Why We May Soon Replace the ‘E’ with ‘C’ in ETRM Software By Gary M. Vasey

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.