Several small niche-specific vendors are convincing energy dealers to scrap their home-grown, high-maintenance systems.

By Maureen Nevin Duffy

When the financial software industry was as wide-open as the Oklahoma oil fields, most systems vendors set their sights on development projects for the more populous FX, interest rate and equity markets. Oil and natural gas dealers were left to build their own systems from scratch. Some of these systems were simply hundreds of spreadsheets, intricately linked together. Others involved heavy-duty workstations and reams of custom C code. Both solutions were high cost and high maintenance.

Recently, however, increasing competition in the more established financial software markets and new end-user demand have made the idiosyncratic oil and natural gas markets much more appealing to developers. Indeed, several small-to-midsize firms are already battling it out for this niche, with the majority offering relatively inexpensive packages that can interface with firms' legacy systems.

Creating software for the energy markets is easier said than done. One of the biggest hurdles is reconciling the "physical" and "financial" aspects that comprise most energy portfolios. "Physical" deals represent the exchange of the underlying commodity; "financial" deals refer to instruments that derive their price from the underlying commodity. To properly gauge your total firm-wide risk, you must include both types of transactions in your risk measurements.

Few products cover both types of deals equally well. "Physical packages claim they can track trade data starting from the trader on the floor all the way through to accounting," says Pamela Szabo, a consultant with BSG Alliance/IT, who recently worked with a Gulf Coast refining and marketing company in the selection of risk management software. "But they can't necessarily blend in, say, futures or swaps used to hedge the physical trades." In part this stems from the fact that physical transactions often entail rather complicated, multi-step delivery processes that are extremely difficult to reflect via a standardized data format.

Indeed, after Szabo completed an extensive search of systems for front, middle and back office operations, the firm decided that the only viable solution for now was to create an interface between two separate systems. The biggest weakness of the current crop of energy systems, she explains, is the paucity of risk analysis: "You can see where your risks are, but you cannot perform, for example, sensitivity analysis or value-at-risk."

Nonetheless, there are more pre-packaged energy systems on the market now than ever before, and some firms are even developing systems that will be appropriate for use in the nascent electricity market.

New York-based ZAI*NET Software Inc. has four energy industry packages which start at about $40,000 for a two-user license. They cover the energy markets' listed commodities (including various types of oil), energy swaps, options, and electricity. The firm has recently of converted its energy products to Windows, which, according to a spokesperson, should make the software more user-friendly and accessible.

ZAI*NET covers a wide variety of instruments and offers many flavors of risk management, including VAR, real time limits and sensitivity analysis. It also includes an array of automatic payment functions, which separates it from the other packages profiled in this survey. The firm's energy modules can also be integrated with ZAI*NET products that manage FX, money markets, equities and margin trading.

The firm's ability to handle a variety of asset classes, however, may be something of a drawback. Because ZAI*NET is not in the narrow sense an "energy specialist," one consultant questioned whether or not the firm was likely to maintain its excellent commitment to rapid development: "The energy markets are so idiosyncratic and rapidly evolving that they require constant, focused attention-and substantial resources."

BSG's Szabo believes ZAI*NET's product has great potential for integrating the physical and the financial components of energy transactions. Other users found ZAI*NET's diversified offerings a definite plus.

User comments:

Ray Brisson, who heads up a risk management department at Wascana Energy, a producer of crude oil and natural gas based in Regina, Saskatchewan, is currently using ZAI*NET's Energy Swaps module for paper deals, but he plans to utilize the physical module when the Windows release becomes available.

Brisson explains that he hedges the monthly IFFERC delivery point prices using swaps and options with New York-based investment banks. He also buys and sells crude oil and gas futures on the NYMEX to hedge physical risks.

Wascana runs the ZAI*NET system on a Sun Microsystems workstation/server under UNIX. From there the ZAI*NET system is networked to other computers for access from both the head office and the marketing division 450 miles away. Data from the module is regularly downloaded to the company's Ernst & Young accounting system using a file exchange interface.

"We wanted a system that was fairly well-developed, at a reasonable cost, that could handle FX, interest rate and commodity derivatives all in one," he says. "We selected ZAI*NET based on these criteria. With an average of 20­25 derivative deals a month, we just don't have enough volume to justify buying a separate system for all three market sectors."

Pros

• Good industry knowledge.
• Risk management capabilities, including VAR.
• Reasonable price.
• Willingness to customize.

Cons

• Insufficient detail for physical deal inputs.
• Incomplete physical inputs. Some oil transactions cannot be completely processed.

Houston-based Primo Systems earned its reputation with its Pathfinder product. Pathfinder runs with the Paradox database for Windows, and it has been successfully installed in 15 sites. A new application for Sybase, called Powerbuilder, is scheduled for release in the first half of this year.

Primo's founders have extensive experience in the energy industry, and it shows in their product's ability to handle complex physical transactions. As with ZAI*NET, Primo's applications are hot-wired for risk management, and they also successfully handle more market data feeds than any other product we surveyed. Users indicated that Primo's front office capabilities are a particular strength.

Primo's range of back office functions, however, is somewhat less robust. For example, Pathfinder can neither generate customer statements nor cash flows. And the price tag, while certainly not outrageous, is considerably more daunting than, say, ZAI*NET's.

But when you consider the bottom line, Primo is a good buy, particularly for those who want a system with a bias towards the front office and a seasoned staff with industry experience.

User comments:

Cliff Howe, director of market risk management and trading operations for Alberta-based TransCanadaEnergy Management Ltd, a major buyer and seller of most energy products, runs an independent risk management department. Howe currently uses Primo's natural gas module in a Pentium-powered client/server environment, though by March he hopes to be using Primo's updated Sybase module, which can run on a higher-capacity machine.

Howe is particularly impressed with Primo's willingness to improve their product. "They've made significant changes to the software to accommodate us, and we look forward to getting the Sybase version on line. We believe that its real strength is its ability to capture all types of pricing and mark all types of deals to market."

Currently, explains Ross Johanson, Howe's project coordinator for the Primo installation, there are about 12,500 deals stored in TransCanada's system, making the firm Primo's highest-volume client. Johanson described the installation, which involved bringing the firm's trading books over from another system, as a "hydra-headed monster." But he gives Primo high marks for their patience, dedication and persistence. "Our biggest problem was getting our data into Primo and generating the correct results," he says.

Although Johanson attests that Primo's system is far superior to the motley collection of spreadsheets that the firm used to rely on, a complete position report requires eight hours to run. Says Johanson: "Primo's major weakness is report generation, because of all the variables inherent in our operations. For example, because Primo breaks out each month of term deals as a separate trade record, we are dealing with a lot of data records." Yet overall, Johanson asserts, "We are very happy with the system."

Birmingham-based Sonat Marketing, a natural gas marketer, uses Primo to assist in monitoring its risk management activities. Steven Meadows, Sonat's financial controller, explains that Primo tracks, values and reports all derivative positions. The physical transactions are tracked on an internally developed trading system called SMARTS. In the very near future Meadows plans to link SMARTS with Primo "so that physical deals can be matched to their corresponding derivative deals for a good picture of physical and derivative risks."

Pros

• Heavy-duty front office, with links to multiple data feeds.
• Solid risk management.
• Interfaces with legacy systems.

Cons

• Could be more user-friendly.
• Limited back office.
• Input screens include insufficient detail for physical deals.

The origin of Triple Point Tech, the maker of Tempest, is a massive systems development effort at Phibro Corp. At one point in the project, Phibro hired a company called SHL to complete the project, prompting some Phibro staff members to leave and form Triple Point. Although SHL bought the rights to the final Phibro product, Triple Point started with an early generic version of the product and proceeded to customize it extensively for new clients.

According to users, that customization process includes more than minor changes in reporting format or user interfaces. It involves massive multi-million dollar company-wide development of custom front, middle and back office software.

Triple Point's focus on customization, however, results in a generic item that is more of a bare-bones template than a robust product ready for immediate use. Indeed, the Triple Point Tempest product lags behind both ZAI*NET's and Primo's standard offerings in terms of risk management functionality, though it does appear to have a particularly well-developed back office.

Triple Point is ideal for users who would like to accelerate the development process and take advantage of top-notch consulting; those who want a purely self-contained package may do well to also consider ZAI*NET and Primo.

User comments:

Users we interviewed were enthusiastic about both the Triple Point "base" product and subsequent development. For example, Melquiades Parra, fuel oil trading manager for Galaxy Energy, explains that his firm uses Tempest for company-wide risk management in its trading, scheduling, operations, treasury and accounting departments. "All of these disparate areas are now technologically integrated," he says, adding that the software allows users to track and run reports on both financial (OTC and futures) and physical deals.

Not surprisingly, Parra attributes much of Tempest's strength to its top-notch development staff: "We initially selected Triple Point because of their unparalleled expertise in programming for energy trading companies. Unlike some competitors, Triple Point was willing and even eager to customize their software to our particular business needs."

Pros

• Willingness to undertake extensive development projects.
• Sufficient resources to undertake large-scale development projects.
• Robust back office.

Cons

• Risk management functions could be better developed.
• OTC product may suffer due to emphasis on custom coding.

SHL entered the energy business with a bang during the Phibro development fest that also spawned Triple Point. Although SHL has maintained its relationship with Phibro and has begun relationships with at least two other large trading houses, it has yet to release a new product for general distribution.

Expected soon, the new product is known as ICTS (Integrated Commodities Trading System). ICTS and should bear little resemblance to its forebear, which users have termed "old" and "clunky."

User comments:

One current client, who is now finishing a development partnership with SHL, says that he and other managers anticipate the successful integration of front, middle and back office functions for all energy-related products.

"This system will be front-end driven," he explains. "Traders will input deals as they are transacted, and the trade records will automatically flow into the middle and back office. We deal a lot with crude oil, straight at the source. This is the 'grass roots' of the business, and physical transactions start at the well-head before progressing along to pipes, trucks, etc. Tracking the many paths this crude can take is a complex business."

Pros

• Commitment to partnership, long-term development.
• New product on its way.

Cons

• New product is largely an unknown quantity.

Chicago-based SAVA Risk Management has produced a robust, highly focused niche product rather than a fully integrated do-everything, be-everything system. The system specializes in risk management and front office analytics and is appropriate for traders who want a wide variety of models and the ability to quickly evaluate the implications of potential trades.

In keeping with its "narrow-casting" approach, SAVA is capable of analyzing OTC instruments only in the energy and metals markets. Its claim to fame is the proprietary Pilipovic Model for the Forward Price Curve, which was developed by the firm's founder, Dragana Pilipovic. The Pilipovic model uses sophisticated mean-reversion techniques derived from a two-factor stochastic process that links short- and long-term forward price behavior. It also lets users perform sensitivity analysis for specific market events and seasonality.

Determining a forward price curve is a critical element in pricing energy derivatives, and the slightest curve differences can make for major arbitrage opportunities. That in itself would make the product highly desirable for proprietary traders. At press time, however, the firm did not reveal the names of any clients.

Basis risk: the risk that results when you try to hedge one commodity with another highly correlated but differently priced commodity. For example, hedging an exposure in heating oil with crude oil would create basis risk, as would hedging natural gas originating at a Texas delivery hub with natural gas originating in Louisiana.

Physical transaction: the exchange of the underlying commodity, which may be oil, natural gas, electricity or something else.

Financial transaction: a deal whose price is derived from that of the underlying commodity. Financial transactions include NYMEX natural gas futures and options, oil swaps, etc.

Delivery hub: The delivery hub reflects the "origin" of a particular commodity and, by extension, the cost of transporting the commodity from point A to point B. Indeed, energy prices can differ significantly based on where the commodity originates. It is important to remember that the energy markets are extremely regionalized.

Basis box: The box is a matrix containing the movements of an energy price index (the physical pricing point) against the independent movements of a NYMEX futures contract (the paper pricing point). This is used to calculate the basis (the spread between the physical and the financial).

Power marketers: Wholesalers who purchase energy from providers, such as natural gas companies or utilities, and sell it in bulk to large end-users. Power marketers use financial transactions to hedge their own exposures. They may also advise buyers and sellers with regard to risk management practices.

IFFERC: The average of various natural gas price points existing along the nation's pipelines. Financial swaps based on the IFFERC are usually made between producers and investment banks as counterparties. Swaps between producers, on the other hand, usually involve the physical commodity with the respective transportation and delivery arrangements that entails.

NYMEX: The New York Mercantile Exchange is a critical player in the energy markets. Important offerings include a wide variety of oil-based futures and options, a highly successful natural gas contract and two planned electricity futures.