Information Technology Insights: Online Trading of Chemicals In the Post-Enron Environment
27 May 2002 00:00 [Source: ICB Americas]
The chemicals trading environment has seen considerable change,
marked by the
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acquisition of ChemMatch by ChemConnect Inc., which was completed
earlier this year, and the well documented demise of Enron Corp.
Although most say the exit of Enron has not had a direct impact on
chemicals trading, it has brought to the fore the issue of online
chemicals trading and its companion, risk management vehicles.
"Enron made a lot of noise, but in reality it didn't do much in the
chemicals arena," says Leif Eriksen, research director at AMR
Research, a Boston-based consulting firm. "Primarily a trader of
, Enron had barely gotten started in
chemical commodities. Besides, ChemConnect and CheMatch
(pre-merger) had already beaten them to the space," he says.
Enron did have a psychological impact in jump-starting the concept,
he concedes, because, as a market maker, "they were willing in
principle to take positions in derivatives, something the neutral
marketplaces and trading platforms" have avoided.
Initially, in the aftermath of Enron's demise, companies were
"nervous about exposure to a so-called 'Enron situation,'" says Pat
McSpadden, ChemConnect's derivatives manager, "but the focus soon
shifted to finding new outlets to restore the lost liquidity that
Enron had provided. We've seen strong growth in our chemical
commodity exchange's over-the-counter (OTC) market in recent
months," he says. "Our increase in transactions is, in part, a
direct consequence of helping to fill the void left by
However, the cautionary side of the Enron tale casts a shadow in
many other directions. Aside from accounting issues, risk
management strategies, in particular, have come under greater
scrutiny and finer tuning.
"In the wake of Enron," says Javier Vega, president of CapTrades,
"there's been significant pressure to go above and beyond the call
of duty in terms of insuring a fair and equal playing field for
transactions of standardized products." CapTrades, a joint venture
between Reliant Energy and EnForm Technology, was formed to conduct
online auctions to facilitate the trading, scheduling and transfer
of electrical-generating capacity option products among generators,
energy traders and retail electric service providers in Texas.
"Because the rules that attach to these products are so
complex-when to ramp power plants up or down, at what pace, how
long to schedule operating and downtime cycles-if there were not a
suitable management system as to how these products are to be
dispatched, one could easily imagine some games being played. It
cost a lot of money to build the system to operate in a completely
aboveboard fashion," he says. "I guess the word de jour is to make
the system eminently 'auditable.'"
Essentially, risk management for chemicals trading has revolved
around price hedging at least for sellers and buyers. For market
makers, the process also inherently involves speculation. While
hedging type tools might very well represent the wave of the future
for the online trading of chemicals, it must be noted that at this
moment in time their development and use are still undoubtedly very
much in their infancy, and, in themselves, do precious little to
mitigate volatility. Best-of-breed forums in which new hedging
tools (paper trades offsetting physical quantities) might take root
include forward auctions (seller offers to highest bidder at a
specified deadline-used for price discovery on new products, profit
margin enhancement or inventory liquidation); reverse auctions
(initiated by a purchaser to get low prices); bid/ask exchanges
(reflecting seller's strategies relative to price, quantity and
configuration); dynamic pricing and forecasting models that
effortlessly tie into trading platforms; platform models that
convert forwards into orders; and real-time risk management systems
(that use analytics to assess and reduce risks such as asset
under-utilization, supply chain defaults or market
Last year, CheMatch (now part of ChemConnect) launched some
regulated futures contracts for benzene and mixed xylenes on the
Chicago Mercantile Exchange. "[I'm] not sure the market was quite
ready for the sophistication of chemicals futures," says Mr.
McSpadden. "Those contracts haven't yet developed much liquidity,"
he says, "but, with greater familiarity, we're confident that the
chemical industry will warm up to the use of the regulated futures
A key advantage of a regulated futures contract compared to an OTC
execution is its anonymity. "Your counterparty is the exchange,"
notes Mr. McSpadden, "not a fellow player in the chemical industry.
You can trade as many contracts as you like. Your position is never
That is typically the way the crude oil
market works through the
New York Mercantile Exchange for crude oil and gasoline or trading
for liquefied natural gas. "Hedgers use these products. The
transactions are highly liquid, completely anonymous, and traders
are able to move in and out of positions with great facility," he
says. "On the other hand, an OTC transaction is bilateral,
conducted between two parties who know each other's identity, who
are compelled to set up a credit relationship with guarantees and
the like," says Mr. McSpadden.
To broaden its offerings in the chemicals supply chain, ChemConnect
acquired the natural gas liquids (NGL) trading platform of Altra
Energy Technologies Inc. in March. "Natural gas liquids are basic
building blocks in our industry. As with other commodities, their
cost and availability impact the entire supply chain," says John
Robinson, CEO of ChemConnect. "By consolidating online NGL trading
on ChemConnect, we are providing buyers and sellers of chemicals
and plastics as well as pure-play NGL traders, access to expanded
trading opportunities in both NGLs and complementary
Koch Industries, Louis Dreyfus Plastics and Shell Chemicals offer
an array of financial derivatives to chemical producers in
commodities such as benzene, polyethylene
liquidity for most specialty chemical products is not likely to be
there unless the producers that are the interested parties handle
the forward and option contracts in their own private e-markets to
create tradable, standardized commodity option products.
Some say the advantages of using an independent marketplace can not
be overlooked. "We have a full service auction offering," says Eli
Ben-Shoshan, vice president, auctions at ChemConnect, "which helps
and trains the client in structuring and executing the auction,
gets feedback from participants, and serves as an independent party
or honest broker in monitoring the fairness of the event." Also,
"we can help broaden the list of potential buyers," says Mr.
Ben-Shoshan, "and bring them efficiently together electronically."
As a second option, the customer can also run its own self-service
auction using ChemConnect's software and servers.
Whether the forum is a public exchange or even ultimately a private
exchange, a key question is how risk management will eventually
take root in the chemical industry.
"There are two schools of thought in the industry on the subject of
risk management," says AMR's Mr. Eriksen. "The battle is raging
between those who believe risk management tools are a necessary
part of creating a more certain and steady revenue stream and more
dependable and regular operating margins and those who argue that
risk management is a waste of time and money, adding unwanted
complexity, and ensnaring a chemical company in activities they
shouldn't be involved in," he says.
"I personally think we will see more trading and risk management in
chemicals, but it's not going to happen overnight," says Mr.
Eriksen. "The opportunities lie in some of the more widely traded
commodity chemicals where the liquidity is potentially there. It
boils down to risk management at what price-the old chicken-egg
quandary: premiums too pricey if the market is illiquid; and if the
action lacks liquidity and is too pricey, people stay away."
That function of being liquidity's provider of last resort was the
perceived value of Enron, according to Mr. Eriksen: "Early on, in
an immature market phase, someone needed to step up and take some
big positions, take an aggressive view toward the market. Enron had
(pre-implosion) the liquidity to do just that. Otherwise a
fledgling market doesn't even get off the ground."
The ChemConnect-CheMatch merger is looked on favorably by most
industry observers. "There was no guarantee the parties would have
made it on their own or how long it would have taken them," says
Mr. Eriksen. "The good news is," he continues, "they didn't wait
until the last minute. The timely consolidation allows them to cut
costs, conserve a relatively healthy bankroll, expand and
consolidate reach (critical for commodity trading), and avoid
falling into 'burn rate' oblivion."
Again, the difficulty with establishing a chemicals commodities
exchange, according to market observers, is the lack of a
standardized product and the necessary liquidity. Certainly, the
potential is there from the petrochemical supply chain. "It's going
to take some time as it stands right now," says Mr. Eriksen, "but I
think it will happen. There's no question about it. It provides a
mechanism to better manage revenues, where growth is not so
susceptible to cyclical swings. Eventually you get swung anyway
because at the very beginning of all these supply chains is either
crude oil or natural gas, two preeminent commodities," says Mr.
Eriksen. "As everyone knows, the last two years, the chemical
industry was hit with a double whammy. First, the run-up in energy
prices when the economy was strong; then, the demand softness, when
the economy crashed."
Chemical companies have always labored under the cyclical tag that
carries with it the curse of a low price/earnings (P/E) multiple
valuation, according to Dave Moshal, @TheMoment's co-founder and
chief technology officer. @TheMoment is a purveyor of Web-based
real-time commerce applications to the chemicals/petrochemicals,
energy and high-tech industries, including to companies such as
Reliant Energy/ CapTrades and CheMatch/Chem-Connect. "The risks
being addressed and hopefully mitigated by the capabilities of our
technology and refined strategies are the usual suspects-demand
forecasting vicissitudes, oversupply burdens, excess capacity and
price and earnings volatility," he says.
His firm's guiding assumption, collaborated by research findings of
the Boston Consulting Group (BCG), is that cyclical earnings
volatility is the primary culprit for the group's P/E multiple
selling at a discount to the market's. Even during peak years, the
industry is still shackled with a low multiple image since Wall
Street is wise to its cyclical history and nature. Logic dictates
that the only way out of the dilemma and to improve to a better
market multiple is to reduce the volatility if possible.
"Bingo," says Mr. Moshal, who believes that "locking in fixed
pricing for certain product sales, present and future; procuring
and producing on order, based on a better gauge of real demand;
selling derivatives (call options) on output in hand, all these
measures ensure greater revenue predictability."
The private online "e-markets" built and managed by the chemical
companies themselves with a dynamic in-house trading capability are
developing and will emerge as a dominant channel, observes Mr.
Moshal. GE, Dow Chemical, DuPont and Eastman Chemical are cited as
key chemical producers that are already making substantial headway
with their own private transactional marketplaces. While the
higher-liquidity public online chemical e-markets such as
ChemConnect celebrate broad reach, neutrality and price
transparency as ideal qualities for the shorter-term spot trading
of bulk commodity chemicals (currently 10 to 15 percent of global
trade in chemicals), Mr. Moshal argues that the private channel is
inherently "better suited for the 85 to 90 percent of the business
done in the form of longer-term contracts." Private e-markets, he
believes, offer chemical suppliers control over their products,
markets, relationships and trading partners.
Contracts, notes Mr. Moshal, are "either 'renegotiable' or
'take-or-pay.'" Renegotiable contracts have either volume or price
fixed, but not both, exposing producers under this structure to
significant renegotiation risk. Take-or-pay contracts potentially
represent as much as 10 percent of the overall long-term contract
business, says Mr. Moshal. They "can be a valuable tool in helping
to reduce earnings volatility risk even though they may sell at a
discount to renegotiable contracts. Take-or-pay contracts," he has
determined, "which can be used to create a beneficial forward curve
weighted average, are best negotiated in private to avoid the
generic adoption of the take-or-pay transaction price as a
reference price for the renegotiable contracts."
Mr. Moshal explains the logic. "You create the forward physical and
paper markets on your own product," he says. There is nothing to
stop producers from selling call options on their products. The
chemical company is selling derivatives to its customers on that
which it is naturally long, at a lower premium than available in a
marketplace (if it exists at all). By selling one's own product in
a private exchange, one can own its liquidity because it is a
matter of just taking existing trades and putting them online. The
question of liquidity goes away.
"Cisco got stuck with a $2 billion inventory write-off," he says.
"If they had had a call option, their premium income might have
been a wonderful hedge. It's an insurance policy against the
volatility. The volatility doesn't help anyone. The volatility is
the enemy, and often, to begin with, only one side is volatile. If
you're at the extreme ends of the chain (gas, crude), it's
volatile, same with plastics. Volatile, but not manageable.
Sometimes the outputs are natural hedges to the inputs,
petrochemicals for oil. But if you're buying crude and selling PET
], you have a huge problem since both
inputs and outputs are volatile and yet are not necessarily
correlated. If volatility can be squeezed out of the supply chain
through predictable smoothing of supply and demand at every
juncture, then the curse of the low multiple that has overhung this
industry can be lifted," he says.
For example, one can use a suitable platform (which in the case of
Trade@TheMoment lists in the $400,000 neighborhood) to determine
option premiums while using current price and time-value of money
to figure out the strike price. "Companies will start with forward
physical markets then move to forward paper transactions," says Mr.
Moshal. Businesses are "experimenting with these instruments right
now. The major players are all keenly interested in volatility
reduction techniques such as our real-time commerce platform," says
Mr. Moshal. "The carrot that is held out to ROI [return on
investment] kingpins is that if you prove to Wall Street that you
can lower your performance volatility, Wall Street will, in return,
eventually reward you with higher valuations." Fresh from its
announced acquisition of Hyprotech Ltd. earlier this month, Aspen
Technology Inc. is looking to return to profitability. AspenTech, a
software provider to the process industries, including petroleum
and chemicals, suffered along with these industries last year.
However, after a series of cost-cutting moves earlier this year,
along with the pending Hyprotech acquisition, the company hopes to
reach revenues of $437 million for fiscal year 2003.
By joining forces with Hyprotech Ltd., a supplier of process
simulation and engineering software and services to the petroleum
industry, AspenTech hopes to broaden and deepen its process
simulation and engineering offerings and expand into the upstream
petroleum market with applications for modeling oil and gas
production. AspenTech says the move enhances the value of its
end-to-end petroleum solution by creating a single open, unified
process modeling framework from upstream production to downstream
refining and marketing.
AspenTech agreed to pay $99 million in cash to AEA Technology PLC,
the parent company of the Calgary-based subsidiary Hyprotech, to
complete the acquisition. AspenTech believes the deal will be
"significantly" accretive through fiscal year 2003. For fiscal
2003, AspenTech anticipates total revenues will be in the range of
$437 million, with earnings per share of 55 cents, a 31 increase
from previous earnings guidance. Excluding one-time charges of
roughly $20 million, the company does not expect any dilutive
impact in the fourth quarter of fiscal 2002.
AspenTech will fund the transaction through a recent private
placement of 4.2 million shares that aimed to raise $50 million and
roughly $50 million in cash on hand.
Hyprotech is a provider of simulation software and services to the
process manufacturing market. Its serves more than 17,000 users,
with roughly 600 customers in more than 80 countries. In the fiscal
year ended March 31, its revenues totaled roughly $50 million,
using subscription accounting to recognize revenues covered by term
license agreements. Were the fiscal 2002 revenues recognized
upfront, which would be consistent with AspenTech's current and
future accounting practices, revenues would have totaled $69
AspenTech will integrate Hyprotech into its newly created
engineering products business unit. The two companies have created
an integration team. Wayne Sim, now CEO of Hyprotech, will become
chief product officer at AspenTech when the transaction
The Hyprotech acquisition comes on the heels of difficult financial
times for AspenTech. Its total revenues for the third quarter ended
March 31, 2002, were $83.5 million, split between license revenues
of $37.4 million and service revenues of $46.1 million. The company
reported an operating loss of $6.9 million.
"We are 100 percent committed to doing whatever it takes to restore
AspenTech to sustained profitability," said Larry Evans, chairman
and CEO of AspenTech, at the time of the earnings announcement in
late April. "Due to the current economic environment, we have taken
difficult, but necessary, short term actions that should enable us
to make money in the current quarter. Our fourth quarter is
seasonally our strongest, and we possess a robust pipeline of sales
opportunities that we believe will close by the end of June."
In an effort to achieve better profitability, AspenTech decided in
April to organize around two primary lines of business, engineering
software and operations software, which includes manufacturing and
supply chain software. The realignment allows the company to reduce
total spending in the first quarter of fiscal 2003 to roughly $81
million or 10 percent from its current quarterly run rate. The
company also planned to cut staff by 10 percent, which numbered
1,950 as of March 31, 2002.
For fiscal fourth quarter 2002, the company implemented a mandatory
furlough program, making temporary salary cuts for managerial
employees, instituted a hiring freeze and substantially cut
discretionary spending. AspenTech expects these actions to reduce
quarterly costs, including cost of revenues, to roughly $83 million
to $85 million, on projected revenues of $86 million to $88
Looking forward, the company will be headed by a new president and
CEO. David McQuillin, now executive vice president and co-chief
operating officer, will succeed Lawrence Evans, effective October
1. Mr. Evans will continue working full-time as chairman of
AspenTech.-Patricia Van Arnum
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