Tag: Enron

Stop Me If You’ve Heard This Before: Houston-based Power Traders Blow Up Another Region’s Power Market

“Bloomberg – On June 5, GreenHat received an invoice from PJM for $1.2 million to cover losses. It didn’t pay. On June 21, PJM declared GreenHat in default. Losses have continued to mount, according to PJM. The portfolio has more hedges that will probably keep losing money for three years…”

I love these types of stories. Pull out a big Wall Street pot and mix in equal parts of leverage, some win at all cost trading and an esoteric financial instrument. Kick in a dash of regulatory incompetence and you’ve got yourself one delightful tale about how someone inevitably blew up their book and caused some turmoil in the broader market.

We see these messes pop up every so often and they usually play out the same way: (i) someone has a “brilliant” trade that almost always includes derivatives or a structured product; (ii) they get caught flat-footed as the market turns against them; (iii) they try and trade their way out; (iv) other market participants catch wind of their troubles; and (v) the book blows up and regulators step in. The only thing that really changes is the asset class. Well gather round, folks: today we’re talking about power markets.

I’m not sure if the general population understands how wholesale power markets even work, so I suppose a quick intro couldn’t hurt. As a result of deregulation in the 90s and early 00s, two distinct market structures developed: (i) traditional, regulated markets in which a single utility company is responsible for generating and transmitting power to both wholesale and retail end users and (ii) RTO/ISO markets where private companies own the generation plants and transmission lines of a particular region. The generation companies participate in auctions, run by the RTO/ISO, for the ability to sell wholesale power into the market based on the energy efficiency of their plants. Once they win the auction, they’ll pay transmission companies a toll to use the grid to deliver the power. In layman’s terms, power generation companies say:

“Hey – we can provide xx megawatts of power at this price because we have a brand new, natural gas powered plant. The other guy who burns coal can’t come close to our price so we should win the bid.” 

And that’s exactly what happens. The company with the new, more efficient plant is awarded the contract and is now obligated to provide a fixed amount of power into the system, in the future, at a certain price – done and done. In a vacuum the system works perfectly – but the world doesn’t operate in a vacuum. Sometimes power demand is higher than normal (like during a heatwave) so the system becomes congested, leading to higher tolls for the power plants and eroding their profits in the process. Well here in America we like profits, so the RTO/ISO markets decided to develop a financial product to hedge against fluctuations in the tolls, which is where our friends at GreenHat Energy come in.

I don’t want to get into all the nuance of what happened with these guys but here’s the skinny. The two traders, Andrew Kittell and John Bartholomew, took a look at historical congestion trends in the PJM market (the largest RTO/ISO in the country) and decided not only would that historical pattern continue to play out, it would be exacerbated into the future. They then went out and amassed a huge portfolio of hedges that would payout were their thesis to come to fruition (mind you these guys weren’t hedging exposure, they amassed a naked, speculative portfolio of power derivatives). The problem for these two rocket scientists was that they didn’t factor grid equipment upgrades / repairs into their congestion models. The aforementioned upgrades reduced congestion rates materially over the last few years, slowly eroding the value of their portfolio until 2018 when the floodgates opened.

According to RTO Insider, the derivative portfolio represented a hedge on 890 million MWh of generation – an absolutely massive financial liability for a fund of their size. The value of the portfolio continued to deteriorate and is now facing estimated losses of $145M… and counting. It doesn’t even matter for GreenHat, either – they’re already in default and thus the losses will be absorbed by PJM and it’s participants (including retail customers). So how were these two guys able to use so much leverage to put together, and subsequently blow up, a portfolio and pass the losses on to everyone else? Put quite simply the problem was poor market structure and lax regulatory oversight.

There were two key weaknesses in the way PJM ran the market that brought GreenHat where it is today. The first is that market participants don’t pay for the contracts in full until settlement which is normally a few years out. GreenHat was able to operate on 100% margin and, as long as their trade was profitable at settlement, never had to worry about paying out on losses (kids, hubris is a terrible risk management strategy). Now is the point where you should be asking yourself about collateral requirements:

“Well, sure – they didn’t need to pay out on the contracts yet, but of course they had to post collateral as the portfolio fluctuated in value. Right?”

Wrong, actually! The collateral requirements are determined on a portfolio-level basis, not a position-level one. This past April, PJM changed it’s credit policy for market participants which would have resulted in a $60M collateral call for the GreenHat portfolio. However, market participants were given thirteen months to comply with the changes and rework their trading strategies. GreenHat used this window to amass enough new, profitable positions on 100% margin to negate the $60M collateral call coming down the pipe for their losing positions. Lipstick, meet pig. The window dressing worked for a bit until those positions moved against them as well, sewing the seeds of GreenHat’s demise and sending PJM and FERC scrambling to stop the bleeding. Regulators and market participants are currently kicking around different ideas on how to best equitably absorb at least $145M in losses.

I’m not exactly sure these guys are two of the most prudent fiduciaries out there. However, while I wouldn’t sign up to be a LP in their next venture, I have to point out that they operated within the framework that PJM and FERC had laid out for them. This will obviously force PJM and the rest of the RTO/ISO markets to restructure their credit policies going forward, hopefully they can figure one out that works this time.

Netflix Likes On-balance Sheet Debt, Too

“Bloomberg – The world’s largest online television network sold $1.9 billion of senior bonds in its largest-ever dollar-denominated offering“

Here’s an unpopular opinion: Netflix really isn’t that great of a product – like, at all. I’ve always felt that their movie catalog was downright awful, filled to the brim with low-budget features that close to zero people have ever heard of. Their television and original series content definitely offers a better selection, but they’ve never been able to convince me to pony up cash on a monthly basis. Alas, the numbers don’t lie – Netflix continues to beat street estimates for new user growth quarter over quarter. So when they announce they’re issuing a bunch of high yield debt to finance new licensing acquisitions and original content production on the back of parabolic customer growth, it shouldn’t surprise anyone. But I’m a cynical numbers guy, so I’m here to poke some holes in everyone’s favorite stock (and one of my least favorite products).

The content industry is very fond of off-balance sheet transactions, and Netflix is no different. The transactions materialize in the form of commitments to purchase content from production houses (Disney, Warner Bros., NBCUniversal, etc.) in the future for a few billion dollars. This ensures that Netflix is able to provide newer content for its audience as tastes change. The weird thing here is how these transactions are accounted for. Netflix amortizes these costs, through COGS adjustments, across the shorter of (i) what they deem to be the length of time viewers will continue to stream that particular show/movie or (ii) ten years, starting on the date that the content becomes available for streaming. As of 12/31/2017, Netflix had amassed $17.7B in content acquisition liabilities, of which $10.2B never makes an appearance in their financial statements as the content isn’t yet available for streaming on the platform.

Once you adjust for the off-balance sheet obligations, Netflix’s total liabilities jump from $15.4B to $25.6B at YE 2017 and $27.5B after this latest bond offering. Normally this wouldn’t be worrisome as your assets and liabilities rise in tandem – or so you thought, until you find this gem they buried in the footnotes of their 10-K:

“…content assets, both licensed and produced, are reviewed in aggregate at the operating segment level when an event or change in circumstances indicates a change in the expected usefulness of the content or that the net realizable value or fair value may be less than amortized cost. To date, the Company has not identified any such event or changes in circumstances. If such changes are identified in the future, these aggregated content assets will be stated at the lower of unamortized cost, net realizable value or fair value. In addition, unamortized costs for assets that have been, or are expected to be, abandoned are written off.”

Ah, yes – there’s always the risk that all of those content assets acquired in the off-balance sheet transactions may not really be worth the acquisition cost, in which case there will be sizable charge-offs that will directly impair their free cash flow (which is already running huge losses as they follow the Amazon business model). As the company continues to grow its customer base, it will need to go to market and increase the size of their content acquisitions, which will inevitably lead to a few charge-offs as their content portfolio expands. This isn’t really an issue from a microeconomic standpoint. It has the ability to become a macroeconomic issue though, if content providers decide they want a bigger slice of the Netflix pie and start jacking up rates for licensing, even as Netflix begins to experience some standalone charge-offs. Any rate increases will continue to hit Netflix right in their cash flow statement. This is the point at which they’d need to pass those costs onto consumers, but who is to say they’ll continue to pay up? Netflix has the benefit of being structured like a low-cost gym membership, where customers forget about (or don’t mind) the cheap, recurring charge hitting their account each month. Were those costs to rise, customers may be a little more sensitive as to what they really gain from their membership, and whether or not it’s worth it.

I’m not saying any of this poses a going concern risk for Netflix, either. I do, however, think it does pose downside risk for equity investors, especially if you’re buying at these levels. Institutional investors are well aware of the off-balance sheet transactions and their cash impact, they just haven’t cared because customer growth has acted as a buffer. If there are any hiccups in customer growth or worse, retention, then lookout below as content cost and cash flow profile move up the ladder of importance in valuing the company.

P.S. – If they knock The Irishman out of the park I will disavow everything I just wrote. Can’t lose with Scorsese directing that cast.