Building an energy trading capability
To trade or not to trade. This has been a philosophical question confronting energy company boards since the liberalization of energy markets.
Trading is the core focus of some company business models e.g. Vitol and Mercuria. But other companies have historically had a strong cultural aversion to trading. Perhaps the most prominent of these is Exxon, where for many years trading has been a dirty word.
But markets are changing and business models with them. Asset value is increasingly being monetised via traded markets closer to delivery. This is true for example in:
- Power markets – renewables driving increase in value from capturing prompt price shape & volatility
- Gas & LNG markets – increase in traded market liquidity and decline of long term contracts
- Oil & products markets – impact of shale in shortening investment cycles and facilitating new entrant players
These trends are changing the attitudes of company boards to energy trading.
New entrant players are building trading functions to allow portfolio value & risk management (e.g. in the UK, new entrant retailers such as Smartest Energy and flex providers such as UKPR & Limejump).
Large producers are looking to acquire trading businesses as a way to expand their footprint and enter new markets (e.g. Equinor’s acquisition of power & gas trader Danske Commodities).
But perhaps the biggest strategic shift of all is that of Exxon which has announced plans to develop a trading business. In today’s article we look at the Exxon case study as well as setting out 5 key challenges that energy companies face in building a robust and profitable trading business.
Case study: Exxon’s shift to embrace trading
Exxon has for decades had a deep-rooted cultural aversion to trading as a source of enhancing margin.
It has been a company that has focused on excellence in engineering: delivering complex upstream projects on time and on budget. This has been underpinned by a very strong ‘controls culture’ which has become part of the psyche of the company. Trading has been at odds with this culture i.e. ‘if you give the toys to the boys, the boys will play with the toys’.
That is why, when it signaled its change of heart by hiring several industry leading traders to build up a trading function, Exxon made global headlines this year.
Exxon has historically left its production virtually unhedged, selling at spot (or 1 month forward). This has been a coherent alternative business model to the more common trading-hedging model of many of Exxon’s competitors (e.g. BP & Shell). As evidence of the effectiveness of this model, Exxon has maintained a AAA credit rating from 1949-2016 (when S&P dropped it a notch to AA+).
The ‘no hedging strategy’ approach has been sold to Wall Street as a ‘pure oil-price play’. As long as Exxon’s balance sheet has been strong enough to ride out the bad times, the company saves on the ‘insurance premiums’ associated with hedging.
So why the change of heart – as a ‘non-trader’, what might Exxon have been missing? Profit growth is the obvious angle e.g. in the increasingly liquid LNG market where Exxon has a strong position. The long term growth outlook for plain vanilla hydrocarbon production is increasingly uncertain in a world of decarbonisation (even if Exxon is notoriously averse to admitting this in public).
A trading function can also bring entrepreneurial benefits, driving innovation and commercial evolution within a company. These are likely to be valuable for a company that has suffered from introversion and commercial blind spots.
Exxon also has an abundance of capital and lines of credit. These are valuable attributes to support a trading function and can be a big differentiator when dealing in derivatives and structured products.
But perhaps the biggest factor in Exxon’s favour is the intangible value arising from the market information available on the substantial physical commodity flow associated with its business. Leveraging physical portfolio flexibility has been the clearest route to trading function success in other energy companies.
Practical challenges in getting it right
Whether it is a giant corporation like Exxon or a small new entrant retailer, there are some key success factors that underpin the development of an effective energy trading business. We summarise five of these in Table 1.
Table 1: Key success factors in developing an energy trading capability
|Culture shift||Traders are different people, by temperament and working practices, than engineers and traditional commercial staff. Neither are easily able to manage the other for best results. Successful trading businesses need adequate representation at a senior management & Board level, particularly if core company focus is elsewhere.|
|Investment & capital allocation||A ‘trading lite’ approach is not a viable option for energy desks. Setting up a trading function requires sufficient investment in people, systems, data, analytical capability. Most importantly it requires the allocation of risk capital (whether implicit or explicit) to support P&L swings.|
|Risk appetite, limits & measurement||Traders require genuine commercial freedom/flexibility to operate within the clearly defined constraints of a well drafted statement of Board risk appetite. A robust risk limits structure underpins the delegation of risk-taking capacity. Limits in turn rely on an adequate risk measurement capability.|
|Incentivisation & performance measurement||Incentive structure is key for trading staff. Well framed bonus schemes drive results. Poor incentives schemes can engender dysfunctional trader behaviours and be divisive within the organisation. A classic flaw is allowing traders to ‘skim’ profits from other divisions, either inadvertently or deliberately, to bolster trading results.|
|Governance||A trading desk is typically the only function within an energy business that can harm the company overnight (safety incidents aside). Trading must be within a top-to-bottom governance framework, including oversight by sufficiently knowledgeable, commercially independent senior management.|
There have been a number of success stories where a physically focused business has successfully applied these principles to develop a strong trading capability (e.g. EDF Trading, Gazprom Marketing & Trading).
There have also been some spectacular company downfalls, led by trading related problems (e.g. Noble’s recent problems and the Enron related collapse of energy traders such as Dynegy, Williams and TXU in 2000-01).
Most energy companies sit somewhere in between success and failure. This often reflects the challenges of evolving a trading function within a company that has its cultural and commercial roots elsewhere. But it also sets up tangible opportunities to bolster profits and improve the integration of trading functions by tackling the 5 success factors above.