Texas Commercial Energy (the "Company" or "TCE") filed for bankruptcy protection on March 6, 2003 in the Southern District of Texas following a sudden and dramatic rise in the price of wholesale electricity. TCE is a Retail Electric Provider ("REP") serving commercial and light industrial customers in the region of Texas administered by the Electric Reliability Council of Texas ("ERCOT"). TCE acquires electricity on the wholesale market and then resells it on a retail basis to its customers. TCE enters into 12, 24 or 36 month contracts with its customers to supply electricity at a fixed price. When the wholesale price of power exceeded the price TCE was charging the result was the inability of TCE to pay its bills as they came due. At the time of the bankruptcy, TCE was purchasing almost its entire supply of energy on ERCOT’s "Balancing Energy" market as opposed to locking in a steady supply of power at a fixed price. At the time of the bankruptcy, TCE lacked the financial resources to properly hedge its power supply against price fluctuations in the market. ERCOT established the "Balancing Energy" market as a mechanism to allow REP’s to buy and sell small amounts of electricity for immediate delivery and thereby balance their fluctuating obligations to supply and purchase power. ERCOT acted as the middleman between REP’s and generation companies for the purpose of providing a marketplace for additional power to compliment the REP’s fixed-price supply.
ERCOT is a quasi-governmental non-profit entity responsible for maintaining the electric grid and the integrity of the electric power market in the majority of Texas. The traditional integrated, regulated utility has not existed in Texas since deregulation in January of 2002. The ERCOT model has three categories of participants – Generation Companies "Generators"), Transmission and Distribution Service Providers ("TDSP’s") and Retail Electric Providers ("REP’s"). REP’s purchase power from the Generators and deliver that power over the TDSP’s power lines to the end users. This economic model is roughly similar to that used by resellers of telephone service. REP’s make money just like any other retailer – they buy large volumes at wholesale prices and resell in smaller amounts to end users.
As a rule of thumb in the ERCOT market, short-term wholesale power sells for 10 times the price of natural gas. For example, if gas sells for $5/mmBtu, then power will sell for $50/MW-h. On February 24 and 25, 2003 during an unusually severe cold snap across the country, the price of natural gas on the spot market rose to $22/mmBtu and power followed suit with prices rising to $220/MW-h. At the time, typical rates for retail power varied from $75 - $85/MW-h. Due to a variety of factors, including the extended period of extremely cold weather, some issues relating to trading which are in dispute, transmission constraints and generation outages, spot prices for power continued to sharply increase, reaching the $990/MW-h cap for several hours. TCE was purchasing all of its power on the spot market, and was completely exposed to this price increase. The Company was unable to withstand this sharp rise in its supply costs.
An REP makes money by successfully managing its supply costs. There are several strategies for managing the risk of sudden increases in the cost of wholesale power. Customary practice is to match the term of load requirements with the term of supply agreements. Starting with the most expensive, an REP could purchase all of its requirements in the forward market under a Power Purchase Agreement – essentially paying today for power that will be delivered in the future. It could enter into a tolling arrangement in which they deliver fuel to a generator and, for a fixed price, receive power in return. It could also contract for power to be delivered over a rolling 3 or 6 month basis. There is not an options market for power in ERCOT, but an REP could indirectly hedge their supply costs by purchasing call options on natural gas. While a well-established, investment-grade company would normally establish "pay as you go" terms with its suppliers TCE had neither the capital nor the credit to qualify for these payment terms. More importantly, TCE did not have the capital to implement any significant hedging program. TCE chose to manage its risk by purchasing all of its supply on the spot market, betting that gas prices would stay low while the company used its limited capital to aggressively pursue new customers and grow revenues. This strategy is perfectly reasonable, if a company has the financial resources to withstand a sudden and sustained rise in supply costs. In TCE’s case, however, this strategy was a recipe for disaster. While an effective hedging program is not necessarily capital intensive, it is certainly credit intensive. A company of TCE’s size requires capital or access to credit roughly equal to three months of supply costs in order to effectively hedge their supply risks. TCE, as a relatively new company which had undergone an amount of management upheaval, was not financially solid enough to withstand the pricing volatility in the spot market.
After filing for bankruptcy protection, ERCOT required TCE to shed 80% of their customers and to begin hedging by buying power on a month-ahead basis. As an interim solution, TCE negotiated a deal with Coral Energy to supply power and risk-management services. Coral required TCE to post letters of credit ("LC’s") for its purchases. The credit support TCE provided was sufficient to fund power purchases on a monthly basis, but not enough to hedge any supply costs for more than 30 days.
In order to successfully reorganize, TCE needed a future source of both exit financing and long-term financing. Manti Resources, the majority owner of TCE, was unwilling to inject any fresh capital directly into TCE. As a solution, Manti established Magnus Energy Marketing to procure power and manage TCE’s supply risks. Magnus markets all of Manti’s gas production and uses this and letters of credit from Manti and TCE’s other equity owner as collateral for power purchases. Magnus entered into a 12 month contract with TCE to supply up to $25 million of power. TCE then proposed Magnus as a post-petition lender to TCE to the extent of its funding of TCE’s power purchases. As collateral for this line of credit, Magnus has a first lien on TCE’s accounts receivable and other protections granted a postpetition lender under the Bankruptcy Code.
At the inception of the case, the view of the Committee and counsel was that a liquidation of TCE may be the only workable alternative for creditors. Later, after much consultation with financial advisors, analysis and review, it was determined that a liquidation of TCE would provide a modest recovery at best for unsecured creditors. TCE’s main assets were cash on the books, accounts receivable and the portfolio of customer contracts. The contracts had an average remaining term of 8 months. The Committee’s financial advisor used two different approaches to value these contracts. First, recent transactions involving the sale of a similar mix of customer contracts showed that the market value of a customer contract was $100. This benchmark, applied to TCE’s 1,200 customers, valued the business at $120,000. The second approach was to take a Mark-to-Market approach and evaluate the Gross Margin that could be earned by retaining the existing terms of the contracts. This approach, after applying a discount for selling the contracts at auction, valued the portfolio at $1.2 million. After collecting the receivables, and paying administrative expenses, the estate was expected to have $2.7 million available to repay $34 million in claims. The creditors’ best hope for a reasonable recovery was repayment over a period of time from the Debtor’s continued operations.
TCE’s initial plan of reorganization called for the creditors to receive full payment of their claims out of a share of future profits over an extended and indefinite period of time. The financial advisors to the Committee tested the assumptions underlying the initial proposal and believed the Debtor’s proposal to be inherently risky for the unsecured creditors of the estate. The issue became how to provide the best, most secure return to unsecured creditors while not burdening the reorganized Debtor to such an extent that it could not continue to grow and generate income from its operations in an amount sufficient to pay creditor claims.
The challenge for the creditors and their financial advisors was to negotiate a proposed repayment plan which was feasible and realistic; and to convince TCE’s equity owners to provide some level of credit support for the promised payments. The final agreement separated TCE’s payments into three different streams. TCE agreed to make lump-sum payments to ERCOT, and the unsecured creditors on a quarterly basis. The unsecured creditors will also get a 25% net profits interest. The majority of the payments were structured as a note rather than a profits interest to give the creditors more certainty of the timing, likelihood of delivery and a means of enforcement in the event of a default. TCE agreed to a number of covenants, including minimum debt coverage and liquidity ratios and capital expenditure limits which provide the unsecured creditors with a means to monitor the debtor’s post-confirmation financial condition. Finally, the equity holders of the Debtor agreed to provide a letter of credit in the amount of $1.3 million for the benefit of the unsecured creditors. The amount of the letter of credit was equal to the value Manti, TCE and the Committee agreed was likely to be recovered in an actual liquidation sale. The plan structure provided a workable mechanism for TCE to repay its creditors from operations, continue its business fully hedged and with much less risk of exposure to market fluctuations in the future.
Letters of credit are a very effective way to capitalize a business like TCE. The use of LC’s can accomplish two things for an actively involved equity investor. First, they amplify the value of an investment Depending on the investor’s relationship with the issuing bank, $1 held as security can support $4 - $8 in letters of credit. ( Of course, the investor still remains liable on a guaranty usually given to the issuer for the total amount of the letter of credit. ) Credit-intensive businesses like REP’s need a modest level of initial cash but a much larger level of credit to support the purchase of its energy supply for its operations. The second thing LC’s do for an investor is to protect against subsequent recharacterization in the event of a bankruptcy. A traditional loan or preferred stock investment can sometimes be recharacterized as an equity investment depending upon the presence of certain other factors Recharacterization is usually a risk to equity investors since equity recovers only after all creditors are paid in any subsequent bankruptcy case. By contrast, LC’s are a credit support, not a loan or other transfer of money into a company.
In Texas, the financial qualifications to become an REP are minimal. While this policy encourages start-up companies to become involved in the ERCOT market and to further the goal of deregulation of the retail power market, there is certainly the risk that a company will become vulnerable to market fluctuations if it lacks the financial ability to become fully hedged. Letters of credit are one way to provide such credit support and can be used effectively in a bankruptcy case to provide additional financing and equity-type capital for a debtor.
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