Monday, January 16, 2006

Is Energy Trading a Dirty Word?

Sunday's New York Times business section led off with an article describing the state of energy trading, just over four years after Enron filed for bankruptcy. While the article was largely a human-interest piece on ex-Enron traders who have moved on to found their own trading operations, it also raised a number of interesting issues about the role and impact of energy trading. Here are some further thoughts on these topics, based on my own experience trading energy commodities from the mid-1980s to mid-1990s.

  • Energy trading profits - The market for the last couple of years has been an ideal environment for traders. Volatility is the most important ingredient fueling the profitability of speculative trading, i.e. trading not directly related to managing the risk on an underlying business exposure. While many blame higher volatility on traders, I'd argue that the volatility arises from the well-documented combination of physical supply problems and geopolitical risk. In general, trading profits are a response to, rather than a cause of, volatility.
  • Trader compensation - Given the huge profits available from trading around the world's trillion dollar a year energy flows, it shouldn't be surprising that some enterprising young folks--and trading is predominately a young man's game--are raking in incomes that put corporate executives to shame. But there are few things in life, other than owning your own business, in which personal contribution to profits is so easily measured, and in which rewarding good performance pays such large dividends for the firm. It's also worth noting that these salaries will fluctuate greatly, since it's unusual for even the best traders to keep winning big, year after year after year. The game changes rapidly; the deals that made you money last year get arbitraged away, and you have to keep innovating ahead of that curve to be successful.
  • The role of hedge funds - Many of the same folks who blame trading for running up prices and volatility focus their ire on hedge funds. While these operations have brought billions of dollars of speculative money into energy trading, that isn't necessarily bad. From personal experience, I can tell you that markets involving only those with real stakes--companies with oil in transit, factory inputs to hedge, etc.--tend to be dull and illiquid. The oil company or utility trader needs a willing counterparty, and as often as not he won't find another oil company or utility that wants to take the opposite direction at the right time. That's where purely financial traders come in, and hedge funds are only the latest in a long line of non-fundamental players who have served that purpose. While they may occasionally drive the market, they have no intrinsic advantages over the companies that produce, refine and distribute the actual molecules and electrons.
  • Recovering from Enron - Most of the people at Enron were smart, innovative, hard-working and honest. It's appropriate that the "scarlet letter" many of them received seems to be fading. I hope for their sakes that the trading operations in which they now work have a higher degree of transparency and checks and balances than Enron did, because the most important ingredient in sustained trading success isn't brains, but a solid reputation.

Politicians who think that regulating trading will bring down energy prices would be better advised to focus on the fundamentals that drive the markets. Stimulating more oil and gas production, facilitating gas imports, and fostering energy efficiency and cost-effective alternative energy will do a lot more for consumers than cracking down on speculation. Coincidentally, these actions will also make trading less profitable in the long run, by reducing market volatility.

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