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 natural gas and electricity, 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 Enron."

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 saturation).

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 market."

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 visible."

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 products."

Koch Industries, Louis Dreyfus Plastics and Shell Chemicals offer an array of financial derivatives to chemical producers in commodities such as benzene, polyethylene and polypropylene. The 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 [polyethylene terephthalate], 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 million.

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 closes.

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 million.

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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