UNIVERSITY OF TEXAS ROUNDTABLE ON ENERGY DERIVATIVES AND THE TRANSFORMATION OF THE U.S. CORPORATE ENERGY SECTOR

• DOI: http://doi.org/10.1111/j.1745-6622.2001.tb00426.x
• Published date: 01 January 2001
• Date: 01 January 2001

JOURNAL OF APPLIED CORPORATE FINANCE

5050

BANK OF AMERICA JOURNAL OF APPLIED CORPORATE FINANCE

UNIVERSITY OF TEXAS ROUNDTABLE ON NOVEMBER 29, 1999

ENERGY DERIVATIVES AND

THE TRANSFORMATION OF

THE U.S. CORPORATE ENERGY SECTOR

SHERIDAN TITMAN: Good afternoon

and, on behalf of the University of

Texas Center for Energy Finance

Research and Education, I want to

welcome you all to this discussion. My

name is Sheridan Titman. I am director

of the center, as well as a professor of

finance at the University, and I will be

serving as moderator. The topic of this

discussion is the deregulation of en-

ergy markets and the emergence of

energy derivatives, and how these

two developments have affected both

the way companies do business with

each other, and how the companies

themselves are organized internally.

The discussion will fall into two

parts. The first will explore how de-

rivatives and corporate risk manage-

ment have produced a new business

model for a number of once tradi-

tional energy companies. In addition

to its ability to change corporate strat-

egy, we will also consider how the

hedging of price risks can affect a

company’s financing strategy and cost

of capital. In the second part, we will

discuss the implications of risk man-

agement for corporate structure and

performance evaluation and compen-

sation systems.

Along with changes in business

models and organizational structure,

the energy business has also seen

some interesting changes in person-

nel. For example, most large oil com-

panies have traditionally been run by

people who started out as engineers

and then moved into management. In

more recent years, however, we have

seen a group of bankers and even

economists—essentially financial

people—taking leadership roles in

the energy business. As evidence for

this assertion, we have assembled for

this roundtable today a group of

mainly ex-bankers whose careers have

taken them into the energy business.

And let me just briefly tell you who

they are.

GENE HUMPHREY is Chairman and

CEO of Enron Investment Partners,

a subsidiary of Enron Corp. Once a

traditional natural gas pipeline com-

pany, Enron today provides a vari-

ety of risk management and financial

products for energy companies, elec-

tric utilities, and any kind of company

interested in using energy deriva-

tives. A former banker at Citicorp,

Gene was one of the people respon-

sible for Enron’s getting into the

financial service of business in the

early ’90s, and he is one of the real

pioneers in developing corporate

applications for energy derivatives.

RON ERD is Vice President in charge

of the structured products group at

Southern Company Energy Market-

ing, a unit of Southern Energy Inc. *

Like Enron, Southern Energy basi-

cally acts as a bank for many of the

E&P companies, as well as providing

risk management services for all kinds

of industrial companies. Ron has a

background in the banking business

at Chase, and also worked as a market

maker at the Chicago Board of Trade

until he joined Southern Energy two

years ago.

JOHN MCCORMACK is a Senior Vice

President of Stern Stewart in charge of

the firm’s energy and real options

practice. Stern Stewart is the company

best known for developing and popu-

larizing a measure of corporate per-

formance known as EVA, which is

short for Economic Value Added, and

John recently developed a new mea-

sure of EVA that is customized for

E&P companies. John started his ca-

reer trading oil and gas derivatives for

the Union Bank of Switzerland.

JEFF SANDEFER, who is not here

now but will be joining us for the

second part of this discussion, is Presi-

dent of Sandefer Capital, which has

$700 million under management and

invests mainly in energy companies.

Jeff is an entrepreneur with very im-

pressive credentials in the energy

business, and I will tell you a little more

about him when we start part two.

So our topic again is energy de-

rivatives and deregulation, and how

they are affecting business. John,

you are the consultant of the group,

and since consultants are supposed

to be very good at framing the is-

sues, why don’t you set the stage by

telling us what’s been happening in

the energy derivatives markets in

recent years, and why we should

care about it?

*Southern Energy, Inc. became Mirant Corporation on January 19, 2001, in preparation for its spin-off from its parent, Southern Company, on April 2, 2001.

Southern Company Energy Marketing is now called Mirant Americas Energy Marketing. Mirant is a global independent power producer with operations in 13

countries. Ron Erd is currently Vice President and Chief Commercial Officer of Mirant Americas-Northeast Region.

AUSTIN, TEXAS

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VOLUME 13 NUMBER 4 WINTER 2001

First of all, these markets are not

simply vehicles for investors to take

a punt on energy commodities. As I

think we will demonstrate in this

discussion, energy derivatives can

be used to provide not only energy

producers, but any company for

which energy is a major input, with

a means of fundamentally transform-

ing their entire business. In this sense,

the corporate uses of energy deriva-

tives can be described as “strategic.”

Energy derivatives are interesting

for a second reason. There seems to

have been a tremendous evolution

in the main players. In the 1980s, the

most sophisticated users of energy

derivatives were investment banks

like Morgan Stanley, J. Aron, the

commodities arm of Goldman Sachs,

along with specialist trading firms

such as Phibro. But by the 1990s,

that had changed very significantly.

Although a lot of listed trading still

takes place in New York, the main

trading arena has shifted to cities like

Houston and even Atlanta. The trad-

ing has shifted to accommodate the

industrial, as opposed to the purely

financial, players in these markets.

And some industrial players have

clearly become much more adept at

using these markets than others.

Notable among this group are com-

panies that, like Enron, might best be

characterized as midstream gas and

power companies. Such companies

have used energy derivatives to

transform themselves into “whole-

salers” of natural gas and power that

transmit these commodities over

great distances. Somewhat surpris-

ingly, however, the major integrated

oil companies have not become play-

ers at all. They have shown little

interest in using derivatives to man-

age their energy price risks and, in

my experience, little awareness of

the potential benefits from hedging

at least part of their price exposures.

And since I think we will be coming

back to this issue later, let me stop

here and turn the floor back to

Sheridan.

The Case of Enron

TITMAN: Thanks, John, for that brief

overview. Now let’s hear from Gene

Humphrey and Ron Erd, the people

whose firms are actually helping

industrial companies to use deriva-

tives. What do both of you see as the

primary economic drivers of new

developments in oil and gas markets

over the past two decades, and par-

ticularly in the last five years? And

how has the changing economic

landscape affected the comparative

advantage of different players in the

business? Why are some companies

using derivatives much more than

others—and why are some very

large companies not responding to

these opportunities at all? And since

Enron has been the real pioneer in

these developments, why don’t we

start with Gene Humphrey?

HUMPHREY: Just to give you some

historical background, Enron was a

sleepy natural gas pipeline company

that was formed, in the mid-1980s,

by the merger of two even sleepier

pipeline companies, Houston Natu-

ral Gas and Northern Natural. Shortly

after the merger, the company was

the target of a hostile takeover at-

tempt by Irwin Jacobs. To fend off

the takeover, the company did a

leveraged ESOP, taking on a tremen-

dous amount of debt. Compound-

ing the problem of its weak balance

sheet, Enron’s asset base—consist-

ing mainly of natural gas pipelines

that ran primarily up into the Mid-

west—was considerably less profit-

able than the pipelines of companies

like Transco and Tenneco, which

were serving a much more lucrative

marketplace in the Northeast. So,

with a balance sheet and asset base

that was now considerably weaker

PART I: RISK MANAGEMENT,

CORPORATE STRATEGY, AND

THE COST OF CAPITAL

JOHN McCORMACK: Thanks, Sheri-

dan. I’d like to just provide a bit of

historical context for energy deriva-

tives. They have existed in some

form for quite a long time. Oil futures

were actually traded in the 1800s.

But, in the 20th century they had

pretty much disappeared from the

financial map until 1978, when the

NYMEX introduced a futures con-

tract on heating oil. This was an

opportune time for launching such

a product because the prices of

crude oil and petroleum products

were about to take another huge

jump after their sharp rise in 1973.

NYMEX-traded oil futures were fol-

lowed by exchange-traded futures

on gasoline in 1981, and futures on

crude oil were launched in 1983.

Options contracts on all of these

futures started around 1986.

The second half of the ’80s turned

out to be a period of fairly stable if

not actually declining energy prices,

and the growth in oil and gas deriva-

tives slowed. But starting about 1990,

with the spike in oil prices in re-

sponse to the Gulf War, energy

derivatives got an enormous second

wind with the introduction of natu-

ral gas contracts on the NYMEX.

Futures and options on electricity

were started in 1996.

How big are these markets today?

It is impossible to know the current

volume of trading in energy deriva-

tives because, for all the size of the

NYMEX and IPE trading, the over-

the-counter volumes are much larger.

So, without attempting a precise es-

timate of their size, I can tell you with

some confidence that these markets

are enormous. And the develop-

ment and phenomenal growth of

these markets is interesting in sev-

eral respects: