By Ann Davis, The Wall Street Journal –
United Airlines, fighting intense financial pressure, decided in late 2003 it needed a better way to get fuel to its planes. To get that job done, it went to an unusual place: Morgan Stanley.
Now, employees of the bank scour the world for jet fuel for the airline. They charter barges, lease pipelines and schedule tanker trucks, delivering more than a billion gallons a year to United’s hubs. They even send inspectors to make sure no one tampers with the stuff.
What’s a white-shoe investment bank doing selling oil? The answer unfolds in Purchase, N.Y., where an army of its commodities traders sit before flickering screens on a vast, domed trading floor staffed 24 hours a day. At the former site of Texaco’s headquarters, Morgan Stanley veterans Neal Shear and John Shapiro run one of the most profitable energy-trading operations in the world.
But they don’t just trade futures, a common way of betting electronically on commodities that involves buying and selling contracts for future delivery. Morgan Stanley also handles real barrels of oil and generates actual megawatts of power.
The reason is twofold. Having access to barges and storage tanks and pipelines gives the bank additional options, to move or store commodities, that most energy traders don’t pursue. And by having its finger on the pulse of the business, it hopes to get a more subtle feel for the market, a crucial asset to a trader.
“Being in the physical business tells us when markets are oversupplied or undersupplied,” says Mr. Shapiro. “We’re right there seeing terminals filling up and emptying. Or we’re there saying ‘I need 500,000 barrels’ when someone else says ‘I don’t have it.’ ”
Morgan Stanley is now a major provider to wholesalers of heating oil in the Northeastern U.S. It has custody of a quarter of America’s strategic reserve of home heating oil. And it is the second-most-active U.S. seller of electric power, ahead of scores of utilities, according to Federal Energy Regulatory Commission rankings.
With energy prices high, this nitty-gritty operation, which includes trading desks in London and Singapore, is throwing off lots of cash. It produced net revenue of roughly $1.4 billion to $1.8 billion and pretax profit of $500 million to $700 million last year, according to various estimates from Sanford C. Bernstein & Co. and others familiar with the operation. The net revenue figure — revenue minus some items, such as interest expense — would be about 6.5 percent of the bank’s total. Bernstein indicated the pretax profit was at least 8 percent of the bank’s total. Morgan Stanley doesn’t break out the figures.
The commodities-trading operation is especially important to Morgan Stanley as it faces slowdowns in some traditional businesses such as bond trading and its brokerage for individual investors.
One member of its team, Olav Refvik, has amassed leases on storage terminals around the globe. The Norwegian-born trader has struck deals to buy and deliver oil to big users, sometimes storing it in the tanks he leases.
In electricity, trader Simon Greenshields oversaw Morgan Stanley’s construction of power plants in Georgia, Alabama and Nevada in the 1990s. When utilities need extra power during peak demand, Morgan Stanley traders sell them some. Those tend to be times when prices are higher.
In dealing with crude oil, the Morgan Stanley team at times buys the rights to oil companies’ production in the Gulf of Mexico, then turns around and sells it while it is still underground.
Wall Street played the energy markets actively before — notably through Salomon Brothers’ Phibro unit in the go-go 1980s — but most firms cut way back as oil cratered and stocks soared in the late ’90s. Then Enron Corp.’s seeming success inspired a spate of trading by power providers, such as Dynegy Inc. and Mirant Corp. — followed by a lull after Enron blew up. Throughout, Morgan Stanley and one other bank, Goldman Sachs Group, stayed the course.
Today, others are rushing to follow them. Merrill Lynch & Co., Credit Suisse First Boston and Citigroup Inc., among others, are stepping up their activity. Hedge funds — investment pools for institutions and the rich — leapt into commodity trading a year or more ago.
The operations carry plenty of risk, and for a trader like Morgan Stanley that gets its hands dirty with physical commodities, the risks are compounded. Messrs. Shear and Shapiro are putting bank capital into oil inventories whose value is sure to fluctuate. The risks grow as they commit to supply clients with fuel or power over extended periods at certain prices. There is also the hazard of a spill or industrial accident.
The surge in commodity trading adds its own uncertainties. Some analysts believe that as speculation increases, rooted in forces such as China’s rapid growth, it raises the risks of “bubble pricing” in the sector. Securities firms report to the Securities and Exchange Commission an estimate of how much they could lose in a single trading day, known as “value at risk.” At Morgan Stanley, the estimate of risk taken in commodities grew 23 percent in 2004 from 2003.
Most other financial firms don’t bother much with actual stores of commodities. They are primarily “paper traders,” just buying and selling futures or making private financial contracts with other players, known as derivatives. Paper traders don’t deliver a commodity or take delivery of one, but instead close out each contract before it expires, by making another trade that cancels it.
Goldman does mostly paper trading, too, but it recently bought 30 electricity-generating plants. They were available at bargain prices after Enron melted down and other power companies found their credit ratings and stocks under pressure. (The late-2001 Enron collapse enhanced Mr. Shear’s standing at Morgan Stanley, a colleague says, because he had often said Enron was a “house of cards.”)
Morgan Stanley’s use of physical assets in its energy trading dates to 1986, a year when the bottom fell out of the oil market. Mr. Shapiro, a former Conoco executive — noting that prices for future shipments of oil were climbing — got his superiors to agree to an unusual request. He wanted to lease some tanks in Oklahoma, stock up on crude oil, and sell it later.
That was the beginning of a quiet strategy that later helped Morgan Stanley muscle into another huge petroleum market: home heating oil.
The trader who largely carved out that dominance is Mr. Refvik. In the 1990s, he made a bold real-estate play along a grimy refinery row in coastal New Jersey near New York Harbor. The New York Mercantile Exchange, the country’s main hub for trading oil futures, designates about two dozen sites there and in New York as places where exchange-traded oil can be delivered. Through leases, Mr. Refvik locked up a large chunk of the official storage space. He laid claim to tank farms — clusters of giant metal storage drums. His team also leases a big storage terminal in New Haven, Conn.
Messrs. Shear and Shapiro worried, at first, that the expensive leases could be albatrosses. But the move has worked so well that traders elsewhere dubbed Mr. Refvik “King of New York Harbor,” a nickname that also reflects his occasional tour of the waters with his yacht, Song of Norway. Meanwhile, Morgan Stanley also acquired large amounts of oil-storage capacity in other countries.
While most traders close their futures contracts without delivering or receiving oil, Morgan Stanley physically delivered 20.7 million barrels of heating oil to other buyers and took delivery of 16.4 million barrels from 2002 through 2004, according to New York Mercantile Exchange figures. Though it amounted to a small fraction of all trading in the fuel, it was 61.5 percent of all barrels that physically changed hands at the Nymex.
By having such volumes to buy and sell, plus the ability to store the fuel, Morgan Stanley has become a factor in home heating oil’s supply-and-demand equation. If prices are low, it can sit out the market and wait until supply gets scarcer. If prices are high, it can release inventory. This is perfectly legal. One thing regulators frown on — and that Morgan Stanley says it doesn’t do — is hoarding oil when there is a shortage. Smaller oil traders less able to afford storage are at a disadvantage when it comes to playing this game.
Mr. Shapiro says Morgan Stanley has to renew its leases regularly like everybody else, and that anyone can get storage if they plan ahead. He also says that, rather than taking large, speculative bets, Morgan Stanley profits from spotting and exploiting small pricing differentials. He cites an example of the kind of question a trader might ask himself: “Is moving oil from New York to New Haven going to cost me six-tenths of a cent, and, if so, can I sell it at seven-tenths of a cent?”
Morgan Stanley’s space play paid off during a 2001 cold snap in the Northeast. In Connecticut, while other suppliers of home heating oil ran out, the bank had plenty to sell. Still, Mr. Shapiro says it lost some of its profit a few days later. Temperatures rose, prices fell and Morgan Stanley was left with two shiploads of heating oil that it had bought at crisis prices.
For work like this, the traders are compensated well. Some investment bankers have been known to scoff at scrappy commodities traders, but no longer. Mr. Shear, the group’s leader, collected an estimated $15 million to $18 million for his group’s record 2004 profit, according to headhunters and people familiar with the firm. They say his senior colleagues made $10 million or more each. Morgan Stanley won’t discuss their compensation, nor will Mr. Shear.
Mr. Shear, comfortable in khakis and an open-collar shirt, has been with some of his trading colleagues longer than in his 17-year marriage. Though he pays his people well for performance, he balks at what he views as indulgence. In 1995, a bad year for commodities, Morgan Stanley’s then-president John Mack offered to give Mr. Shear’s group more compensation than it was due, in order to boost morale. Mr. Shear’s response: “No, we don’t run it that way,” recalls a former management-committee member.
After it mastered heating oil, the Morgan Stanley team turned to other refined petroleum markets. In November the team agreed to take over most of the responsibility for finding fuel for TransMontaigne Inc., a Denver-based distributor of gasoline and diesel fuel. The company was buying fuel at refineries’ doorsteps and then transporting it. It was tying up $90 million to $100 million for fuel it didn’t yet have in its possession. In the meantime, the price could swing.
Morgan Stanley agreed to deliver fuel directly to about 50 TransMontaigne terminals along the Florida coast, for a fee, as well as to pipelines across the Eastern U.S. Because of its size and closeness to the markets, Morgan Stanley can buy in bulk all over the world, chartering tankers to get the fuel to the U.S.
Mr. Refvik and his colleagues helped United Airlines with a similar problem in September 2003. United not only was buying its own fuel but also had an operation that supplied fuel to other airlines. It had $180 million tied up in inventories, fuel in transit and accounts receivable, at a time when parent UAL Corp. was operating in bankruptcy protection.
United sought a deal with a supplier better positioned than it was to finance trades and assume the cost of transporting fuel. It feared that “the cash requirements to continue what we were doing would have almost doubled,” because of higher lending costs and fuel price increases, says Robert Sturtz, United’s head of fuel purchasing.
“We didn’t expect that this would be a Wall Street solution,” he adds. But Morgan Stanley won the job, and he says it has shown a high-level grasp of the logistics of finding fuel and delivering it. United pays Morgan Stanley ahead of time, plus financing fees, for the fuel the airline will consume the next day. Morgan Stanley employees lease barges, secure pipeline space and ensure deliveries.
Some jet-fuel experts wonder how well United is faring financially under the deal, given that Morgan Stanley’s heavy trading might influence the price at which jet fuel trades. Mr. Sturtz says the investment bank’s trades don’t run up United’s costs, but allow both parties to benefit by finding the best deals available.
Meanwhile, the insight Morgan gets from sourcing fuel, from Lithuania to Kuwait, proved valuable as the price of jet fuel rose steeply last year. The climb caused heavy losses for some less-experienced traders, including those at China Aviation Oil (Singapore) Corp., which now is operating in bankruptcy.
In the electricity business, a Morgan Stanley specialty of late is helping power companies pull out of the slump that followed Enron’s collapse. From providing financing to scouting sources of power, these are skills that have brought in hundreds of millions of dollars for the bank so far.
A repeat customer is Calpine Corp., an independent power producer left with crushing debt from an expansion begun about five years ago. By 2003, the power sector was cratering amid a glut of production capacity. San Jose, Calif.-based Calpine wanted to raise money, but investors were skittish.
There was one bright spot: Calpine had signed a long-term power-supply deal with the state of California in 2001 at advantageous rates. Morgan Stanley’s Mr. Greenshields helped his bank win an $802 million bond underwriting with a novel sweetener. The bank would, in effect, take over the job of finding and delivering power to California, in exchange for sharing in the lucrative contract. Morgan Stanley’s sterling credit helped make the deal a success, as investors bought the bonds.
Morgan Stanley wrung an estimated tens of millions of dollars in fees and trading profits from the arrangement. It got above-market rates for the power it sold, while Mr. Greenshields and his colleagues bought power at lower rates. Though prices have since risen, the traders had locked in some profits by buying power ahead of time.
Source: Pittsburgh Post Gazette