Compared with the torrent of scandal-related press releases issued by energy merchants this year, Aquila Inc.'s May 31 announcement was utterly benign. Boring, even. And yet it spoke volumes about the new attitude of energy traders. The company reported that 70% of 2002 and 75% of 2003 operating earnings will come from the more traditional side of its business mix. "More recently we've become known for our trading expertise in the merchant energy sector," it quoted Robert K. Green, Aquila president and chief executive officer, "but our roots run deep in the regulated utility networks business, where this company has 85 years of experience." It wasn't all that long ago when touting the "more traditional side" of an energy merchant's portfolio would have seemed terribly passe. Innovation was the buzzword; the industry was charged with dot-com-like excitement. Gleaming new trading floors became the main attraction at corporate headquarters. Now it couldn't be more different. Fixed assets are all the rage; easy-to-understand balance sheets are a must. Energy trading personnel are being forced to look for other jobs. General business magazines such as Fortune are running headlines such as "Is Energy Trading a Big Scam?" No, energy marketing and trading is not a big scam, industry observers say. It is still necessary to get energy from A to B. In last month's Oil and Gas Investor, a strong advocate of energy market reform-the Coalition for Energy Market Integrity and Transparency-acknowledged that energy merchants are necessary to move energy from producer to consumer. "There is always going to be a role for legitimate aggregators of supply," said Obie O'Brien, Houston-based director of government and regulatory affairs for 1Apache Corp. , one of the coalition's organizers. Yet, while the industry may support the role of the energy merchant in a general sense, there's a major image problem when it comes to the specifics of the business. The Federal Energy Regulatory Commission (FERC) is investigating whether "round-trip" trades have been used to illegitimately boost companies' trading volumes, and whether traders were involved in schemes to manipulate California's energy markets. Changing strategies Amidst all of this controversy comes the transformation of the energy merchants themselves. Dynegy Inc. and CMS Energy Corp.¸ accepted the recent resignations of their chief executives. Some companies are cutting their trading staffs, and virtually all are working to support their trading desks with core assets and a strong financial profile. Balance sheet reforms and equity offerings are becoming de rigueur. "It remains early in this process," says Gordon Howald of Credit Lyonnais Securities (USA) Inc. "What appears to be clear, however, is that focusing on marketing and trading activities is becoming less important, and asset ownership, and trading around these assets, is becoming more of a priority. "The industry, it appears, is reverting to what it used to look like several years ago, except those companies that want to maintain an active marketing and trading presence must have a better-capitalized balance sheet than ever before. This is a requirement of the new energy environment." For example, El Paso Corp. is halving its energy trading staff and focusing on other areas of the natural gas business. By limiting its investment in trading and that business' demand on corporate credit and liquidity, the plan is to allow El Paso to use its strengthened balance sheet and credit profile to take advantage of growth opportunities in natural gas, the company reports. It will concentrate on developing its portfolio of U.S. gas reserves, expanding its liquefied natural gas (LNG) business and building its gas pipeline franchise. Shortly after El Paso's announcement, The Williams Cos. countered by reaffirming the place of marketing and trading activities in its organization. "The market, the media and the world need to know that it is entirely possible to run an honest, profitable energy marketing and risk management business, using a dose of prudence and legitimate accounting procedures," said Steve Malcolm, Williams president, chairman and chief executive officer. Howald says 2002 is a transition year for energy merchants, so investors need to consider 2003 earnings and cash flow when valuing the group. However, accurately predicting next year's financials will be tricky. For some companies issuing equity, the price of these potential stock sales remains uncertain. And even if they can issue enough equity at current prices to have the necessary impact on their balance sheets, how much of that can be absorbed by the industry? There could be more than $10 billion of stock sales in gas and power during 2002, he says, and companies "first in line with this new round of equity will have an advantage over the rest." Williams expects to issue $1- to $1.5 billion in common equity during the next 12 months. Malcolm says issuing common equity is not Williams' first choice, but that it is "absolutely essential" to build a stronger capital base to underpin its business. Companies proposing asset sales to reduce debt and maintain investment-grade status have the right idea, but it will come at a price, according to Howald. "Selling assets, even if the proceeds are used to reduce debt, will likely dilute per share earnings and cash flows," Howald wrote. "In addition, selling assets could make it more difficult to grow earnings going forward, again affecting valuation." Jeffrey Harris, senior managing director of Warburg Pincus, says energy-marketing companies still could be considered good investments for private equity funds, despite the unease that has developed around questionable trading practices by some firms. However, the assets that have been put up for sale by distressed companies have not represented the best deals for investors, he adds. "They don't tend to try and sell the good stuff first. There have been very few transactions done, in part because seller expectations are still above buyer interest levels." Winning back investors Moody's Investors Service has called for a "fundamental restructuring" of the energy merchant business to regain investor confidence. Energy trading, as it is now, "may lack investment-grade characteristics unless it is ancillary to a more stable core business that generates strong sustainable cash flow," the agency reports. It suggests the following options for restructuring the industry: • Sector consolidation that would lead to fewer, well-capitalized participants with diverse asset bases and strong liquidity profiles. This could include the participation of financial institutions with solid credit ratings. For example, UBS Warburg is an owner now of Enron's trading business. •The establishment of a clearing system or trading exchange that would provide liquidity, transparency and a more efficient transfer of credit risk. Clearinghouses work best for standardized contracts, so there likely will remain a demand for customized contracts as well. • The creation of bankruptcy-remote or externally supported derivative product companies that would be rated independently of the sponsor. Similar companies were established during the last decade following the downgrades of many financial institutions. The typical energy merchant business model combines a Baa-caliber energy producer and distributor with a volatile trading operation, and even a modest credit rating downgrade can trigger a significant call on cash, Moody's notes. On top of that, the lack of regulatory oversight and opaque accounting can strain counterparty confidence. "In Moody's view, energy merchants all too often lack the level of market risk management, liquidity management and internal controls characterized by the most sophisticated traders in the securities market." Recently the chief risk officers of American Electric Power, Constellation Energy Group, Duke Energy, Mirant, Tractebel North America Inc.; and TXU banded together to study how best to improve industry risk management practices. Their "Committee of CROs" is open to all companies participating in energy trading and marketing activities. "Due to recent market events and the increased scrutiny being placed on companies involved in energy trading and marketing, it is important for those of us actively involved in the industry to take constructive steps to define risk management practices and communicate these standards to our stakeholders," says Mayo A. Shattuck III, president and CEO of Constellation Energy. The committee plans to develop proposals for standardization in risk management metrics, credit practices and disclosure. In addition, it intends to work toward generic guidelines for risk policies and procedures. "Through the committee, it is possible to create new netting agreements and clearing platforms that can reduce our industry's collateral requirements by as much as 90%," says Marce Fuller, Mirant president and CEO. Re-regulation? One of the risks increasingly mentioned in this business is that the government will perform an about-face on deregulation. Howald believes it is very unlikely, however, that the wholesale markets for power and natural gas will move back to full regulation. "The move to free markets in this economy remains strong-and we believe appropriately so," says Howald. However, some increased regulation, such as expanded regional price controls or other oversight, is quite possible, he adds. Peter Rodgers, head of energy and commodities at Washington-based law firm Sutherland Asbill & Brennan, says it will be difficult to predict the direction power markets will take, until the nation has a better idea of what went wrong in California. "We're in the middle of an examination of what went wrong," Rodgers says. "I think until you step back and FERC completes its study of what happened in California, and makes a broader examination of what worked and didn't work in the power markets, it will be very difficult for anyone to design a set of controls, a set of rules that will enable us to essentially move back into a competitively functioning market." Energy marketers perform an important economic function, and they will have a role to play in creating a price-efficient market for energy, he says. "The arbitrage that is really at the heart of what these companies do is important ultimately to the delivery of the least-cost energy supplies that are available. Who will be the survivors-what type of company is best situated to play that role-I think could change. My guess is that the premium on having a very, very substantial balance sheet will be a very important part of that."