Madoff: the lessons for the energy market

Bernard Madoff has just been sentenced in the New York courthouse (http://amfix.blogs.cnn.com/2009/06/29/victims-life-term-for-madoff/). It looks like the person that set up the largest investment fraud ever is going to spend the rest of his days in jail, that is, if he doesn’t live for more than 150 years from now on. As Europe’s energy markets share more and more characteristics with stock markets, what can we learn from this story (which would have been the financial story of the decade, if it hadn’t coincided with the financial crisis)?

1. Damages in markets are often impossible to compensate.

2. Scandals will continue to occur as people will continue to believe that some know better where the market is heading.

3. Authority is dangerously attractive.

Mister Madoff’s wife has to pay back 80 million dollar from the family fortune. Lucky for her, the judges have been compassionate enough to let her keep 2,5 million dollar which should allow her to continue a more or less comfortable life. This looks like a sound judgment, as the poor woman apparently was as much surprised by her husband’s wrongdoings as the rest of the world. After having lost her husband and her family’s reputation, condemning her to poverty would have been cruel. But the 80 million dollar stands in dark contrast to the estimated 65 billion dollar in damages caused by her husband’s fraud. This means that this money will allow to pay back a little bit more than 0,1% of the damages. For those involved, they will probably never see a penny back of the money that they had entrusted Mr. Madoff with. They will have to take some comfort from the fact that the man spends his old day in jail. 

In energy markets, we also observe that the damages can be so large that it becomes impossible to compensate them. This risk is obvious from the consumer’s point of view. Power failures can cause huge economic damage if they occur in an industrial zone. If the grid companies that are responsible for avoiding such failures would be responsible for compensating that damage, they would have to raise grid fees to astronomical amounts. Consumers of energy should be aware that energy suppliers also have huge liabilities in the wholesale energy markets where they source the energy that they sell to their clients. If for example a big industrial consumer stops consuming, the supplier can remain stuck with an off-take obligation (physical risk) or with a certain amount of futures contracts that he has bought to hedge the price for that client (financial risk). Another form of counter-party risk became clear when Lehman Brothers went broke. All of a sudden, the counter-party in many hedges had disappeared. The financial crisis has confronted energy companies with these risks. We can daily see that they are consciously trying to mitigate them by adding new clauses or interpreting old clauses more to the letter regarding take-or-pays, financial securities or payment terms.

People tend to look at markets with the deterministic approach that we apply in our daily physical life. If I let a pen drop, I can be pretty sure that it will fall on the floor. The fact that it has done so in the past, gives us relevant information of what it will do in the future. This is not the case in economics. First of all, the number of factors influencing markets is huge. Therefore, the market price is not the result of a simple cause and effect process like dropping a pen. It more resembles the mishmash of causes and effects and effects that cause new effects, and so on, that we know from weather forecasting. And we know how difficult it is to interpret such multi-cause and effect systems. This weekend was supposed to be rainy, according to last Friday’s weather forecast. It was the sunniest weekend of the year. Moreover, markets are made by people. People react on the information that they get. And this adds a crucial element of unpredictability to markets. But we fundamentally dislike this unpredictability. Therefore, someone telling that he can read the future of the markets better than everybody else, looks like an attractive proposal. That is the reason why people entrust guys like Bernard Madoff with their money. And we can see the same thing happening in the energy markets. Consultants that base their services on forecasting will continue to find clients for that. I also find the mathematical wizardry that they apply to support their advices often quite impressive. Only, so far I haven’t seen one of those systems give the right kind of information. On the contrary. Most systems are so hapless in identifying trend reversals that they constantly make clients fix energy prices much too late. If your interest as an energy procurement consultant is mainly in building long term relationships with your clients, you will carefully avoid forecasting. But people will continue to pay money for forecasting services to consultants that create the impression that they have a better knowledge of where the market is heading.

One of the reason’s that Bernard Madoff could attract so many people to what was basically a simple pyramid system or Ponzi scheme, was his reputation. The man had been non-executive chairman of Nasdaq and as such he was regarded to be an authority. (And judging from his pictures, he looks like a sympathetic guy.) Even if it is a medieval idea, we attach more importance to authority than our enlightened spirits confess doing. Just look around at conferences. The guy with the huge experience at a reputed institute gets a lot more attention than the one from the start-up, however interesting the latter’s ideas might be. Again, we often observe this in the energy market. I once saw a client waiting to fix prices because their CEO had talked to the boss of a major oil company that had told him that he was convinced that the oil prices would fall. Many people take advice from their energy suppliers when taking their price fixing decisions. That is, they believe that energy suppliers are authorative when it comes to talking about the direction of the market.

However deep their knowledge of the market, I don’t believe that energy suppliers know any better where they are heading than any one of us. If they would, the price development in those markets wouldn’t be so volatile. Moreover, if they had that knowledge, why would they share it with their clients? I would imagine that such information would be considered to be of strategic importance. It would give them a huge edge over their competitors so would they send out their account managers to share it with everyone? The same applies to a consultant. If I would know what the future of the energy prices is, I could win a lot more money as a hedge fund manager than as an energy procurement consultant. It’s a phrase often used, but mostly ignored: anyone that knows what the future price of energy will be, would sit under a palm tree in the Bahamas.

The Madoff case reminds us that no miracle solutions for dealing with markets exist. The future of the market is unpredictable. We better protect ourselves from the risks of that unpredictability instead of trying to bypass it.

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