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The Market’s View of Cinergy’s Default

Shankar Nagarajan, senior manager in capital markets at Deloitte & Touche LLP, examines the intersection of market and credit risk in one of the critical events in the energy market.

There we went again. For the second year in a row, the summer of 1999 saw power prices peak in the Northeast, with spot prices in New England, New York and Ohio hitting several thousand dollars for a few hours in June and July. Figure 1 offers a look at the electricity spot price returns at the Cinergy hub and the associated 10-day rolling volatilities. Earlier in the year, a Federal Energy Regulatory Commission study following the defaults of certain power marketers in the summer of 1998 had all but discounted the possibility of a repeat of the 1998 “contagion”—a chain reaction of defaults from power marketers unable to deliver on the promised contracts. While there was always a difference of opinion in the industry regarding the seriousness of the threat posed by small and undercapitalized power marketers, little did anyone imagine that a large, well-capitalized utility would voluntarily default on its physical contracts.

Which is exactly what Cinergy did. On July 29–30, citing unusually hot weather, the large Cincinnati-based energy company invoked force majeure on eight firm contracts to deliver power, totaling 3,850 megawatts over 36 hours. The counterparties involved were reported to include Enron, Williams and Unicom, the parent of Commonwealth Edison and now in the process of merging with Peco Energy. Wall street analysts, never to miss an opportunity after the fact, were quick to downgrade Cinergy stock, while the rating agencies put most of its debt on watch for possible downgrades. A few major energy firms even announced their intention to stop trading with Cinergy. The management was even considering getting out of the trading business.

By September, the tide had turned miraculously. Soon after the default, Cinergy announced that it was negotiating with the affected counterparties, and indicated that it might be willing to pay liquidated damages. The company was vindicated when, on September 2, Moody’s announced that after a thorough review the agency was reiterating all the original ratings on Cinergy debt. Apparently, the offending contracts would be rolling off Cinergy’s books soon, and the problem was blamed on past risk management practices at the firm, which were unlikely to be repeated. The company then announced that it was, after all, going to retain its trading operations.

This happy ending makes a curious story even more curious. Why was the company caught short in the first place? Many market participants believe the company had not foreseen another hot summer—and failed to purchase firm transmission and delivery. Even if it was short, why did the company default in the first place, rather than buy spot replacement power to fulfill the contracts in question? Subsequent to declaring force majeure, why did the company offer to pay liquidated damages? After all, it would have been cheaper to buy replacement power at spot prices than to suffer the ignominy and risk the wrath of Wall Street and the credit rating agencies. Finally, from an investor’s standpoint, when is a default a nonevent? Inquiring minds may never know all the answers.

What do we learn from this case study? With little public information forthcoming from the companies involved, an important indirect source of information is the financial market itself. We can examine the market’s response, as measured by stock prices, to the events surrounding the default to shed some light on the seriousness of the event not only for Cinergy but also for its counterparties. The markets had a choice of different interpretations of the default event:

  1. Good news for Cinergy and bad news for its counterparties.
  2. Bad news for Cinergy and good news for its counterparties.
  3. Good news for Cinergy, with no significant effect on its counterparties.
  4. Bad news for Cinergy, with no significant effect on its counterparties.
  5. No significant effect on all parties concerned.

Figure 1

Cinergy On-Peak Spot
Cinergy On-Peak Spot
Time

To this end, we have plotted the cumulative daily stock returns for Cinergy as well as for its publicly announced counterparties (Enron, Unicom and Williams) in Figure 2. Except for Enron, the other three stocks have had a downward trend since the beginning of June. Perhaps the market had anticipated the effect of a hot summer on these firms’ trading portfolios. Surprisingly, the default event itself appears to have produced no significant impact on the stock returns of any of the companies involved.

The 10-day rolling volatilities of the four firms are shown in Figure 3. The default event did cause the volatility of Cinergy stock to increase, but it settled down soon afterward. No significant change in the patterns of the volatilities of the other stocks can be detected. Fans of the KMV model (itself derived from Robert Merton’s model) might argue that it would have been more appropriate to look at debt-holder returns, but in this case it is not necessary. If the default event did not affect the underlying asset value of Cinergy, then it must be the case that debt-holders were unaffected by the event, since the stockholders themselves were unaffected.

If, on the other hand, the default event signaled a negative outlook for the underlying asset values, it is possible that debt-holders took a beating, but it seems unlikely. The total amount in question ($18 million) is too small relative to the size of Cinergy’s balance sheet for it to be even noticeable. Besides, Cinergy seems to have “cherry-picked” the counterparties to default.

Figure 2

Event Study
Event Study
Date

The Cinergy episode has sounded a wake-up call for better credit risk management practices in the energy industry. So what, if anything, do we learn from this case study?

Despite the frequent bad rap they get, investors (yes, energy investors) are fairly rational. The sky did not fall, and the stock prices of Cinergy had already been drifting down since the beginning of June. The change in the volatility of Cinergy’s stock subsequent to the event can be attributable to uncertainties about how the firm would handle the default.

The contract terms in this industry need to get more homogenized. What exactly constitutes force majeure? While unusual weather may be an act of God, if effective (but expensive) prophylactics are available, would a firm’s failure to avail itself of these measures constitute force majeure?

If, as reported, Cinergy chose not to buy firm transmission, presumably because it was deemed expensive at the time, the company had, in effect, taken a bet on the weather. Rather than hedge using weather derivatives—again, an expensive proposition—the company decided to go naked. This is equivalent to self-insuring what is actually a market risk. In the long run, weather hedges may become more affordable, and a market may develop to insure extreme market risk directly.

Except for Cinergy, no other significant power marketer defaulted last summer. Does that imply good news for credit risk in the power market? Yes and no. It is true that more attention is being paid to credit risk than ever before, but the quality of risk management practice varies widely in the industry. There are still too many untested credit supports, such as vague parent guarantees.

Figure 3

10-Day Rolling Volatality
10-Day Rolling Volatality
Time

Many energy credit risk models are simply imported from the financial services industry. It is difficult to see historical bond-default and recovery-rate data shedding much light on unrated power marketers. The integration of market and credit risk is at an early stage. Even market risk models at many trading firms are naïve: As good as it is, the Black model (1976) is probably not the best one for pricing daily energy options. Elaborate Monte Carlo techniques for calculating value-at-risk can create a false sense of security, if the underlying assumption is multivariate normality.

Many high-quality firms proudly claim they trade only with the good guys, and that they are not overly concerned with credit risk issues. Even if this is true, this behavior tends to create a segmented market, in which the good guys get overconfident. At the end of the quarter, Do you know whom your counterparty is trading with?

A disproportionate amount of power trading is now done by a handful of big firms. Worse, this concentration is time-varying and correlated to market risk. A major misstep by one of them could easily drag the whole market down with it, à la Long-Term Capital Management. Unfortunately for the energy market, there is no Alan Greenspan waiting in the wings for a timely bailout.

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