Texas Commercial Energy (TCE) filed for bankruptcy protection on March 6, 2003 (Cause No. 03-20366-C-11; In re Texas Commercial Energy LLC, debtor; in the U.S. Bankruptcy Court for the Southern District of Texas, Corpus Christi Division), following a sudden and dramatic rise in the price of wholesale electricity. TCE is an Allen, Texas-based 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 sells it on a retail basis to its customers. TCE typically enters into 12-, 24- or 36-month contracts with its customers to supply electricity at a fixed price.

During February 2003, the wholesale price of power in Texas increased dramatically and exceeded the price TCE was charging its customers. Prior to filing for bankruptcy protection, TCE was purchasing almost its entire supply of energy from ERCOT on the spot or "balancing energy" market rather than acquiring a steady long-term supply of power at a fixed price. TCE lacked the financial resources at that time to hedge adequately its power supply costs against price fluctuations in the market. ERCOT established the "balancing energy" market as a mechanism to allow REPs to buy and sell small amounts of electricity for immediate delivery and thereby balance their fluctuating obligations to supply and purchase power. The market also serves as the intermediary between REPs and generation companies in order to provide a source of marginal amounts of additional power to compliment a REP's fixed-price supply.

ERCOT is the Independent System Operator (ISO) for the electric grid in the majority of Texas. It is a member-owned, non-profit entity and is responsible for maintaining the integrity of the electric power market in the majority of Texas. The traditional vertically integrated, regulated utility has not existed in Texas since the electricity market was deregulated in January 2002. ERCOT has three categories of participants: generation companies (generators), transmission and distribution service providers (TDSPs) and load serving entities (LSEs). REPs, subgroups of the LSEs, purchase power from the generators and deliver that power over the TDSPs' power lines to the end users. This economic model is roughly similar to that used by resellers of telephone service. REPs make money just like any other retailer: They buy large volumes at wholesale prices and resell in smaller amounts to end users.

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Recharacterization is usually a risk to equity investors since equity recovers only after all creditors are paid in any subsequent bankruptcy case. By contrast, LCs are a credit support, not a loan or other transfer of money into a company.

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As a rule of thumb in the ERCOT market, short-term wholesale power delivered during the peak demand periods of the day sells for an annual average of 10 times the price of natural gas. For example, if gas sells for $5/mmBtu, then power will sell for $50 per megawatt-hour (MW-h). On Feb. 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, trading issues and practices that are currently in both dispute and litigation, transmission constraints and generation outages, spot prices for power continued to increase, reaching the ERCOT-imposed $990/MW-h cap for several hours.

Managing Supply Costs

A 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 strategy, a 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. Alternatively, it could enter into a tolling arrangement in which it delivers fuel to a generator and, for a fixed price, receives power in return. It could also contract for power to be delivered over a rolling three- or six-month basis. Finally, since there is not an options market for power in ERCOT, a REP could indirectly hedge its supply costs by purchasing call options on natural gas. While no single strategy can remove all of a REP's supply risk, an appropriate risk-management policy can minimize the volatility of a company's supply costs.

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 hedge effectively their supply risks. TCE, as a relatively young company that had undergone a modest amount of management change, was not financially strong enough to withstand the pricing volatility in the spot market.

Post-filing Strategies

After TCE filed for bankruptcy protection, ERCOT required the company to shed 80 percent of its 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 (LCs) for its purchases. TCE's equity owners posted these LCs for TCE's benefit. The credit support provided was sufficient to fund TCE's 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 source of both exit financing and long-term financing. Manti Resources, an independent oil and gas exploration and production company and 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 for TCE and manage the associated supply risks. Magnus markets all of Manti's gas production and uses that in addition to letters of credit as collateral for power purchases. With the approval of the court, Magnus entered into a 12-month contract with TCE to provide a revolving-credit facility that will be used to fund the purchase of up to $25 million of power. As collateral for this line of credit, Magnus was granted by the bankruptcy court a first lien on TCE's cash and accounts receivable along with other protections typically provided to a post-petition lender.

At the inception of the case, the view of the creditors' committee and its counsel was that a liquidation of TCE was likely to be the only workable alternative for creditors. After much consultation with financial advisors, analysis and review, the committee determined that a liquidation of TCE would provide a modest recovery at best for unsecured creditors. TCE's main assets were cash on hand, accounts receivable and the portfolio of customer contracts. At this point during the proceedings, the contracts had an average remaining term of eight 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 approximately $100. This benchmark, applied to TCE's 1,200 customers, valued the business at $120,000. The second approach was to take a market-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 accounts receivable and paying administrative expenses, the estate was projected to have $2.7 million in cash 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 reorganization plan called for the creditors to receive full repayment 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 challenge was to structure the proposed plan to provide the highest, most secure return to the unsecured creditors while not burdening the reorganized company to such an extent that it could not continue to grow and generate sufficient income from operations to repay the creditors in accordance with the plan.

The goal of the committee and its financial advisors was to negotiate a repayment plan that was feasible and realistic, and to simultaneously 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 fixed payments to ERCOT and the unsecured creditors on a quarterly basis. The unsecured creditors will also get a 25 percent net profits interest. The fixed 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 enforcing their rights in the event of a default. TCE agreed to a number of covenants, including minimum debt coverage and liquidity ratios and capital expenditure limits that provide the unsecured creditors with a mechanism to monitor and measure the debtor's post-confirmation financial condition and compliance with the terms of the reorganization plan. Finally, the debtor's equity-holders 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 and continue its business fully hedged.

Use of Letters of Credit

Letters of credit are a very effective way to capitalize a business like TCE. The use of LCs 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 REPs need a modest level of initial cash but a much larger level of credit to support the purchase of the energy supply for their operations. Second, LCs 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 on 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, LCs are a credit support, not a loan or other transfer of money into a company.

In Texas, the financial requirements for establishing a 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, it does nothing to mitigate the risk that a company will become vulnerable to market fluctuations if it lacks the financial ability to appropriately hedge its supply risks. 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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Footnotes

¹ Board Certified in Business Bankruptcy Law by the American Board of Certification. Return to article