New Players in Energy Trading

Investment banks and oil giants have become alternate power sources

You'd be hard-pressed to find a villain as universally loathed as the energy trader. The sector's sham deals and price-gouging have hurt investors, damaged the power industry, and forced some giants of trading to the brink of bankruptcy. The latest: On Nov. 20, a major investor accused El Paso Corp. (EP ) of inflating profits through bogus trades as recently as August. And on the same day, Swiss bank UBS Warburg said the lackluster market would force it to scale back the energy trading operation it acquired from Enron Corp. in February. Blasts one California consumer advocate: "All traders offered us was manipulation. My position is goodbye and good riddance."

Not so fast. It may be a reviled symbol of boomtime excess, but energy trading is here to stay. As firms such as Dynegy (DYN ) and El Paso turn out the lights on their trading floors, the banks, big oil producers, and insurers are tiptoeing in. Lured by the potential profits to be made in hedging volatile energy prices, new leaders are filling the vacuum left by the failures of the energy sector. In a few years, say analysts, they'll dominate an industry Enron made famous. Says J. Michael Stice, president of ConocoPhillips Gas & Power (COP ), which is beefing up its trading team: "That void has offered us an opportunity."

Mind you, it won't be the frenzied bazaar it once was. There's no going back to days when traders shamelessly pumped up trading volume and a top Enron trader generated $750 million in profits in a single year. Today, Enron is bankrupt and its former rivals are being punished by once-generous creditors for their crushing debt and poor cash flow. The latest blow: On Nov. 26, Moody's Investors Service downgraded El Paso's debt rating to junk.

El Paso is leaving the trading business--and its not alone. Eight of the top 10 electricity traders have either stopped trading or are scaling way back, including former stars like American Electric Power (AEP ), Aquila (ILA ), and Mirant (MIR ). "That part of our business will shrink as our asset base shrinks," says Mirant Chief Executive S. Marce Fuller. Meantime, the number of megawatts traded daily at the Midwestern Cinergy hub, the country's most active power marketplace, has plummeted 70%, to 4,884, from last year, says energy market tracker Platts.

So why doesn't any of this worry the survivors and new arrivals? "We will benefit from having persevered," says Neal Shear, global head of commodities at Morgan Stanley (MWD ), which has been trading energy since the mid 1990s. Other emerging leaders: Goldman Sachs (GS ), Bank of America (BAC ), oil giant ChevronTexaco (CVX ), and insurer American International Group (AIG ). As the industry's credit problems are resolved, these players expect trading volume to tick up. Most trades will likely be short-term deals linked to hard assets such as plants and pipelines, not long-term bets that depend on near-fictional forecasts of future power prices. Much demand is coming from companies needing a mechanism to manage the risk of fluctuating energy prices.

For banks and insurers, their ace in the hole is their solid balance sheets. When trading surged in the late '90s, traders were forced to borrow heavily to back deals. So when business crumbled, they were caught short of cash. With plenty of capital and solid credit ratings, banks have no such worries. Their experience trading in commodities, tight regulatory rules, and internal controls should prevent Enron-style risks, analysts say. And unlike energy firms that touted trading as a growth engine, these diversified giants can wait for a market rebound.

Of course, that won't happen until the system regains credibility. UBS's experience with Enron's trading business is instructive, analysts say: The bank bet too big on a revival of trading and had to scale back.

Indeed, there's no getting around the fact that energy trading remains a risky business. Regulators are tightening rules to force greater disclosure. Meanwhile, deregulation has slowed to a crawl, threatening the outlook for companies hoping to profit from greater competition. Says analyst John E. Olson, chief investment officer of Sanders Morris Harris Inc.: "We're going to see power trading shrink to a shadow of itself." Given how scary the original version was, that might not be a bad thing.

By Andrew Park with Wendy Zellner in Dallas, and bureau reports

    Before it's here, it's on the Bloomberg Terminal.