As Companies Make Managing Energy Exposure

A Strategic Priority, Big Investment Banks Gain

Originally published in the May 2007 issue

A study of corporate strategies for managing energy exposure reveals that Goldman Sachs and Morgan Stanley dominate global energy trading due to the breadth and consistency of their service quality. “Goldman Sachs and Morgan Stanley’s superior product platform, service levels, and unwavering commitment to the commodities business over the years has put them at the top,” says Greenwich Associates consultant Giovanni Carriere.

Almost 40% of companies in North America, Europe and Asia identified as active users of OTC energy derivatives use Goldman Sachs as a dealer, while Morgan Stanley has achieved a market penetration of 35%, according to the results of the 2007 Greenwich Associates Energy Trading Research Study. Barclays Capital is also broadly used, ranking third in franchise size with 27% of the study’s product users citing the firm as one of their counterparties in these products. Although Goldman Sachs and Morgan Stanley are strong globally, the picture does change on a regional basis.

In Europe, Barclays Capital is essentially tied with Goldman Sachs for the lead in market penetration, with both firms cited as a dealer by approximately 40% of European OTC energy derivatives users. Morgan Stanley and Société Générale represent a close second tier in the European market, with market penetration levels of roughly 30% of product users.

“By contrast, Morgan Stanley and Goldman Sachs have attained a dominant position in the United States, where they have achieved market penetration levels of 47% and 45%, respectively,” explains Greenwich Associates consultant Frank Feenstra. “Filling out the remaining top slots in the United States are BP and Banc of America, both with market penetration levels of roughly 25%”

On the other hand, Morgan Stanley has clearly the largest franchise in Asia, dealing with 52% of the OTC energy derivatives users interviewed. Barclays Capital ranks second with 37%, while Goldman Sachs trades with one third of the accounts in Asia – a relatively lower penetration compared with other regions. In the business of executing customers’ orders in listed derivatives, Goldman Sachs is again the clear leader. Among firms offering risk management capabilities, BNP Paribas has gained top status in exchange-traded commodity derivatives, and deals with almost one in five among the companies using these instruments – trailing second-ranked Morgan Stanley by a modest margin.

Managing Energy Exposures: Corporate Strategies

Of the 287 companies interviewed by Greenwich Associates, 58% say they currently have exposure to natural gas, 48% to electricity, 47% to refined oil and 43% to crude oil.

On average, the companies participating in the research hedge 48% of their physical sales or purchases of energy. European participants hedge the highest proportion of their physical sales at 63%, followed by companies in the United States at 50%. “Companies broadly categorized as energy ‘consumers’ hedge an average 55% of their exposure, while ‘producers’ hedge about 40% – hardly an unexpected difference in light of increasing energy pricing,” notes Greenwich Associates consultant Woody Canaday.

While corporates as a whole expect the proportion of their total energy exposure hedged to remain unchanged over the next 12 months, the data reveals significant variation in hedging strategies on a case-by-case basis. When asked how they plan to change their hedging practices in coming months, 22% of participants say they expect to increase the proportion of total energy exposure hedged, while 12% plan to decrease it.

“These results suggest that significant numbers of companies expect to hedge more actively, while a smaller cohort plans to reduce the proportion of hedged exposures by a considerable amount,” says Greenwich Associates consultant Peter D’Amario. Canadian energy users expect the share of their physical exposure that they hedge to decline from the current 36% to just 30% in the next year, while companies in Europe and Asia expect to see a modest increase. Looking ahead to the next 12 months, almost 20% of Canadian participants expect to hedge less.

As one would expect, companies in the more developed and deregulated markets of Europe and the United States appear to be the most active in OTC derivatives, with more than 60% of participants in both regions naming at least one dealer with whom they have a very active relationship. Globally, the typical energy user active in OTC derivatives makes 350 trades each year but there are meaningful differences by region. “Even though the proportion of companies trading OTC derivatives is equal in Europe and the United States at 60%, U.S. companies are much more active in terms of the frequency of their trades,” says Greenwich Associates consultant Tim Sangston. “As one would expect, even wider discrepancies are found between the trading activity of the largest and smallest commodities users.”

Corporates use an average of 5.3 dealers for energy trading, including 3.8 for OTC derivatives, 2.4 for exchangetraded derivatives and 3.2 for physical trading (These averages exclude purely physical providers). Companies in the United States maintain the largest number of dealer relationships overall at an average of 6.3, followed by Europe (5.5), Asia (5.2) and Canada (3.6).

Given the small number of dealers used, it is not a surprise that customers tend to concentrate a high proportion of their energy trading with their most important providers. On average, they allocate roughly 80% of their OTC derivatives business to their top three dealers, with their lead dealers capturing 44%, second dealers winning 21% and third dealers receiving 15%.

Organizational Structure and Policies

Energy hedging, trading and overall exposure management is generally a function of corporate finance or treasury departments. Nearly half of the participants in the Greenwich Associates study work in finance, and roughly 20% in purchasing, while 11% are part of the marketing department. There are significant variations from region to region in terms of where energy trading is housed within a corporation. Almost 70% of Asian energy traders are housed in finance, while in the United States, less than 30% work in finance.

“Our conversations with companies around the world suggest that there is a general trend in which they are shifting commodity exposure management away from traditional purchasing departments as boards become more aware of exposures and risks,” says Frank Feenstra.”In many companies and in many regions, these responsibilities are being shifted to the treasury function. At the same time, a growing number of companies are moving these responsibilities to dedicated risk management functions and employing specialists for commodities hedging.”

Indicative of the sophisticated and specialized skills needed to be active in the commodities derivative markets, more than two-thirds of study participants are energy “product specialists.” Companies in Canada and the United States are the most likely to employ such specialists, whether these individuals are housed in the treasury function or elsewhere. When asked “What other financial products do you personally trade?” 87% of Canadian respondents and 68% of U.S. respondents replied “none.” Between 40% and 50% of respondents from Europe and Asia say they personally trade additional products, with FX and interest-rate derivatives the most common responses.

More than half of corporates say energy transactions with strategic implications for the business need to be approved by the CFO, the CEO or the board of directors. Giovanni Carriere concludes: “Basically, almost one in five of the participating companies say such trades must be approved by the CFO, nearly as high a proportion say such deals must be approved by the CEO and almost 15% of companies say strategic transactions must get approval from the board of directors.”