Energy Trading

J.P. Morgan Payments Advisory works with clients in the Energy Sector to provide industry expertise to ensure clients remain successful in navigating key challenges. We previously released an article that focused on the growing importance of the Energy Trading sector as well as highlighting a number of difficulties this sub-sector was facing. 

Why Energy Trading Matters

We have seen a continued increase in investment by our clients and the wider industry into Energy Trading. Generally, driven by the desire to benefit from increased margins that are available when delivering the last mile to the end customer or by ensuring that a single supplier can satisfy the entire demand of an end customer in an attempt to dissuade the end customer from engaging with or buying from the competition. In both cases the company is seeking to make more margin per barrel or molecule delivered.

The need for more volume

Energy Trading businesses carry significant overheads which require more volume to pass through it in order for the business to make a contribution to the overall group result. Therefore, it is critical the Energy Trader is able to source an increasing amount of  third party Energy in order to be able to trade and optimise more material in order to cover the fixed costs. However, increases in third party volume and production investment face both political headwinds as well as significant reductions in tradable volumes due to factors such as sanctions. The supply side constraint is made more acute by the increasing number of trading companies operating in this space.

Regional Differences

When observing the business cycles of Energy Traders across the world we see a distinct difference between the behaviour of US Energy Traders vs European Energy Traders. In the US market, we see a drive to build greater market share which appears to be driven by the more recent development of these newer Energy Trading businesses. This is a market which seeks to use financing tools to differentiate the Energy Trader in order to drive more volume through embedding financial tools into offtake contracts. Whereas in Europe, where the Energy Trading model is more established, we see a drive to seek to use trade financing as a tool to control working capital usage in both times of high commodity price volatility as well as a perceived risk of lower for longer commodity prices. We believe this behaviour is as a result of the European Energy Traders proximity and exposure to the gas price volatility observed in 2021/22. 

Competition Focus

Energy Traders seek to lock in third party volumes via the use of structured trade finance tools, such as medium to long term prepayments. The Energy market has seen a shift in the use case for prepayments as a result of higher average commodity prices leading to more cash generation at the producer level. This has led to fewer traditional prepayments coming to the market over the last 2 years. Where prepayments have come to market, they have been largely as a result of M+A activity, where a private company buys a producing asset and seeks to refinance all or part of the purchase cost via a prepayment. These opportunities are in shorter supply and often more challenging to execute. As a result, Energy Traders have been rethinking how they can embed financing into their offtake offering on contracts which are not subject to a prepayment. 

A large proportion of the material bought by an Energy Trader will be based on short term or spot contracts. Often the supplier has a weaker financial profile when compared to the Energy Trader. As a result we are seeing a sustained move in the market where Energy Traders will seek to use short term payables facilities such as Bills of Exchange or Supply Chain Finance to offer the supplier with the option to discount the payment obligation due on the Energy Trader at a rate which is substantially below the suppliers cost of capital. The intention is to motivate the supplier to either continue to sell, or to start selling to the Energy Trader as a result of the additional ancillary benefit the financing brings to the table. 

Liquidity Focus

As Energy Trading businesses become more established, it quickly becomes clear that whilst they can be highly profitable they carry two distinct drawbacks. Firstly, they can be enormous consumers of working capital, especially in an increasingly competitive world where in order to lock in the purchase and sale opportunity an Energy Trader often needs to provide both logistic services as well as better terms than the competition on both the purchase and the sale. The second drawback is that the working capital consumed by the business can be highly unpredictable as it is driven by the volatility in the underlying commodity price and the associated margin calls the business will face as a result of its hedging activity. 

This can be especially acute in a rising commodity price environment where large margin calls may need to be made immediately against unrealised future gains on a commodity that is yet to be sold, or has been sold but the buyer has yet to pay. In such cases the Energy Trader needs to ensure optimal velocity of its own cash so that it can be redeployed where and when needed in a matter of minutes, if not seconds. This move towards real time Treasury – which is discussed in the following white paper previously published by the J.P. Morgan Payments Advisory team – aims at delivering two key enablers of modern treasury. 

The ability to consolidate Group-wide cash in real time into a central Treasury vehicle comes first, improving availability and usability of cash for the Energy Trader to focus on its business. This is driving greater adoption of solutions such as virtual accounts, delivering real time consolidation of cash throughout the day. The velocity of cash in the Energy Trading business also results in a better counterparty exposure management. The latter is facilitated through virtual accounts allocated to various counterparts, ensuring faster and more efficient reconciliation of open items. In such a set-up, buyers can prepay existing amounts due to the Energy Trader to release capacity on existing open account trading limits as an example. This can be further enhanced by real time reconciliation or invoice matching solutions which can harmonise the reconciliation process with the Energy Trader’s counterparties. 

The enhanced visibility into global cash positions comes next, ensuring better informed and more agile decisions when it comes to the allocation across Trading Desks of Group-wide cash; which remains Energy Traders’ cheapest source of funding. This visibility can nowadays be granted through various routes, including the leading ERP and TMS solutions, with minimal technical integration effort. 

It is also important that an Energy Trader is able to ensure a seamless customer experience for both the supplier and offtaker. An area of conflict has always been the prospect of financial hold, i.e. where a commodity cannot be loaded or discharged from a vessel as a result of funds not being available. The extended clearing window provided by J.P. Morgan combined with innovative solutions offering 24/7 settlement capabilities ensure that cut-off times, week-ends and bank holidays are no longer the reason for dispute between the Energy Trader and its valuable counterparties.

Trade Finance Levers

On the debt side, we see Energy Traders requiring the use of liquidity levers in the form of Trade Finance facilities which can be used to dynamically raise significant working capital at short notice in order to fund activities such as margin calls. Whilst there are many ways working capital can do this, an example would be the use of Sales Financing, where a portfolio of account receivables can be bought by the Bank on the basis of diversification within the pool. The benefit of using a Trade Finance facility is that as most are uncommitted in nature and therefore do not include a commitment fee, during times of benign price volatility, the facility may not be drawn and only upon drawing will a margin be payable. This lowers the cost of the lever for the Energy Trader vs other tools such as an RCF or bonds. 

On the payables side, we are seeing greater adoption of Supply Chain tools which can be used to generate liquidity by delaying the time in which the Energy Trader has to make a payment to a supplier under a purchase contract. This may provide the Energy Trader with enough time to collect on the sales contract before having to make payment to the supplier and can therefore be used to smooth out the cash flow volatility faced by an Energy Trader.

Can cash be a limiting factor?

An Energy Trader will often look at the total amount of liquidity at hand (often excluding the RCF as this is not expected to be drawn). The Energy Trader then estimates how much volatility the underlying commodity market is likely to experience. As a result the Energy Trader can calculate what the maximum volume of commodity they can trade based on the cash on hand. Having access to readily drawable facilities such as Sales Financing can result in an increase to the volume that can be traded which should increase the total profitability the Energy Trader can make in the same time period. 

What should Energy Traders do?

An Energy Trader needs to look at several parts of its treasury system and working capital stack in order to either become, or remain, competitive in the market whist also ensuring it is operating at scale in order to maximise the opportunity it sees. That necessitates the use of the most up to date treasury technology to benefit greater immediacy, visibility and usability. 

In addition, the Energy Trader should consider what the most critical business objective is, i.e. gaining market share, ensuring ample liquidity, or ideally both at the same time. In doing so, the Energy Trader can engage with the Bank to consider how working capital tools can be leveraged to drive profitability and therefore long term business success. 

We would be delighted to hear from any Energy Traders that would like to discuss the content of this article further and assist you in meeting both the demands of today as well as thinking about the needs of tomorrow for your business.