UtiliPoint IssueAlert
Patrick Reames

Energy Trading and Risk Management (ETRM) software providers have been enjoying considerable success over the last several years. With a market buoyed by higher commodity prices, high levels of volatility, new regulation and reporting requirements, and new market entrants, software vendors have been making some serious hay. These companies have been seeing new records for unit sales and revenues and have struggled to keep up with demand. However, at UtiliPoint, we’ve been projecting that the rapid market expansion, while not necessarily ending, would be slackening as there is only so much growth that’s sustainable over the long term in a market of this type. In our recently released 2008 North American ETRM Market Analysis and Sizing Report, we’ve forecast that slowing, projecting market growth this year to be substantially down from the double digit growth rates of 2006 and 2007. Our forecast has been based upon a number of dampening forces which started emerging in energy commodity markets in the first quarter and have reached a crescendo within the last week. These forces are now hammering many in the energy commodity markets and have started, and will continue, to impact sales of software products servicing those markets.

The Financial Services Crisis is Being Felt in the Physical Energy Markets

The dollar magnitude of the transactions in the energy commodity markets demand that players have ready access to credit, and by extension, a solid balance sheet. Credit is the oxygen that keeps this market alive. Consider a common sized transaction for natural gas: 10,000mmbtu/day for a month. At current market prices, that transaction is worth around $2.25 million. Small trading shops may be buying and selling up to a half of a BCF of gas per day, meaning their exposures will be north of $100million prior to the end of the month settlements. Mid-sized traders, those up to 1 BCF/day, will have exposures measured in the hundreds of millions of dollars, with the largest companies, those trading several BCF/day, having multiples of that. This is not a “cash on the barrelhead” business. These trading companies rely on ready access to quality credit reserves to provide assurance to their trading partners that they can meet their obligations despite any negative market developments. If market players start to doubt the credit worthiness of one of their trading partners, they will stop selling to that company in order to reduce their exposures, leaving that suspect company dead in the water and unable to meet their obligations to the companies they’ve sold product to.

Last week saw the crash of Constellation Energy for this very reason. Despite the fact that Constellation’s energy trading group was successful, generating up to 80% of the parent’s revenues, the markets were increasing uncomfortable with the quality of the firm’s credit due to the failure of Lehman Bros. (who held a less than 6% stake in the company) and the suspect nature of a few banks who were proving relatively modest credit lines to the company. As a result of credit downgrades associated with Lehman’s demise and the questionable credit lines, many of Constellation’s trading partners started to pull back and the company’s stock plunged 45% in a single day. Ultimately Constellation was salvaged via a fire sale to MidAmerican Energy at $26.50/share, less than half its price just 10 days ago.

When Enron collapsed over the period of a few days in Oct. 2000, most companies couldn’t react in time to shield themselves from losses - they had already sold significant volumes to Enron based on credit ratings that were ill-informed and ultimately far too optimistic. These companies, unable to recoup their losses, took significant bad debt write-offs, contributing to the demise of many them. It was only after banking and financial services firms stepped up and into the market did any semblance of confidence return. Not only did these financials enter the markets directly through acquisition of existing trading companies or expansion of their own subsidiary commodity trading groups, they also extended and backed credit lines for other players. The recovery of the energy markets, catalyzed by the entrance of the financial companies, brought the ETRM solutions market out of the doldrums and fueled significant market growth for a number of the larger vendors.

With the market taking several years to emerge from the damage caused by Enron, credit managers have, for good reason, increased their diligence, and in some cases have become hypersensitive when it comes to counter party credit exposures. However, until recently, if a counterparty had one or more solid lines of credit from one of the major banks or financial services companies, credit managers were pretty comfortable with the source and were more willing to extend credit. The source of the credit helped assure them that the transactions were adequately backstopped in case something bad happened.
However, the sub-prime lending crisis has changed all that. With 3 of the 5 largest financial services companies imploding and with major banks, like IndyMac, going under, there are few if any golden backstops these days. Credit managers are seeing the quality of their counterparties’ credit being impacted as firms such as Bear Sterns, Lehman Brothers and Merrill Lynch have either gone under or have had to be rescued by larger entities.

Even for those energy trading companies that have been able to maintain sold credit, those credit lines are being exhausted more quickly as commodity prices have taken off. Simply put - a doubling of the price of a commodity will double the credit exposure for a same sized transaction. Credit has become a limiting factor for growth for many companies as commodity prices have continued their steady rise over the last 24 months.

With credit being impacted by the ongoing financial market crisis and higher commodity prices, the oxygen is clearly being sucked out of this market and ETRM system providers are starting to feel the impact.

Budgets have Absorbed Higher Prices

Producers have always been a steady market for ETRM vendors, making up 10 to 20 percent or more of the system sales in any given year. With the run-up in commodity prices, many energy producers generated profits beyond their budgetary projections. This unexpected influx of cash enabled many to upgrade their systems earlier than they may have otherwise; improving their transaction management capabilities at a time they needed it the most.

Unfortunately, this accelerated replacement cycle in the producer space will create some hangovers for vendors. As UtiliPoint’s research shows that the normal replacement cycle for these systems averages 5 to 6 years, pulling many of these future deals forward will take some license sales opportunities out of the market for the next couple of years. For many of the energy companies that had stayed with their legacy systems through the period of rapidly escalating prices, the recent slump in commodity prices has them rethinking near-term system purchase plans. With budgets developed last year during the upswing in the market, the recent sell-offs in commodities are forcing a number of companies to re-examine and potentially delay planned expenditures for IT infrastructure.

Some Positives

Despite many troubling developments in the market, there are some positive trends that should provide opportunity for ETRM system providers.

With crude having traded close to $150/bbl recently and still hovering around $100/bbl, industrial scale consumers of crude-based products continue to adopt aggressive price hedging strategies. UtiliPoint is anticipating that these industrial-scale consumers, including transportation companies, railroads, and airlines, will continue to seek out ETRM system capabilities to better manage their energy purchases and hedging strategies.

We also expect to see continued growth in the market for systems servicing non-energy buyers, such as agricultural product producers and traders. This market has been emerging for the last 18 months and should continue to drive new sales for the vendors that have capabilities in the space.

An additional bright spot in the market is the widening acceptance of ASP or “Software as a Service” (SaaS) solutions. These solutions, delivered over the web, have been selling well in the last couple of year as they enable smaller market participants, such as municipals, to acquire ETRM capabilities at a lower price and with less implementation effort. Given their appeal to the lower tiers of the market (a segment likely to be lest affected by the credit crisis), we believe the ASP/SaaS software vendors will continue to see success and enjoy good market growth.

Some Vendors More Impacted than Others

2006 and 2007 saw solid growth for most of the solutions providers - the rising tide lifting all boats. 2008 and 2009 don’t appear to offer the same widespread opportunities - there will be winners, but there will be more losers than in past years. Vendors that have been successful in the industrial, fuels, and non-energy markets (such as Solarc, Triple Point and Allegro) should continue to see success. Additionally, companies like OATI, OilSpace and others that can service the ASP/SaaS markets will also continue to sell products. Still, there is little doubt that all vendors will feel the impact of the turmoil in the markets, although some much more than others.