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IS THERE REAL VALUE IN E-TRADING?

Robert Lukefahr is a Vice President in Booz Allen Hamilton's Global Energy Business based in Houston and London. Mr. Lukefahr has worked with a broad range of clients on business strategy, eBusiness and innovation, organizational design, and business transformation programs. Tim Donohue is a Principal in Booz Allen Hamilton's Global Energy Practice. Mr. Donohue has extensive experience in strategy, performance management, and operations improvement for energy trading groups. Prior to joining Booz Allen, Mr. Donohue was a derivatives trader for a major energy company. Keo Rubbright is a Senior Associate in Booz Allen Hamilton's Global Energy Practice where she specializes in product and trading strategy. Prior to joining Booz Allen, Ms. Rubbright was a crude and products trader for a global commodity trading company. She is based in Dallas, Texas.

Abstract
Over the past 3 decades, trading volume on the world energy markets has grown almost 100 fold. From the emergence of the Spot market in the 70's and early 80's to the explosive growth of derivatives in the 90's, the energy trading business has grown from an environment of highly regulated and long-term contracts to one of the most dynamic commodities markets in the world. In the late 1990s and the beginning years of the new millennium, the pace of change accelerated. A wide range of new products appeared on the scene driven by deregulating markets, the rise of merchant energy companies, and significantly relentless innovation from Enron. It was against this backdrop that energy trading companies crashed into the e-Commerce boom and its concomitant proliferation of Web technologies. Commodities trading and the Internet seemed like a perfect marriage. The Web promised global reach, low cost information flows, and the possibility of "many-to-many" exchanges where big and small players alike could conduct commerce in an open, transparent environment. When the e-Commerce bubble on Wall Street burst, the whirlwind of publicity and activity surrounding e-Commerce and trading began to subside. Then, in the Fall of 2001, the collapse of Enron left the industry wondering if there was any real money in energy trading and whether it was worth the risk to chase it. By the early Spring of 2002, most of the major players in the energy markets had shifted focus from innovation to shoring up the balance sheet. But the new electronic trading media did not disappear with EnronOnline. Instead, most of the volumes quickly shifted to other proprietary and open exchanges. EnronOnline's one-stop shopping and easy-to-use system had brought hundreds of new players into online trading. The trend now appears unstoppable. In this paper we argue that: There is a real value proposition for e-Commerce and energy trading in back-office efficiency, front-office effectiveness, and expanded markets and volumes. Traditional brokerage, marketing and risk management services will come under increasing margin pressure and the ability to leverage proprietary positions and seize arbitrage opportunities will become more fleeting. In order to profit from these changes, traditional trading companies need to move their back-office and front-office to a more flexible and efficient technology, and seek selected areas where they can develop innovative products to serve the new customers and markets reached by online platforms.

2002, Booz | Allen | Hamilton

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Introduction
Commodity traders thrive on change. From the emergence of the Spot market in the 1970's and early 1980's to the explosive growth of derivatives in the 1990's, the energy trading business has transformed from an environment of highly regulated and long-term contracts to one of the most dynamic commodities markets in the world. As the markets have grown, each new commodity and new geography has brought with it additional players and new opportunities for profit. In the late 1990s and the beginning years of the new millennium, the pace of change accelerated. A wide range of new products appeared on the scene driven by deregulating markets, the rise of merchant energy companies, and significantly relentless innovation from Enron. Between 1999 and 2000, the volume of energy trading among large merchant energy players in the US more than tripled. It was against this backdrop that energy trading companies crashed into the e-Commerce boom and its concomitant proliferation of Web technologies. Commodities trading and the Internet seemed like a perfect marriage (at least to the hundreds of entrepreneurs, venture capitalists, and new business development managers that launched Web-trading initiatives). The Web promised global reach, low cost information flows, and the possibility of "many-to-many" exchanges where big and small players alike could conduct commerce in an open, transparent environment. By late 2000, three new global trading markets backed by industry heavyweights had arrived on the scene (ICE, EnronOnline, and TradeSpark). Several narrower start-up markets like Houston Street and Altra Energy seemed to be emerging as market leaders in niche commodities (e.g. NGLs). Perhaps more importantly, the Web opened the possibility that traded markets would increasingly extend downward, to smaller wholesale markets for fuels and electricity. Even in the most traditional markets, for example marine fuels, global electronic marketplaces like OceanConnect began bringing more real-time transparency to today's heavily brokered local commodities. By the beginning of 2001, nearly all of the largest energy trading companies were actively pursuing several e-Trading plays. Some, like BP and Shell, pushed industry product exchanges and supported global trading exchanges sponsored by the leading energy trading banks. Enron built and supported its own marketplace and used the exchange to launch and drive volume for emerging products like its weather derivatives. Most companies at least bought a few hedges for the e-Business wave by buying (or promising trading volume in exchange for) a small portion of equity in technology companies and start-up trading markets. When the e-Commerce bubble on Wall Street burst, the whirlwind of publicity and activity surrounding e-Commerce and trading began to subside. Skeptics were reassured that e-Trading really was "the next fax machine" rather than a disruptive technology. Internet champions were left wondering how all of the potential and promise they had envisioned seemed to suddenly dissipate alongside the dubious web businesses that promised to secure their fortunes by counting "eyeballs." Then, in the Fall of 2001, the collapse of Enron left investors (and many senior energy executives) wondering if there was any real money in energy trading and whether it was worth the risk to chase it. By the early Spring of 2002, most of the major players in the energy markets had shifted focus from innovation to shoring up the balance sheet. But the new electronic trading media did not disappear with EnronOnline. Instead, most of the volumes quickly shifted to other proprietary and open exchanges. EnronOnline's one-stop shopping and easy-to-use system had brought hundreds of new players into online trading. The trend now appears unstoppable. In this paper we ask, and pose tentative answers to, three questions: Is there a real value proposition for e-Commerce and energy trading? Will the Web technologies in trading be transformational or incremental over the next five years? How can traditional trading companies profit from the change?

2002, Booz | Allen | Hamilton

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A PLACE TO START: "WHAT IS TRADING?" Such a basic question may seem like a peculiar place to begin when addressing an audience of managers and executives from large energy firms. But we have found that the trading businesses are generally the least understood part of most energy companies. Senior executives typically come out of generation, exploration, or manufacturing. The business intuition they have honed over decades often fails to guide them effectively in the less tangible world of financial instruments. Then too, there is a pervasive trading culture that perpetuates the notion that trading should be a separate part of the business following distinct rules. Traders have adopted a vocabulary that is practically unintelligible to their colleagues in other parts of the industry or other areas of their own companies. Indeed, while energy traders tend to be among the very highest paid employees in most large energy companies, there are few companies that understand how much of their trading profits are due to the expertise of individuals and how much is due to the assets and positions they inherit. So, some demystification seems in order. At its core, trading is the simple act of committing to the purchase or sale of a commodity at an agreed price, quantity, quality, and payment term (the deal) and the series of information, administrative and operations support services surrounding the deal (the deal support processes). Simply put, you buy, you sell, you transfer the money. Using this definition of trading, every marketer who sells a product and every purchasing agent who buys one is a trader. And, in fact, they are traders. One of the recurring themes in e-Trading is the blurring of traditional bright-line differences between "low-end" sales transactions and "high-end" commodity trading. Throughout this discussion, it is valuable to bear in mind that the differences between traditional commodity traders and their sales/purchasing agent counterparts are more a matter of "degree and outlook" than type. As sales calls and long-term contracts are replaced (or at least supplemented) by industry exchanges, the marketing/purchasing environment is taking an important step closer to becoming a trading floor (see, for example, OceanConnect). Fundamentally, traders provide three interrelated services: Brokerage services matching suppliers with excess product and consumers with excess demand Marketing services buying excess supply (usually at a depressed price) and marketing to potential buyers Risk management services shielding buyers and sellers from price and credit risk

HOW TRADING MAKES MONEY Energy companies trade for a variety of reasons. In its most basic form, trading allows physical players to balance their system acquire product in situations where their marketing commitments exceed their production/generation capacity or to dispose of excess product when the reverse is true. The primary reason global trading markets exist is to provide an efficient mechanism for resolving supply and demand imbalances that are geographically or chronologically separated. (This is an important point, and one we will return to later.) Trading also serves as an effective mechanism for discovering and communicating a true market price. Where efficient spot markets exist (for example wholesale gasoline in the US) well-established benchmarks serve as a basis for structuring longer-term deals. Where no such spot market exists (for example LNG in Asia) the structure of longer-term deals is difficult and frequently pushes unnecessary risk onto both the buyer and the seller. Finally, trading allows energy producers to shift price risk to companies with a more aggressive risk profile.

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Although there are innumerable ways to trade (thousands of products with their own idiosyncrasies, paper vs. physical, liquid vs. illiquid markets, etc.), there are only five fundamental ways to make money in trading (Figure 1). "Rents" from a proprietary position Leverage exclusive rights or information from an asset position to extract value above free market rates Arbitrage Profits because someone is quicker or more discerning, they can find no-risk/low-risk opportunities to profit from price differentials that others cant find, or before others can find them. Pay for Service because someone bundles some service with the underlying trade, they can get paid for this service. Return for Risk because someone is willing to assume risk (because they have better information, because they have scale to self-insure, or because they are less riskaverse) that others will pay to lay off, they earn a risk premium
Arbitrage Profits Arbitrage Profits

Five Ways To Make Money In Trading


Spread From Spread From Market-Making Market-Making

Rents From A Rents From A Proprietary Position Proprietary Position

$
Return For Risk Return For Risk Pay For Service Pay For Service

Spread from Market-Making because someone is willing to make a market by willing to either buy or sell at some-one else's option (but at the prices they set), they earn the bid-ask spread as a payment for providing liquidity to the market. While a reasonable income stream can be achieved through fee-for-service products in risk management, brokering, and marketing services, the real money remains in leveraging proprietary positions and exploiting arbitrage opportunities. Of course, not all markets are trade-able. Viable markets exhibit five characteristics (See Figure 2). The ideal trading market is a highly volatile, largely liquid (but not completely liquid), structurally imbalanced market with accepted benchmark prices and product standards. In such a market (the California electricity market in the summer of 2001, to point to an extreme example) someone with good information and a tradable position has a license to print money (at least for a short while).

Characteristics Of An Attractive Trading Market


Supply / demand variability and imbalances create need for intermediary to facilitate physical product flow

Imbalances Imbalances

Benchmarks allow markets to scale easily and provide opportunities for arbitrage

Benchmarks Benchmarks Attractive Market

Volatility Volatility

Large price swings offer opportunities for trading profits from arbitrage, spread trading, market view and risk management product offerings

Standards Standards
A common description allows traders to price quality and reliability differences

Liquidity Liquidity
Availability of multiple trading options increases market efficiency and enhances odds that counter parties find a mutually negotiated range (I.e., reduced bid / ask spread)

Figure 2

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e-TRADING: BRINGING THE THREADS TOGETHER As experienced traders know, the modern trading business remains firmly rooted in practices and traditions established nearly a century ago. Even many of the global commodity markets in oil, refined products, chemicals, and other commodities look to both insiders and small players like a "membersonly club" where everyone knows everyone else and the rules of the game give big participants and long-standing members a significant "home-field" advantage. Evolution or Discontinuity? In the early days of the e-Commerce revolution, the Internet, with its open architecture and global reach, appeared to be threatening the trading club. It seemed to have the potential to destroy traditional barriers between local and global markets, create transparent pricing (shrinking bid-ask spreads, diminishing arbitrage opportunities), and level the playing field between the big guys and the local players. This potential discontinuity remains a legitimate possibility. Clearly, the fee-for service brokerage, marketing and risk management activities will increasingly come under pressure as the needs of buyers and sellers becomes more transparent and the services become more competitive. Moreover, new players especially financial services companies with risk management expertise will be attracted to the market for risk management products. The more predictable impact is evolutionary rather than revolutionary and represents a stage in a typical market development path. An exchange always exists, just in different forms, and just becomes more effective and efficient. As such, it threatens to impact the way traders made money (see Figure 3).

Sources of Trading Profit

Impacts of Market Maturity


Profits will be highly under Profits will be highly under pressure as market price pressure as market price transparency drives transparency drives traditional commodity traditional commodity margins toward marginal cost margins toward marginal cost trading trading

Extracting rents from a Extracting rents from a proprietary position proprietary position Capturing arbitrage Capturing arbitrage profits from being profits from being quicker or more quicker or more discerning discerning Capturing pay for service Capturing pay for service from bundling a service from bundling a service with an underlying trade with an underlying trade Capturing a return for Capturing a return for risk that others will pay a risk that others will pay a premium to lay off premium to lay off Capturing a spread from Capturing a spread from market making (I.e., fee market making (I.e., fee for providing market for providing market liquidity) liquidity)

Profits will shift to new Profits will shift to new products as market products as market efficiencies e-enable supply efficiencies e-enable supply chains and create new chains and create new trading and service trading and service opportunities opportunities

Figure 3

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Creating New Markets As EnronOnline demonstrated, e-Trading opens the opportunity to dramatically expand the number and range of trade-able commodities. While it is unlikely that another one-stop shop will arise to trade everything from short-haul trucking to natural gas, within the energy markets there is ample room to develop more localized, custom products. We expect a range of new benchmark products more tailored to local geographies will arise and begin to be traded. Electronic trading platforms and marketplaces will make these products accessible to a broader range of customers. The Inside Play Perhaps the most important short-term impact of the rise in e-Trading is the need to leverage the technology to enhance the trading organization's capabilities. Next generation front-office systems will enhance both the efficiency and effectiveness of the traders in order to compete effectively in more diverse and transparent markets (see Figure 4). Traditional traders, especially those that leverage big company assets to trade around proprietary information, are already seeing their markets getting tighter. Successful traders will need to become increasingly sophisticated in their market knowledge and the products they trade. Managing this complexity demands shifts in organizational structure, managing across a number of online and offline markets, and effectively leveraging information tools to manage the flood of new data that has suddenly become available.
Vision For Next Generation Front Office 1
Portfolio Update
Near real-time exposure, credit and VAR as needed on a portfolio and trader basis Intraday loss alerts Trader time spent on value add activity

$ Price Discovery

Extended trading enterprise Instantaneous capture of market and internal information Transparent forward price picture

3
Trading Strategy

Best in class trading analytics and decision tools Intelligent data sorting, sharing and alerting Instantaneous portfolio effect

4
Deal Execution

Push of a button deal execution Instantaneous sharing of deal data and confirmation with counter party

Figure 4 As traditional fee-for-service activities come under increasing margin pressure, automated "straightthrough" processing will be required to execute significantly higher transaction volumes efficiently and accurately (see Figure 5).
Vision For (Straight Through) Deal Processing
The Vision The Vision

Deal Entry

Contract Generation

Deal Actualization
Automated and real-time actualization Minimization of manual effort and differences with counter parties

Pricing / Invoicing

Cash Application & Payment

Vision

Timely, accurate and intelligent deal capture enabling clear picture of current position

Fast and flexible new product set up/market entry Instant and fully transparent sharing with counter party Minimization of manual effort and rework

Automated price calculation Minimization of rework / differences with counter parties Straight through processing and paperless invoicing Competitive processing costs

Fully automated checking / matching cash flows Awareness of Clear picture of credit status

Figure 5

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Conclusion
While much remains uncertain about how the online energy trading markets will evolve, several clear trends should inform trading companies' actions over the next few years: 1. Trading exchanges will consolidate (both off-line and online exchanges) into a few, preferred venues. 2. Electronic exchanges will expand to include more off-line commodities and futures. 3. Online trading will continue to expand access to smaller players and smaller markets putting pressure on traditional brokerage and marketing activities. 4. The increased transparency and accessibility of the market will continue to attract new entrants especially in areas of risk management. 5. Smaller players will seek one-stop solutions that include market-making, risk management, and deal processing. Returning, then, to the three questions we initially posed: Is there a real value proposition for e-Commerce and energy trading? We see clear value in leveraging web technologies to drive back-office efficiency through integrated, straight-through processing. Moreover, the increasing margin pressures on basic trading services makes this an practical imperative for most energy traders as expanded markets and increased volumes overwhelm legacy systems. Similarly, deploying low-cost, flexible front-office information management tools will be critical to enable trading organizations to compete effectively in the more fragmented and transparent markets. Will the Web technologies in trading be transformational or incremental over the next five years? While traditional brokerage, marketing and risk management services will come under increasing margin pressure the bigger threat to traditional trading companies is increased difficulty in leveraging proprietary positions and seizing arbitrage opportunities that become even more fleeting. From an overall market perspective, the e-Trading platforms will drive rapid evolutionary change rather than transformational change. For trading organizations that fail to keep up with the underlying shifts by adapting their organizational structure, trading processes, market posture and technology infrastructure the market changes represent a real threat. How can traditional trading companies profit from the change? In order to profit from these changes, traditional trading companies will leverage the efficiency gains associated with electronic trading, clearing and settlement. Additionally, innovative use of next generation front-office systems to leverage proprietary assets and to spot market trends should generate significant returns for early adopters. Finally, as Enron demonstrated, there is plenty of room for companies that seek selected areas where they can develop innovative products to serve the new customers and markets reached by online platforms.

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