Energy traders see biggest bonus increases on the street
COMMODITIES HAVE BEEN hawked around, speculated on and hedged for centuries, but Wall Street’s attitude towards trading them has been highly erratic. Plenty of firms have viewed it as an interesting niche business, ploughed money in, got burnt on a large position that their infant businesses were too small to swallow, and shut up shop. True, most businesses at bulge-bracket banks get scaled back as the profitability of any given market dictates. Few, though, are dumped altogether so quickly and unceremoniously as commodities.
Until the next bull run in the market, that is. Right now, on the back of high prices, high volatility, high trading volumes and enhanced interest from traditional counterparties and new investors entering the market, commodities, and particularly energy trading, is hot.
Third-quarter results, not just from energy heavyweights Morgan Stanley and Goldman Sachs, but also others, such as JPMorgan and Merrill Lynch, were propped up by energy trading. When JPMorgan reported a 78% rise in quarterly earnings on the back of strong trading revenue of $2.4 billion, energy trading was particularly strong, and president and COO Jamie Dimon mentioned that he was pleased the bank was investing in this business. Merrill Lynch said debt market net revenues were up 57% over the third quarter in 2004 as a result of higher revenues from principal investing and commodities. Perhaps this is just as well; Merrill spent $800 million buying an energy business at the end of last year.
Once again, many players are frantically trying to build or buy a presence in energy trading. Citigroup has been hiring this year and moved its energy trading business to Houston; Deutsche Bank has hired 20 new staff since May and plans a further 15 to 20 new hires next year. Barclays Capital, BNP Paribas and SG are already aggressively competing for business. Energy trading is Wall Street’s golden child and a handy diversification play away from equities and interest rate products. As the market for energy and energy derivatives becomes more mainstream and demand grows, there’s a perception that the bull market for energy can be sustained in the long term. Banks with no significant presence in the business at the moment are making apologetic noises about not having yet cashed in.
Is the market strong enough to sustain all the companies vying for business in this latest iteration of energy fever, or are banks belatedly entering the market at the peak of the cycle, just in time to get spanked? “There are two very large scale players, we have joined them, and there are now others trying to get in,” says Joe Gold, managing director and head of north American power and gas trading at Barclays Capital. “It’s unlikely there will be room for more than four or five with serious scale. It’s not a business that can be sustained by everyone.”
Banks that are investing again say that this time their interest is sincere – they’ve got management and capital behind them and they’re building long-term sustainable businesses. That’s fairly predictable, but hard to swallow when many firms have pulled out of energy trading at least once before, often at times when energy prices have plummeted. Some have moved in and out with alarming regularity. Merrill Lynch sold its energy trading unit in 2001, signing an agreement to stay out of the business for two years, then changed its mind in 2004 and bought the trading joint venture Entergy-Koch.
The banks expanding in energy are taking different approaches. When Merrill Lynch bought Entergy-Koch last year, it inherited 300 traders in London and Houston. This September, Bear Stearns entered into a joint venture with power company Calpine to trade natural gas and electricity. Bear Stearns will provide capital and Calpine the traders. CSFB, like Bear Stearns, has less appetite for proprietary energy risk but has already taken the joint venture route – its arrangement with TXU fell apart in September. Now it is hiring traders to help win more structured energy mandates in its investment banking franchises. In April, the bank hired Rita Nagle from Goldman Sachs to run gas trading and now CSFB has about 25 people trading electricity and natural gas.
JPMorgan has also plumped for organic growth, but is setting a much faster pace. After hiring Beau Taylor, Morgan Stanley’s former head of eastern US power trading, in March and a number of other key hires, many of them also from Morgan Stanley, the bank quickly made some energy wins in the third quarter. “They took a proprietary bet, which paid off. They were willing to take a risk and it played out well,” says a trader at a rival firm. “We had some good fortune in this last quarter,” says Taylor, who is now JPMorgan’s global head of energy.
Getting the mix right
JPMorgan and its predecessor firms have also been in and out of the energy business before, although its involvement was only ever on a small scale. However, this time Taylor says he has the full support of senior management and that the hiring the bank has done so far – it now has an energy team of about 70, up from 35 at the start of the year – is just the beginning of a much bigger build out.
So far, JPMorgan’s emphasis has been on power and gas, Taylor’s specific area of expertise, but the bank has plans to get into global oil and European gas and power. It also wants to grow in Asia. “I feel good about our steady growth over the past few months,” says Taylor. “We’re not going to make sacrifices on clients or infrastructure, which can happen if you try to do everything simultaneously.”
Unsurprisingly, there are critics of each different growth strategy among the more established players. Some say that Bear Stearns will not be able to net all the revenue potential through its joint venture with Calpine if it is not doing any of the trading itself. Others say that although Merrill’s acquisition gives it immediate scale, it hasn’t got the optimum product mix given that the Entergy-Koch joint venture trades just power, gas and weather derivatives. Many warn that growing a business organically, as CSFB or JPMorgan are attempting, requires a lot of capital, a lot of scale, a lot of time building trading infrastructure and a lot of spending on recruitment [see Energy traders see biggest bonus increases on the street].
Other traders are critical of any bank that is just getting into energy trading to provide high-margin structured, integrated solutions for investment banking clients. It’s something Morgan Stanley and Goldman Sachs have done with great success in recent years. When Goldman Sachs advised a private-equity consortium on the purchase of power company Texas Genco last year, for example, it also provided the debt financing and entered into a contract to buy a portion of the company’s baseload capacity for four years.
But then Morgan Stanley and Goldman Sachs have big flow-trading and prop trading businesses to mitigate the risk. “When the market is volatile and so illiquid, you may not get paid for the risk you’re taking for the largest client transactions. It’s very difficult to do large structured trades because of the large bid-offer spread,” points out one trader. You have to manage your own portfolio risk to effectively manage the client risk.”
BarCap’s Gold says that you have to be a trader of significant scale in the day-to-day market to retain that commodities-related investment banking business in any case. “If you walk into the client and you’re not offering the best price, their loyalty will last one deal,” he says. That is if they can find those investment banking clients in the first place. As one trader glibly points out, everyone wants to do structured deals for energy producers and consumers these days. The newcomers had better join the back of the queue.
Essentially, though, the banks expanding in energy trading now all face the same structural problems: they have to home in on one part of this business to begin with, such as power and gas trading. This means their risk isn’t diversified, a problem if they decide to take big risks from the outset. “A lot of people are growing way too quickly,” says one market player. “If they don’t have the right risk management, it’s a question of how soon will they pull the plug?
Goldman Sachs and Morgan Stanley have large, diversified commodities businesses now that are core features of each franchise. Morgan Stanley has more than 200 sales and trading people in its global commodities business working on flow trading, prop trading, physical supply and distribution, and creating complex structured transactions for investment banking clients. 80% of that activity is related to energy – crude oil, oil products, natural gas, power, coal and freight and emissions.
But back in 1988, when Morgan Stanley established its business, it did so with small steps. “We’ve built our business very gradually over a period of 20 years. It hasn’t always been so profitable as it is today. But now we are diversified between many different products and markets,” says John Shapiro, a 20-year veteran of Morgan Stanley and the firm’s managing director and global head of commodities. “You’ve got to look for where the business is moving, not just where you’re making your money currently.”
About five years ago, Barclays Capital, a consistent player in commodities trading for several years, also decided to go for this strategy. “It’s taken an awful lot of careful planning,” says Gold. “Every couple of years, we picked one area of demand from our client base and focused on building it to be the best possible business it can be. It means we’re not a slave to swings in our client activity or price path of a particular market, which means our P&L is consistent and not influenced by the outcome of one major deal.” Now the bank is best known for its metals business, but it also has a global oil desk, power and gas in Europe and the US, and coal in Europe. Most recently, it went on a hiring spree to bulk out its US business, adding electricity trading, some new investor products and newer product areas such as emissions trading. Last month, the bank also acquired power company Duke Energy’s North American power and gas derivatives book.
New investors
The good news is that today there’s more flow-driven business in energy trading, particularly in energy derivatives, than ever before. For a few years, large energy consumers and suppliers have turned to investment banks for their energy hedges. Following the demise of Enron in 2001 and the exit of other utilities companies from the trading business, the highly rated bank community moved in.
But this year energy producers and large-scale consumers have needed more energy hedges to deal with price volatility and consolidation in the industry. As well as that, new investor groups are emerging. Five years ago, hedge fund players were virtually non-existent in this market, now they account for 10% to 12% of total commodities revenues. Pension funds and insurance companies also now view energy as an important source of diversification.
Many banks now offer different investor products such as structured notes linked to commodity indices. Taylor, for one, plans to build out a global commodity indices business at JPMorgan to appeal to passive investors. As Euromoney went to press, Deutsche Bank was about to launch its first commodities-linked exchange traded fund. Mark Ritter, global head of commodities trading at Deutsche Bank, says the pool of interested investors is still increasing. “Wealth managers are increasingly thinking of commodities as an asset class and we have already had interest from retail investors in our commodity-linked ETF,” he says.
Increased demand means that there should be room for more banks in the energy trading market. “Business must be growing because the number of people establishing successful businesses is increasing, but it is not affecting us. The market is not flooded,” says Morgan Stanley’s Shapiro. He adds that there has been some margin pressure in the third quarter because of the number of new entrants in the market, but that it has always been pretty competitive. One global head of fixed income says that more committed players could actually spell good news for the market, pointing out that more banks offering two-way prices on a day-to-day basis would provide the enhanced liquidity that this market so desperately needs. “If we can increase the number of genuine market makers in energy trading, that has to be a good thing,” he says.
Yet it’s exactly these market structure issues that make it difficult for new entrants to succeed, according to Brad Hintz, analyst at Sanford Bernstein. In a research note on the subject, he remains sceptical that they would find energy to be “fixed income – like trading goldmines” because of the illiquidity, the inconsistency in spreads and the difficulties of price discovery.
Digging a hole
The results can be equally inconsistent. Morgan Stanley and Goldman Sachs experience large revenue swings from this business from quarter to quarter. Deutsche Bank’s Ritter and Louise Kitchen, the bank’s global head of structuring and marketing, both of whom joined from UBS this year, says the firm drives the business through flow trading, rather than prop trading. This, he says, make results more consistent. “Volatility in earnings is part of the nature of the business, but we mean to build a high mean, low variance business,” he says. Nevertheless, anyone looking for a steady meal ticket should probably stay away.
Furthermore, although it has always been a volatile and illiquid market, the risks inherent in trading energy for the banks are higher now than ever before. Unprecedented price volatility in the oil and gas markets, particularly in recent months as hurricanes Katrina and Rita in the US have caused energy prices to spike up and down rapidly, is presenting newcomers with some enticing arbitrage opportunities – and also, of course, chances to dig themselves a very deep hole. When banks are fixing the price on a long-term or high-volume client hedge, there’s a lot at stake. Coming out on the wrong side of one transaction in today’s market can sink a new business altogether. “Volatility has grown a lot, but it’s also a lot less friendly volatility,” says Gold. “You have to be skilled to manage the risk. For example, you can lose your entire year off the price you quote on an E&P asset hedge.”
The two Wall Street firms that have dominated the bank market in energy trading for 20 years have a much better handle than most on the risks attached, not just because of their long-term experience, their diversified businesses models and the size of their businesses, but because, unlike other firms on the street that just trade energy futures and energy derivatives, both of them also supply and distribute the product. Morgan Stanley produces some of the electricity that it trades, and transports and stores some of the oil products it trades. It owns petroleum storage, distribution and blending facilities in New York, New Haven and Rhode Island and three commercial power generators – an oil-fired plant in Georgia and two gas-fired plants in Alabama and Nevada.
“Being in the physical business helps us spot new opportunities, but it’s obviously part of the opportunity as well,” says Morgan Stanley’s Shapiro, who used to be an executive at oil company Conoco. “Hurricanes Katrina and Rita this year showed that the physical business has its issues. But being in that business also means that if we have a need in the US, we can bring oil from Europe. If there’s demand from China, we can send it there.” Morgan Stanley has a number of long-term supply contracts, including a seven-year contract to supply TransMontaigne with gasoline and distillate and a long-term contract to supply United Airlines with jet fuel. As a result of the contract with United, the bank built out a presence in jet fuel, then hired an additional four people. So now it has a global team sourcing and moving jet fuel around the world.
In owning energy assets themselves, Morgan Stanley and Goldman Sachs have access to part of the market that no other banks are in. It also gives them information on supply levels – and hence pricing – in this extremely opaque market – information that is not available to other traders. Being able to store product also helps Morgan Stanley and Goldman buy when they see an opportunity and then wait till the price rises again.
Many banks, notably Salomon Brothers in the 1980s, have been in the physical business before. In fact, the lack of access to the physical market has prompted banks on occasion to pull out of the business altogether. Right now, though, Morgan Stanley and Goldman Sachs have the monopoly on this crucial strategic advantage. However, JPMorgan’s Taylor, a former Morgan Stanley man himself, says this isn’t a problem. “If I did view it as a disadvantage, I wouldn’t be here. Unlike some of our competitors, our approach at JPMorgan is more derivatives centric.”
Perhaps he’s right. Near-term conditions for the purely “paper traders” look good. BarCap’s Gold says he can’t see price volatility declining much. “Volatility isn’t going to go away – when you get this far out on the supply/demand imbalance, prices are always going to move a lot on one-off events.” That should keep volumes up. “Given the volatility, I think people are going to stay focused on hedging right now,” says Taylor.
Pot of gold
He also thinks that still more investors could get interested in this market. “Looking at the volumes in energy trading, versus fixed income, the potential is enormous. Everyone uses energy after all.” The large amount of interest on the street in the IPO of the Intercontinental Exchange, an global electronic exchange for trading energy futures, which priced as Euromoney went to press at the top of the range, is indicative for some bankers of that potential.
Shapiro agrees it’s easier for banks to get into this business today because the market is so much more developed and sophisticated. He says the fact that there is so much more growth potential might entice firms into a longer-term commitment to the business. “Some may not exit the business as quickly this time because they see the potential pot of gold.”
Hintz estimates that energy trading already brings Wall Street $8 billion a year in revenue and that the “pot of gold” will actually grow at a rate of 15% a year for three years. Of that pool, he estimates that while JPMorgan and Citigroup made $150 million from the market last year, compared with Morgan Stanley and Goldman Sachs, which made about $1 billion of revenue and 10% of earnings from energy trading last year, a number he thinks could go up to $1.7 billion to $2 billion by 2007. However, he also thinks the net revenue the two heavyweights in this market might make will be limited at 20%, so it would seem there’s room for other companies to take advantage of the market’s growth potential.
However, the sustained bull run for energy is by no means certain. “The weather will be the primary driver, then the state of the economy,” says Deutsche Bank’s Ritter. “If we go into a recession in the US, that will dampen volatility and prices will move back to more traditional levels.” This could spell bad news for banks struggling to expand their businesses, particularly those that are pricing aggressively to get into the market. As one trader puts it: “It will be interesting to see if they can figure out how to make money when the markets aren’t so strong.”
Shapiro point outs that to have long-term success in this market, you have to make money in the good and bad times, pointing out that his business did better in 1991, one year that the market collapsed, than it did in 1990. “The market is now stronger overall than it has been before, but we will still have weak years. There will be periods in 2006 that don’t look so good.”
Given the other challenges of building and maintaining a successful energy trading business, those firms growing now that can also profit in the bad times stand a fighting chance of being among the four or five that will have sustainable businesses.
