A new consensus pricing service for energy derivatives could help cast light on the murky world of energy derivatives trading and the endless scandals that it seems to generate.
Enron’s energy derivatives trading business was at the heart of the scandal that brought down what was once America’s seventh-largest company. It now appears, though, that Enron was merely the initiator of a trend for energy derivatives traders to get involved in financial malpractice. Dynegy, Duke Energy, and even that paragon of risk-aversion, Royal Dutch/Shell, have all found themselves embroiled in scandals relating to how they valued their energy derivatives trades.
Of course some also engaged in round-trip trades to beautify their books, so it may be unfair for Shell to appear with them in the same sentence, but the tendency of the energy derivatives market to generate scandals suggests that there may be serious problems with marking these contracts to market.
Part of the problem is that a large proportion of energy (including oil and gas) derivatives are traded in over-the-counter (OTC) markets that are unregulated and opaque to all but the traders involved.
Another aspect that complicates the process of ensuring that the value of contracts is accurately marked according to their market price, as required by law, is that many of these contracts are extremely illiquid. If an esoteric contract is not traded for five weeks, its recorded market value in the accounts at the end of four weeks is most likely to be the product of a forward curve generated by a model.
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“It’s more accurate to say that they are marked to model, not marked to market,” says Thomas Browns, head of KPMG’s energy trading advisory group. “The best you can do is to examine the model and its assumptions, look back at the real world, test the model and its results, and then make a judgement and ensure sufficient reserves are set aside for the uncertainty.” The process is exhaustive and takes between four and six months to complete. Although such reviews are extremely thorough and the external advisers engaged are typically highly experienced, ultimately even the best models become worthless if the data input to them is inaccurate.
There is also the danger that a deliberate effort may be made not to mark contracts to market. Enron is an extreme case but the fact remains that the combination of the way that traders are remunerated and the opacity of many OTC energy derivatives contracts, provides both the incentive, and in the absence of adequate controls, possibly the opportunity, for contracts to be incorrectly marked intentionally.
“There are all sorts of reasons why someone would intentionally not mark to market,” says an industry insider. “What management and investors would like to see is nice, steady, consistent profit delivery, they don’t want to see huge daily P&L swings. It’s in the trader’s interest, and it’s what Enron was doing, to show what appears to be a nice, relatively risk-free steady profit growth. So they were mismarking the books, keeping their profits with the rainy-day provisions and rolling them over to the next time so that they could report profits regularly.”
Additionally, a trader’s bonus is often determined by the state of his books on one particular day at the end of a year. If a trader has had a bad year, he may then have an incentive to make it look worse, as he is unlikely to get a bonus anyway, and then to build on that “profit” the following year.
One solution to these problems is being offered by Totem Valuations, a London-based “valuations clearing house”. Totem has launched a consensus pricing service for the oil and gas OTC derivatives markets that could help product controllers and risk managers to obtain more reliable valuations. Subscribers to the service agree to send their best estimates of prices for a range of products confidentially to Totem, which then uses the data it gets from all its subscribers to calculate a consensus price, which it then passes back to them.
A way to talk to traders
“It gives product controllers and risk managers a tool which they can use to have a meaningful discussion with their traders,” says Tim Barker, CEO of Totem Valuations. “To have any confidence in your risk management systems, you’ve got to know that where you’re starting from is a true level in the first place”.
Founded in 1997, Totem gained its reputation by providing similar services in the OTC equity and interest rate derivative markets and has an association with PricewaterhouseCoopers. It also claims as its clients a significant number of the major players who represent a high proportion of active trades in a number of liquid and illiquid products.
Totem’s new energy derivatives consensus pricing service will initially concentrate on the most liquid oil and gas indices such as Brent swaps and Henry Hub Natural Gas. Totem also has ambitious plans to expand its service to cover less liquid products and electricity derivatives in a number of European markets from the end of August 2002.
While product controllers, risk managers, traders and auditors, have found many of the consensus pricing services useful in the less liquid markets, some are not convinced that the new oil and gas service is a particularly valuable addition. As Jonathan Taylor, the head of oil risk management at Barclays Capital points out: “If it’s highly liquid, the professionals in the market know the price anyway.”
