and 2007 saw solid growth for most of the solutions providers—the rising tide lifting all boats. 2008 and 2009 don't appear to offer the same widespread opportunities—there will be winners, but there will be more losers than in past years. Vendors that have been successful in the industrial, fuels, and non-energy markets (such as Solarc, Triple Point and Allegro) should continue to see success. Additionally, companies like OATI, OilSpace and others that can service the ASP/SaaS markets will also continue to sell products. Still, there is little doubt that all vendors will feel the impact of the turmoil in the markets, although some much more than others.
Having tracked activity in the Energy Trading and Risk Management (ETRM) solutions market over the last several years, UtiliPoint has seen trends emerge and disappear and market leaders rise and fall, only to rise again. It's an impossible proposition to declare any particular solution vendor THE winner of the race, for not only is the race never complete; it's difficult at times to even define WHICH race is being contested.
As we've written about many times in the past, the ETRM market is a wide ranging space. It covers virtually anyone and everyone that buys or sells wholesale energy commodities, physical or financial. It includes exploration and production companies, producing and selling oil and gas; hedge funds that may not hold a particular energy commodity for more than a day or two; power utilities that produce, and sometimes buy or sell, wholesale quantities of power to service their native retail loads; refineries buying wholesale crude and selling finished products; airlines purchasing huge volumes of jet fuel … the list goes on and on.
Given the breadth of the space, it is practically impossible for any one vendor of ETRM software to address the entirety of the greater market's needs. The business processes are simply too wide ranging for any single product to be the best fit for everyone involved in whatever form of energy trading and risk management they have chosen to pursue. The reality is that for every strip of business model, there will be one or two vendors that will be a best fit for that model, and over time, the “best fit” vendors will change as members of that group pursue new functionality or shift focus to address other needs that exist in the wider market. Nonetheless, we can look back over the last couple of years and see some consistent trends when it comes to identifying either particular market segment leaders or identifying companies that have had significant success in the broader market.
Following on from our IssueAlert article of Jan. 28th, Energy Trading and Risk Management Systems Market 2007 Results, 2008 Outlook, and Customer Implications, and based on the granular information we've gleaned from the market and reported to us by many of the vendors, we wanted to break down the 2007 results and identify market leaders in a number of categories, some broad, and some more specific, but ones in which there was one or two clear leaders:
Total New Client Signings in 2007 For this category we took into account only net new business, not expansion license sales or new modules that were added to an existing customer. We also did not take into account reselling an existing customer - that is moving them off one product and onto a different product.
For 2007, Allegro and Triple Point came out on top in terms of global unit sales, or put another way, they signed the most new customers for their products around the world. Close on their heels last year were Solarc, OATI, and OpenLink.
ASP Delivered ETRM Solutions
In order to fully explore this category, we've broken it down into two segments: financial trading and physical trading. On the financial side, Kiodex, the pioneer in delivering solutions via the internet to energy centric trading shops, continues to sell significant numbers of new systems in the space, although their client base now encompasses many non-energy commodity and financial trading firms as well.
On the physical side, OATI continues to see great success for their ASP delivered webTrader product family. Their primary market, small to midsize utilities, continues to be one of the most progressive in terms of adopting the “software as a service” model in physical energy trading, allowing OATI to capture the most sales in the “ASP for physical trading” space.
Industrial and End User Market
Solarc has been the leader in this category for the last several years and was one of the first to recognize the value of, and pursue, large energy consuming end users. Airlines in particular have been selecting Solarc's RightAngle more than any other product on the market, and as a result, the company has virtually locked up the airline segment. They've also been successful selling to package shipping companies and agricultural firms, amongst others.
One of the emerging challengers to Solarc in the end-user category is Allegro. 2007 saw several new end user clients for the company and they are well positioned to see additional success in 2008.
Financial Oriented Trading Market
In 2007, financially oriented trading companies, like hedge funds and bank founded and/or backed trading companies, continued buying ETRM systems to help them better manage their growing portfolios of physical energy commodities. Triple Point and Openlink have been the primary beneficiaries of this growing physical focus over the last several years and that trend continued in 2007.
Solarc also found success in the financial oriented markets in 2007 and may emerge to challenge the market leaders in 2008.
Utility Market OATI has been able to leverage their huge customer base for their tagging and market communication products for power trading, yielding them solid success selling webTrader to small and mid-size utilities. On the upper end of this market (those utilities with large scale associated trading operations), the picture is less clear with several different vendors having each sold multiple systems to the market.
E&P Market
The oil and gas exploration and production (E&P) market has been a consistent, if not exceptionally large, market for ETRM vendors over the last 10 years. Every year, this segment comprises about 10 - 15 percent of all deals done. Over the last decade, Allegro has been a consistent market leader, a position they continued to enjoy in 2007.
OpenLink has focused on development of additional producer functionality over the last couple of years, and as a result, has closed several significant new E&P deals in 2006 and 2007, positioning them near the top of this market with Allegro.
Solarc is positioned to mount a challenge to these current leaders, having acquired Trinity Apex in late 2006, a product with solid producer functionality and one which has already brought new E&P clients to the company.
Most Diverse New Client Base in 2007
Looking at the results of 2007, Triple Point added the most diverse group of new clients, ranging from traditional energy trading firms to financials, refiner/distributors, biodiesel producers, agricultural companies, generators and metal traders.
Several other vendors, including Allegro, Solarc, and OpenLink, also distinguished themselves from the pack in term of market segments serviced in 2007.
International Sales for a North America-based Vendor
Triple Point showed significant strength internationally last year, with their relationship with SAP and access to that company's global client base proving to be a differentiator versus the competition. Triple Point closed the largest number of deals in Europe of any North American based vendor and added a new client in Africa. With their SAP relationship, Triple Point should be considered one of the favorites in capturing not only additional European business, but should also see growing success in other international markets.
Among the other vendors, Allegro, Sungard, Solarc, and OpenLink also showed solid international sales, with the group signing new deals across Europe, Asia, and Australia.
Other Markets
As mentioned above, there are numerous ways to slice and dice the ETRM market. However, for each of these slices, there is no one or two vendors that clearly stand out. Consider the refiner/ distributor market—while several vendors, including TradeCapture, Allegro, Triple Point and Sisu Group sold products into that market, there simply were not enough transactions to definitively establish a market leader. Biofuels emerged as new market for ETRM vendors, and while several companies sold products to biofuel producers, again, the numbers don't yet indicate a market leader.
We didn't consider, for this analysis, markets or products that don't encompass all or most of the core business processes of energy trading and/or risk management (defined as contract management, deal capture, position management, analytics, pre-scheduling, scheduling, actualization, accounting and invoicing), including those solutions that provide functionality peripheral to, but in support of, the buying and selling of energy commodities. These solutions include such things as power market communications, NERC tagging, asset management, logistical support tools, and analytics packages amongst others. We did find that many of the vendors providing these products (and who may also produce full scale ETRM solutions) experienced very good results and in some cases, record years. The roster of companies enjoying a good 2007 would include The Structure Group, OATI, Power Costs (PCI), RiskAdvisory, and Ventyx.
Conclusions
For a company considering the purchase of a new ETRM system, these results should be viewed as informative, but not a definitive indicator of what you should buy. If your business fits one or more of the categories described above, certainly you should take a close look at the leader(s) for your segment, but, you should not limit your search to those companies. Every energy commodity related business, including yours, is a unique mix of assets, geography, commodities, and business priorities. Given that UtiliPoint's Directory of Energy Trading, Risk and Transaction Management Software Solutions and Providers now lists more than 70 firms producing solutions within the ETRM universe, the odds are good that you will find one, or possibly a mix of multiple solutions, that can meet your unique needs—and it may not be the current market leader.
A senior executive at an ETRM software vendor mentioned to me the other day that his management team was discussing strategy and had focused the discussion on the theories expounded in the book “The Discipline of Market Leaders” authored by Michael Treacy & Fred Wiersema, first published in 1995. For those unfamiliar with the book (and I'll have to partially include myself in that category, having heard the theory but not really being familiar with the source), the authors advanced the notion that truly successful organizations embrace a singular value proposition and align their organizations around that value proposition. In Treacy and Wiersema's book, they identified three distinct value propositions that companies can follow to achieve a market leadership position:
• Operationally Efficient—In an operationally efficient company, it's all about the delivery of products and services in the most (as the name implies) efficient and effective manner. These companies are highly process oriented and highly productive. They generally get their products out the door quickly and cheaply. Their customers get reliable products and services; and the company is pretty easy to do business with. You're not getting a leading edge product, but you can be sure that what you're getting will generally meet your expectations and at a price that is lower than the competition. Examples of companies that follow this model are Wal-Mart, McDonalds and Dell.
• Product Leader—In a company embracing product leadership, the focus is on identifying, understanding and responding to market needs, both current and future, and in the process providing the best, most advanced and innovative products. These companies are creative, innovative risk takers. In doing business with these companies, you're getting the best product in the category. However, you're going to be paying a premium for that leading edge product. Example companies for this category include Apple, Sony and 3M.
• Customer Intimate—Customer intimate organizations strive to understand the customer intimately and provide the best total solution. In the process, they strive to gain customer loyalty and develop long-term relationships. These companies are friendly, responsive and adaptable to customer demands. As a customer you're not only getting a customized, personalized product, you're also getting a trusted advisor and partner. However, when you're doing business with these companies, you're paying top dollar. Companies that fit this model include Nordstrom and Ritz Carlton.
In the authors' view, in order for any company to achieve the status of “market leader,” no matter the industry or market they serve, they must embrace one of these value propositions, both internally and externally, and always focus their efforts to achieve the goals that they have elaborated in the adoption of the proposition. Additionally, no company can embrace all three, they must focus on one and do the best they can with the other two, but never to the determent of their chosen value proposition. The theory implies that trying to be all things to everybody will lead to the inevitable state of being nothing for anyone.
The theory is still very popular and widely used today, and it's easy to see why. Focus and discipline are universally accepted as qualities that are necessary for anyone or any company to succeed, and applying those traits around a central value proposition would seem to almost guarantee success (if you truly have a product and a market that wants it).
Applying the “Discipline” Theory to ETRM Products and Markets
However, applying the “Discipline” theory to ETRM solutions vendors can be problematic. The market for these products is extremely small when compared to almost all consumer products, and further, you can divide this small market up into even smaller discrete segments, grouped by commodity, geography, or business model.
Consider this group of fictional companies:
• A small west Texas gas producer sells equity production and schedules gas on a handful of pipelines.
• A Washington State merchant power producer sells power from multiple units into two ISOs, requiring real-time scheduling.
• A Wall Street energy trading company takes positions in virtually every energy commodity across the country. They trade both physically and financially.
• A large Chicago based airline tracks JetA fuel purchases at three regional hubs in the United States and two international hubs. They hedge these purchases whenever its makes sense.
• A global energy company is involved in the production of almost all hydrocarbon products world-wide and markets their products on five continents.
The small gas producer and the merchant generator would probably want to do business with vendors that have embraced the operationally efficient model, a vendor that can provide a low cost product that while not leading edge, still meets their somewhat “generic” needs. These companies probably wouldn't be interested in a “total ownership” experience given that what they do, while not easy, is pretty straightforward. They aren't really looking for a solution partnership, just a product.
The Wall Street firm however, is going to be depending on their ETRM solution to help make them money. They will want a product that can keep up with their needs. They view themselves as a trading shop, not an IT shop, and therefore rely on their vendor to be more than just a software supplier; they want the vendor to be their partner, ensuring that they have the vendor's ear and access to their talent to ensure their systems never hold them back. Clearly, this is a company that would place high value on a Customer Intimate experience.
The airline will be looking to their vendor to provide them with a product that can capture the single commodity (JetA fuel) both physically and financially, but in multiple currencies and possibly in multiple units of measure. Their IT staff is probably not going to have significant experience in these types of systems, so they will most likely be looking to the vendor to supply ongoing support and services, similar to that of the Wall Street firm, but in a less intensive mode.
The global energy producer may have a very large global IT organization. In their business they need a large support staff, not only to service the marketing organization, but also the exploration, production, and refining groups. They have a sophisticated marketing operation and because of their geographic reach, they trade products in all the major market regions around the globe. This is a company looking for a leading edge product, one that they can deploy to address their marketing needs now and that will keep up with their growth. Given the size and experience of their IT staff, they're self-sufficient and aren't looking to the vendor to be a partner. They want to do business with a product leader.
Most of the major ETRM software vendors will view each of those companies as a potential customer for their products. Clearly, the needs of the west Texas gas producer have very small overlap with the needs of the Wall Street firm or the global producer; and the needs of an airline or a merchant generator have even less. Yet in these days of multi-commodity, physical/financial ETRM products, a single vendor will visit all five and demonstrate how the capabilities of their product(s) might meet the needs of these companies.
The Vendor Perspective
So, how does a single vendor address the needs of this heterogeneous market and what are the implications for that vendor when trying to establish their value proposition?
In some cases, the vendors in the ETRM market still develop their products around a monolithic code base. They may disable some features and/or functions depending on the client needs; but, it's still the same code serving the small west Texas producer and the Wall Street trader. It costs the same to produce for both customers, but it is sold at different prices. Given that the vendor's investment in the product was made to address the needs of the top end of the market (the global multi-commodity, physical/financial trader), that vendor will have a very difficult time elaborating a value proposition that makes sense for the small producer market. The market segments are clearly different and have different business drivers. It is impossible for a single product to be stretched over a fractionated market and meet the expectations of the majority of the players therein. So, this vendor would need to focus on that high end market, define their value proposition in terms of that piece of the market, and just do the best they can for the rest, risking a significant amount of market share in the process.
Given the difficulties in developing a market wide value proposition for their product and their company, and if one assumes that the “Discipline” theory is valid, the vendor of the monolithic product is probably not going to become the market leader in the broader ETRM space. They could lead a niche market, but for the majority of the market, they will find themselves in the position of trying to be everything to everybody, with the attendant result.
However, if the vendor can supply a product set built around a modular, service oriented architecture, and deployed with a common integration infrastructure, that vendor can start to view the market as the heterogeneous environment that it is, and develop specific strategies and products to address the different segments. Each combination of market segment and product module can potentially be oriented as a separate entity, all rolling up to the vendor parent. The selection of the value proposition for these separate entities could then be undertaken using the processes outlined in Treacy and Wiersema's book; based upon standardized metrics, including the cost to service, and the value expectations of, the various market segments.
The Buyer Side
So, what does this mean for the buyers of ETRM systems? It means that you must understand and clearly express your expectations to the vendor, and ensure that vendor's value proposition (either explicit or implied) is aligned to meet those expectations. If your's is one of the smaller operations, trading only gas or only power, and you don't have aspirations of triple digit year-over-year growth, the answer may be that you want to do business with an operationally efficient vendor that can give you a decent product at a lower price. If you don't require leading edge functionality, you'll probably find that it's good enough.
However, if you're working for a growing international trading company that takes both physical and financial positions in gas, power, coal, crude, and NGLs; the low cost provider solution is going to be wholly inadequate. The scale and scope of your business dictate that you need the latest functionality. It may even mean that your company's business is unique enough that you need a somewhat customized solution. You're going to be seeking out a product and a vendor that can maintain your pace. Given your circumstances, your vendor will either need to be the superior technology company or the full service, customer intimate organization. But, you should be prepared to pay the cost associated with the product and service level you expect to receive. Trying to buy and implement a sophisticated ETRM solution on the cheap is a receipt for disaster.
You can't expect to shop at Nordstrom and pay Wal-Mart prices.
Energy trading, transaction and risk management (ETRM) software is that category of software applications, architectures and tools that supports the business processes associated with the trading of energy commodities. Energy trading is here taken to mean both the buying and selling of energy commodities such as crude oil, coal, natural gas, electric power, emissions and refined products – both physical and financial, the management of the movement and delivery of the energy commodities, and associated risk management activities. Not surprisingly, ETRM software suites tend to comprise a very complex set of functionalities that varies considerably depending on which commodities are traded, what assets are employed in the business, where those assets are located, and what the company’s business strategy and associated business processes are.
Recently, the market for ETRM software has been quiet buoyant. It rebounded significantly as hedge funds, proprietary traders and investment banks entered the market while European deregulation has also helped foster the explosive growth in energy and other commodities trading over the last 4-5 years. UtiliPoint research has indicated growth rates for ETRM software in North America and Europe at 15% in recent years . Additionally, the maturing of electronic marketplaces such as ICE and NYMEX has also, in effect, reduced many of the barriers to entry for those wishing to trade commodities and the expansion of the number and type of instruments to trade has fueled this growth. Another aspect of the growth in ETRM software markets has also been simply that overall the requirements have changed and, particularly in North America, replacements of older ETRM solutions has taken place. In fact, the changes that we have observed in commodity markets in general and energy commodities in particular in the last several years are helping to drive fundamental changes in both trading and risk management practice and in the requirements for ETRM software.
Changes in Commodity Markets
The increasing financialisation of energy and commodity markets has brought many significant changes which in turn have impacted ETRM software requirements. The backdrop and catalyst for these changes has clearly been the underlying fundamentals as documented by Fusaro & Vasey, 2006 .
Almost all commodities are still in supply/demand tightness as a result of increased demand led by the twin Asian economic powerhouses of China and India. Essentially, natural resource industries which had underinvested in infrastructure over a 12- 15 year period of relatively stable and low commodity prices were caught out by a demand side surprise. Because of the long cycle time in natural resource industries, even the higher levels of investment of the last 4-5 years has so far had little impact on supply. Indeed, the added factor of the environment has added cost, complexity and time to what was anyway a long cycle time. The supply/demand tightness in many commodity markets has resulted in vastly increased volatilities and generally rising commodity prices and, market sentiment has emerged as a new risk factor in price formation for commodity traders. Any event deemed to have an impact on supply – whether real or fictitious – can and does now impact price formation on a routine basis. Of course, this has taken place also at a time of a weakening US economy and US Dollar which in turn, has accentuated those price rises for raw materials priced in the US Dollar.
Almost at the same time, a raft of new entrants into energy and commodity markets including hedge funds, investment banks, proprietary trading firms and more has helped bring about fundamental structural changes in commodity markets. In fact, one must not underestimate the ordinary investor’s impact either. The advent of Exchange traded instruments such as ETF’s, ETC’s an ETN’s has provided a basis for the ordinary investor to gain exposure to commodities in a way previously not envisaged. Anyone with a trading account and money to invest can now gain exposure to crude oil, natural gas, uranium and other commodities using these highly liquid instruments . New trading participants and increased trading volumes have also encouraged the rapid emergence of a raft of new instruments to trade, new exchanges, electronic trading and exchange cleared trading which in turn have opened up the possibility of new trading strategies while significantly reducing the barriers to and cost of entry to these markets. The impact of this is simply that almost every day new traded volume records are set. Another impact is that this has opened up markets by increasing transparency and liquidity and introducing new counterparties for traditional traders. European markets, which were essentially limited to incumbent utilities as recently as 3 years ago, have particularly benefited by this rapid increase in potential counterparties.
As commodities continue to be in supply/demand tightness and as new entrants increasingly viewing commodities as a must have asset class engage in trading activities, new relationships have emerged between commodities and older, trusted relationships have broken down. The emphasis on Corn for Ethanol in the US, for example, has had a ripple effect throughout he commodity complex as Ethanol prices bear a relationship to Gasoline prices, Corn prices bear a relationship to Ethanol prices and as farmers increased Corn acreage at the expense of other grains, Wheat, Soybeans and other grain futures have soared. But the impact doesn’t even end there. The rapid increase in feedstock prices has had the effect of depressing meat and livestock prices as farmers slaughtered their animals sooner rather than pay higher feed costs. Older relationships such as that between Heating Oil and Gasoline have broken down at times in the recent past.
Overall, there has been an increase in traded volumes through an increase in the number of instruments, exchanges and traders, a growing financial aspect to commodity trading, larger and more erratic price swings and volatilities and prices have often become dislocated from the underlying fundamentals as ‘sentiment’ took over. Increasingly, commodity price movements have veteran traders fooled and looking for rhyme or reason to explain market events. One characteristic of today’s commodity markets that must not be overlooked is the idea that commodities are now an asset class. For example, it could be argued that the commodity correction that took place in the third week of March, 2008 had little to do with fundamentals and everything to do with large financial institutions selling profitable commodity positions to raise cash to support losses and margin calls in areas of their portfolios related to other asset classes like debt, credit and equities.
Impacts on Commodity Trading and Traders
At the highest level, there are three major impacts of all this in terms of trading and risk management. The first major change that UtiliPoint has observed is that unlike a few years ago, it’s difficult to trade just a single commodity. Multi-commodity trading – not just in energy - but across all commodities – is increasingly the norm. As an example of this, in a survey of energy companies in Europe conducted in early 2007, UtiliPoint found that only 1 in 50 traded a single energy commodity .
A second significant change is that simple directional trading strategies that profited earlier in the commodities bull market are increasingly being replaced by more sophisticated trading strategies including spreads, options and even black box trading. Some trading strategies conducted by financial players in these markets would not make much sense to traditional physical energy traders. What often gets forgotten is that hedge funds and investment banks make money in both up an down markets and, as discussed above, are not limited to a fundamental view of the commodity world but might see opportunities that play across different asset classes. Furthermore, there are a wider variety of instruments to trade
The final change worthy of note is that with these new instruments, trading strategies, factors influencing price formation and changing commodity inter-relationships, there is an impact on risk management. Firstly, as volatilities and other parameters have changed, traders should ask themselves the question ‘are the risk measures being used still reliable?”. Many quantitative statistical measures assume that certain factors are within certain bounds, for example volatility. If this is no longer the case then the risk measures might now be being used inappropriately. However, as historical trends break down, it can also be argued that risk measures relying on historical data and market behavior are now also increasingly inappropriate. Now is the time to review your risk measures and statistics and to move to models that rely more on stochastic models. Now is also the time to conduct more rigorous stress testing of your portfolio.
While this is just a summary of some changes that have taken place in energy and commodity trading as a result of the changes observed in commodity markets this last few years, it isn’t and cannot be comprehensive in the context of this article. What should be apparent however is that as markets have changed, so to has trading and traders and risk. These all impact the requirements for your ETRM software.
ETRM Software Impacts
In faster moving and more volatile energy and commodity markets your ETRM software has to be responsive, scalable and adaptable. It needs to support new trading instruments, new exchanges, new trading strategies and do so in a faster and more responsive manner than in the past. But faster moving markets and more complex trading also requires that your ETRM software provides true Straight through Processing capabilities and workflow support to help cut down room for error, oversight and abuse. Workflow involves smoothing and automating business processes so that authorizations, approvals and limits, for example, are all handled seamlessly by the system. In today’s faster moving commodity markets, this is increasingly essential because trading firms require improved controls such as security of access to data, documentation as well as more checks and balances throughout the business process. This should be provided by the ETRM software.
Reporting has traditionally been a weakness of ETRM software which often arrived with a third-party report writer, a few hundred template reports and the potential for a large consulting bill for building more and more reports. Reporting should be built into you ETRM software. The user interface should be graphical and complete with intuitive reporting and drill-down capabilities. Again, in fast moving and complex markets, users need to access information quickly and efficiently and not have to develop a new report from scratch.
In some ETRM solutions, risk management is simplistic and provided via third-party tools and add-ins. Risk management in today’s markets as stated above is a key area of concern and solid stochastic risk measures should be central to the ETRM solution that you utilize. The risk tools should be easy to use, include stress testing and what-if scenario tools and they should be responsive.
In fact, the basis for many of the features and functions required by ETRM solutions for today’s markets ought to be enabled through architecture. Service Oriented Architectures and parallel processing are increasingly being adopted by ETRM software vendors because they provide scalability, responsiveness, adaptability and connectivity to their software. The adoption of these architectures has so far been the key to vendor innovation in providing the tools that are needed, indeed, demanded by their clients.
Another important key requirement is the need to support multiple commodities. Many trading firms now trade not just energy commodities but related commodities such as emissions, freight rates, various softs and metals and so on. They require a single software platform that can support all the diverse commodities that they trade. This trend has become emphatic in the last 18-months or so and many of the leading vendors of ETRM software have recognized it and adapted to it. In fact, it will soon be time to replace the ‘E’ with a ‘C’ in ETRM. But not all vendors have picked up on this trend early enough and remain focused on adding software to support the energy value chain. In doing so, they are limiting their ability to respond to the growing recognition that commodities are an asset class.
The ETRM/CTRM Conundrum
In fact, it is difficult not to have sympathy with the ETRM vendor community. Markets and users change and at speed. Consider that their clients could be hedge funds, investment banks, utilities, oil and gas producers, refiner/marketers, generators, end users such as airlines, coal producers and more besides. One single solution for all these types of end users? And therein lays the reason why there are still so many suppliers of ETRM software simply because no single vendor has yet been able to meet the needs of all of these potential energy and commodity traders in a single solution.
While the uptick in commodity markets is where the focus of attention might be as vendors scramble to move from energy trading and risk management to commodity trading management and risk management, there are also other specialist niches for ETRM software. Asset ETRM software is a prime example where asset heavy firms such as Utilities and Generators require the ability to forecast market prices, optimize their assets and manage the bid to bill process. Asset ETRM software includes a good deal of additional functionality and points of integration and is far more complex and costly. On the other hand, there are users whose focus is more towards fuel procurement and hedging. They simply do not require the vast range of functionality that an out and out trader does and they may decide to opt for a solution provided through an Application Service Provider or simply use spreadsheets.
The issue remains that Energy trading, transaction and risk management is a complex area with widely varying requirements that this article has only scratched the surface with. While the big trend right now is to move toward commodity trading and risk management software – i.e. replacing the ‘E’ in ETRM with a “C”, there will always be room for more specialist software providers in the more typical ETRM space. For the vendor, that’s a conundrum and for the prospective user, it can be downright confusing.
About Dr. Gary M. Vasey
Dr. Gary M. Vasey is an energy industry expert noted for his industry analysis, consulting, and marketing skills. Gary currently manages UtiliPoint's European practice from its office in the Czech Republic. Gary is the co-author of the books ‘Trends in Energy Trading, Transaction and Risk Management Software - A Primer' and ‘Selecting and Implementing Energy Trading, Transaction and Risk Management Software - A Primer'. He also contributed two chapters to ‘The Professional Risk Managers‘ Guide to Energy and Environmental Markets' published by PRMIA and two chapters, co-written with Peter C. Fusaro, to ‘Weather, Energy and Environmental Hedging - An Introduction' (ICFAI University Press, 2007) edited by Amando F C Da Silva.