According to International Petroleum Exchange (IPE) chairman Bob Reid the future of the energy markets is in over the counter (OTC) products. This view, made at the formal acceptance by the IPE board of the Atlanta-based Intercontinental Exchange’s (ICE) bid to acquire IPE, does not present any new thinking on energy trading. But it does raise an interesting question. Can OTC and futures markets be effectively and efficiently integrated? Obviously ICE and IPE believe they can. The vision of ICE is for a global online trading platform comprising OTC and futures products, traded 24-hours a day. A similar view is held by IPE’s main energy futures competitor, New York Mercantile Exchange (Nymex). The New York exchange, the world’s largest energy futures exchange, will launch its new OTC online trading platform during May. And it is not just the heavyweight exchanges that are looking to offer customers the choice between OTC and futures products. In Europe, electricity trading platforms such as Frankfurt’s European Energy Exchange and Leipzig Power Exchange are combining OTC and futures products on to one platform.
The view of a number of market observers is that just as night follows day, OTC and futures markets will converge. Given the facts there is little point attempting to argue against this view. A more reasonable point of debate is whether the convergence of OTC and futures markets serves any long-term benefits and as a consequence whether there is any future for energy futures.
Energy futures had their heyday in the 1980s and the early 1990s. Following on from the success of the financial futures markets and the end of the energy crisis in the 1970s, Nymex and the IPE listed a series of futures contracts for crude oil and refined products. At the time there was little alternative for companies seeking to hedge their price risk exposure. But in the late 1980s the first OTC energy swaps were transacted and market participants had an alternative.
It is interesting to note that at the time of the emergence of OTC energy transactions the futures exchanges were lightly dismissive of the threat. How times have changed. While crude and refined product futures have remained successful, with increasing volumes year on year it is a different story for the gas and electricity markets. These newer and less commoditised markets were ideally suited for development in the OTC market.
With the onset of mass gas and electricity market liberalisation in the late 1990s the resulting competition and increased price volatility found a haven in the OTC markets. The unregulated and flexible nature of OTC markets endeared it to the emerging gas and electricity sectors. While Nymex rolled out successive electricity futures contracts, none were successful. It has since moved these contracts to its electronic trading platform but again they show no sign of being ressucitated. Even on the worlds most successful electricity futures exchange, Nord Pool, futures only account for around 25 per cent of all transaction volume with the balance being provided for by the OTC market.
In a sense the energy market has moved full circle in little over 20 years. While futures provided the market liquidity and price transparency in the 1980s and early 1990s, this role is now taken by the OTC markets. Unfortunately for futures this role will not be reversed. Although not in terminal decline, futures markets will not recover their previous highs. It is also questionable whether futures will ever play a significant role in the gas and electricity markets.
Although both OTC and futures markets are highly compatible, futures products can only be successful if they mirror the specification of their OTC counterparts. This is evident in the recent launch of European electricity futures which have all followed the development of an OTC market. It is also noticeable that trading innovations, such as spark spreads, have evolved in the OTC market first.
In the short-term a converged OTC and futures trading platform will serve a valuable purpose in the market. OTC products will be many and varied, with little standardisation, as participants seek highly flexible products – both in terms of specification and contract maturity, in order to manage their price volatility and risk exposure. During this period the more standardised futures products will be used to re-hedge OTC positions as well as being used to manage a proportion of a participant’s portfolio.
But as the market consolidates and the OTC products become more standardised the value of futures will further diminish.
The main selling proposition of futures is that they mitigate credit and counterparty risk. OTC products, by virtue of their unregulated nature, do not. But consider the impact of market consolidation. As the market consolidates the number of counterparts will reduce, and as the number of counterparts falls the risk of default between counterparts will also subside as counterparts will transact with ever decreasing numbers of counterparts and become more comfortable with their credit exposures. Taking this scenario, market participants will have to decide whether they are prepared to pay the high margin calls to trade futures. In addition, with the advent of OTC clearing, the credit risk associated with OTC products will reduce. It is no surprise that Nord Pool futures volume, as a percentage of total Nordic trading volume, fell when clearing for OTC contracts was introduced.
If the future of energy trading is the OTC markets then the ultimate benefactor of any convergence between OTC and futures exchanges is the OTC market, not futures. In the short-term the futures products will benefit from OTC volume being re-hedged on futures. But as the market develops, OTC product standardisation increases and OTC clearing becomes more prevalent the value of futures is reduced. While this scenario is less acute for the more mature oil markets, it will impact heavily on the gas and electricity markets.
While there will be those that will bemoan the passing of futures contracts the market has to move on and adapt to new challenges. In the gas and electricity markets it is the OTC market that has risen to the challenge and it is the gas and electricity market that will be the main benefactor.