August 20, 2010

Energy, Liquidity, and Crisis: Lessons from Enron and the Great Recession

The energy industry provides solutions to recurrent financial liquidity crises through liquidity management structures.

The recent economic turmoil has brought liquidity issues to a crisis point for many industries. The energy industry, by its very nature involving high-dollar capital expenditures and high-dollar commodity transactions in changing markets, has always faced larger liquidity issues than other industries. This has made the energy industry into a leader in designing structured financial solutions to manage these liquidity risks. However, the recent global financial crisis has brought to light that some of these solutions have not worked as intended. A review of past liquidity management techniques and mistakes, in light of the recent economic crisis, may provide lessons and new ideas for liquidity solutions for the energy industry and beyond.

Liquidity Crisis

A liquidity crisis is characterized by an unexpected and prolonged removal of both market liquidity (the ability to trade an asset or financial instrument on short notice without a large price impact) and funding liquidity (the ability to raise cash by selling assets or borrowing money). For example, portions of the energy industry faced a liquidity crisis in the aftermath of the Enron bankruptcy in November 2001 when uncertainty over the effect of Enron's bankruptcy on other industry players and energy market price collapses caused financial institutions and other major energy market players to lock down on credit (the Post-Enron Crisis). In the last two years the energy industry has experienced an even larger liquidity crisis, along with most of the rest of the world, as part of what has become known by some as the Great Recession (the Great Recession). In both of these liquidity crises, within the energy industry, collapsing market prices increased the negative effect of reductions in access to liquidity.

Energy Asset Holders

The energy industry has many sectors, and each one is impacted by liquidity crises in different ways. For energy asset holders at the beginning of the energy supply chain, one important liquidity issue is the ability to refinance short-term debt that may be associated with long-term assets. Many energy-related assets, such as power plants, require long-term large capital investments. Liquidity crises have shown that having long-term capital needs financed with shorter-term debt can create financial stress. In these cases, asset holdings may allow balance sheets to reflect financial health, even while a company is undergoing financial stress.

One example of solutions implemented for these types of risk are the actions taken by RRI Energy, Inc. (RRI), during the Post-Enron Crisis. RRI had material shorter-term debt associated with certain longer-term assets and was faced with refinancing parts of its shorter-term debt during the liquidity crisis. This was difficult to accomplish on an unsecured basis, though RRI successfully refinanced on a secured basis. Following the refinancing, RRI did place additional longer-term notes, more closely matching its longer-term assets. By placing some longer-term debt to match longer-term assets, RRI was able to eliminate future risk of needing to refinance parts of its capital structure during a liquidity crisis.

This solution, however, may not work for all entities. One problem, as we have seen in the Great Recession, is that liquidity crises can reach beyond a certain industry or sector and cover much of the economy. Even an asset pledge may not be enough to convince a financial institution to give credit support. Second, the corporate structure of the entities may pose a problem. Many entities develop special purpose entity structures under which assets are separated from the parent company into a specially created entity designed to be protected from a parent company bankruptcy, or "bankruptcy remote," as these structures are often called. The purpose is to allow separate financing of these assets, which is typically done on a secured basis—therefore, as far as the parent company lenders are concerned, those assets are already pledged and therefore are not available.

However, it may be possible for a parent company to obtain liquidity value from special purpose entities previously thought of as bankruptcy remote through clever use of the bankruptcy courts, under the methods permitted by the court in In re General Growth Properties, Inc., No. 11977 (Bankr. S.D.N.Y. Aug. 11, 2009). General Growth involved a publicly traded real estate trust that, like many energy asset companies, had many of its assets financed in special purpose entities. Here, the parent company was balance sheet solvent but felt it was faced with a liquidity crisis based on pending maturation of long-term loans over three years, during which time significant loans matured and large balloon payments would become due. Faced with large debts and the potential, but not yet immediate, lack of liquidity to refinance during the Great Recession, the parent company--along with all of its special purpose entity subsidiaries--filed for bankruptcy. The special purpose entity lenders challenged the filing, claiming that the parent company's actions to bring the special purpose entities into the bankruptcy was improper on several counts, including the balance sheet and cash flow solvency of the special purpose entities.

The General Growth court, however, ruled that bringing the special purpose entities into the parent company bankruptcy was not improper, thereby making available to the parent company, as a source of liquidity, the cash and cash flow of the special purpose entities. The court stressed first that there is no requirement that a company be in financial distress before filing bankruptcy, and they refused to create an arbitrary rule about how distant in the future the impending crisis had to be. Second, the court stated that although the parent company was structured in a way to make certain entities bankruptcy remote, certain factors (such as parental guarantees) meant that the financial picture of the group should be reviewed by the court as a whole. In effect then, the parent company was allowed to tap the liquidity trapped in its special purpose entities despite their individual solvency instead of seeking the liquidity in the capital markets during the Great Recession. While the court warned that this method would not work in all cases, and certainly better designed bankruptcy remote structures may prevent the decision of solvent special purpose entities from filing bankruptcy, the General Growth case does reflect a potential new solution to liquidity problems arising out of the Great Recession.

Wholesale Energy

While energy asset companies face liquidity needs associated with their long-term assets, the wholesale energy sector experiences liquidity problems because the nature of the energy markets is high dollar, high exposure, and volatile. Due to these factors, most counterparties require a cash collateral credit posting for trading transactions above a certain collateral threshold, which is often set based on the credit rating of the counterparties. During a liquidity crisis, as shown by the Post-Enron Crisis and the Great Recession, those credit ratings may fall, and financing may become unavailable, leaving wholesale energy companies without the available cash necessary for required posting under their existing relationships.

Liquidity crises have forced wholesale energy companies to consider several different options depending on the nature of their businesses. A pure trading company has the ability to use a different matching strategy than the one used by RRI described above--instead of matching long-term credit to long-term assets, wholesale energy companies can match their posting exposures on one set of trades to posting receipts required from their wholesale trading counterparties, thereby making them liquidity neutral with respect to cash postings, in theory. One problem with this matching solution is that unlike the credit-to-assets matching, where a deal is negotiated upfront and the terms are set, counterparties using exposure matching remain exposed to their credit rating, which may be based in part on their self-reported posting and liquidity exposure to changing market conditions. If an entity faces real or perceived problems in reporting, rating agencies may be concerned about whether or not the exposures are matched, and the entity's credit rating may drop, creating additional liquidity problems. Faced with this type of problem, Constellation Energy turned to nontraditional emergency financing from Warren Buffett and secured over $4 billion in financing to weather the Great Recession. This type of solution worked for Constellation only because they were able to (1) recognize the problem, (2) react to the problem very quickly based on extraordinary efforts from the finance and legal teams, and (3) create a transaction structure that was attractive to Buffett because of inherent underlying value in Constellation's business.

Finally, certain wholesale energy companies are also energy asset companies with physical assets. If this is the case, these assets can be posted instead of cash to secure the trading under shared lien facilities. While this may be impractical on a counterparty-by-counterparty basis, applying the collateral agency concepts used in syndicated lending, a set of assets can be posted to a trading group as a whole. Not surprisingly, the most common form of these facilities is the shared-first-lien structures developed by Dynegy, NRG, Calpine, and others following and in response to the Post-Enron Crisis. In these facilities, lenders providing long-term financing for long-term physical assets share their comprehensive lien structures with trading counterparties. The lenders frequently gain comfort in the fact that trading transactions that are secured must be "right way risk" transactions that pay off to the companies in circumstances when the physical assets are decreasing in value, theoretically producing a more financially stable company over commodity price cycles.

Retail Energy

Another sector of the energy industry is the retail energy sector. The retail sector faces all of the challenges of the wholesale sector because most energy retailers purchase at least part of their supply in the wholesale markets and are faced with posting as described above, and have an additional problem--they cannot require posting from their retail customers, so the wholesale matching solution is not available. 

Here, for the retail energy supplier in the middle, energy flows are matched, and the energy customer receivable matches (and hopefully exceeds) the payable to the wholesale energy supplier. But while the wholesale energy supplier requires posting for mark-to-market exposure, retail customers do not post. The imbalance is obvious and the resulting liquidity issues are made more severe in a liquidity crisis where the retail energy supplier cannot borrow to supply the difference. Out of this imbalance, and following the experience of retail energy suppliers during the Post-Enron Crisis, retail energy companies sought out posting-free wholesale energy suppliers. For example, RRI's former retail business (Reliant) was able to implement a credit sleeve with Merrill Lynch Commodities, Inc. In this structure, instead of Reliant posting to wholesale counterparties, Merrill provided guarantees and posted for Reliant. The higher credit rating and relative stability of Merrill assured counterparties and freed Reliant from posting, giving Reliant improved liquidity.

The learning continued in the Great Recession. The lesson learned in the Great Recession is that even the most clever liquidity solutions may turn out to be less than perfect during a global liquidity crisis. Unlike during the Post-Enron Crisis, in the Great Recession liquidity was impaired across industry lines, including among and between financial institutions. From Reliant's viewpoint, this meant that Merrill might not be able to provide Reliant's counterparties with the same level of comfort. From Merrill's viewpoint, the cost of providing the guarantees and posting was increased. Ultimately, Reliant's retail business was sold to NRG, whose substantial asset base in Reliant's markets provided a self-supply balance to Reliant's customers.

It is possible in these circumstances that the retail energy supplier could protect itself from the credit supplier's instability through a "ratings trigger," a credit rating point at which the retail energy supplier can break the agreement and find a different credit supplier before a real liquidity problem sets in. But the Great Recession showed that ratings triggers, at least at levels financial institutions would accept, were in practice so low as to be useless because by the time the ratings trigger would occur, a financial institution would no longer be viable. There may be no way to protect against all of the effects of something as broad as the Great Recession.

Conclusion

Although the Great Recession has brought liquidity issues to the global forefront, for the energy industry, liquidity issues and managing them have always been a key aspect of staying in business. As time goes on and liquidity crises occur, each sector of the energy industry will likely continue to develop new and refine old ways to acquire liquidity when liquidity is scarce. The most recent Great Recession has highlighted that despite such efforts, it is likely that liquidity concerns will remain ongoing in the energy industry in the future.