For someone who once made his living shouting and waving his hands in other people's faces, J. Robert (Bo) Collins, president of the New York Mercantile Exchange, is surprisingly soft-spoken. He speaks with a calm assurance about a marketplace in energy futures that has been anything but calm in recent months-not to mention that the Nymex building is only about 100 yards from where the World Trade Center stood. Terrorist attacks, imploding Enrons, skittish traders and the chronic volatility of commodities that trade in the pits have only served to reinforce the position that the exchange holds in the tumultuous energy world. Risk, after all, is what producers go to Nymex to hedge, and speculators to capitalize on. One risk, however, one will not encounter at Nymex is the risk of counterparty default, which Enron demonstrated so dramatically on the OTC (over-the-counter) market just a few months ago. Nymex guarantees the creditworthiness of each trade through its roster of clearing members who collect deposits called margins from buyers and sellers to cover any potential losses because of their position in the market. The clearing members also contribute to a "guarantee fund" to cover a default by a customer. In 130 years, it hasn't been needed. The challenge that Nymex faces, besides coping with the volume of trades-which already exceeds 1,000 contracts a minute-is extending the guaranteed liquidity available through the exchange to the OTC market, a process that is happening at nanospeed as its trading systems expand online. And at press time, Nymex was rumored to have reopened talks with a rival, the web-based Intercontinental Exchange (ICE) of Atlanta, about some kind of alliance. Oil and Gas Investor met with Collins in January on myriad topics, including the different schools of thought held by E&P executives about the role of Nymex in the pricing of oil and gas, and the future of trading as it moves beyond the open outcry of its trading pits and onto the Internet. The concept of a transparent, free market is widely supported in the energy industry. Nymex is where the concept is put into practice. Investor How would you characterize the extent of hedging among independent producers today? Collins There are two schools of thought among producers-well, three. One is the wildcatter who gets emotionally tied to the product he's pulling out of the ground and, if it's natural gas, he thinks it's worth $10 all the time. Any price other than that he suspects is because of some collusion. Another school of thought is held by investors who expect to have price risk-in fact, the reason they are investing in your company is to have exposure to the potential rise or fall of the price of your product. The third is held by those who don't care if they are producing crude or water or air or cotton balls or whatever. They see hedging as an opportunity to invest their dollars and lock in a guaranteed rate of return on that investment of 30% to 40%. That's a home run by anybody's standard. Investor Nymex is more than 100 years old, but the futures market in energy products is relatively new. Why? Collins The energy risk-management universe really began in earnest around 1980, and it evolved for 20 years in somewhat of a vacuum. The principal instruments people used were the Nymex futures, and perhaps some counterparty relationships that could be customized for an independent oil and gas producer, or, for that matter, an Exxon. As the world of finance began to understand derivatives and financial engineering better, that expertise bled into the oil patch. As a result there has been an explosion of products designed to help the users and producers of the products manage risk. Technology now allows us to absorb 100 or 200 product categories, where in a traditional phone-based OTC system or in our pits it's much more difficult to get beyond four, five or six key products. Today an independent producer or an Exxon is faced with a vast array of choices. Investor Too many, some think. The energy markets can seem hopelessly complex. Collins In a sense it has become more complex for an end-user to make a simple transaction, but inherent in that complexity is a more efficient market. The odds are also good that you can come up with a final product that truly fits your needs. For instance, let's say you're a producer of 100% Rockies gas. A classical hedge five years ago might have been to call up Nymex and place a one- or two-year strip on our floor, and consider yourself done. You've hedged your exposure but you had to deal with that last-day risk on physical delivery. Then the over-the-counter market started creating basis markets (the difference between the region-specific cash price and the exchange's futures price). So instead of worrying about that disconnect of Henry Hub pricing versus Rockies pricing, you can now move your actual hedge so that the net exposure of your financial position will be on Rockies gas. As an independent you now have a much more secure position. Investor Why haven't more smaller producers committed to hedging? Collins A classic issue they deal with is cash flow. To the extent that you hedge your gas on the Nymex, and the market rallies to $10, you're responsible to make up the financial difference of that movement right then; not when you deliver the gas. That means you're writing a check to your bank before you get paid. That's probably been the main deterrent for a small independent producer to hedge. However, now energy merchants will write you a contract that allows you to hedge your production without having to worry about paying margin. They then turn around and hedge it on us. Investor In what ways will the market change as it expands into an electronic universe based on the Internet? Collins Moving into the electronic universe is going to allow us to provide the customized products that are traded over-the-counter with the same transparency, the same liquidity and the same open access that our core products have had for years. The issue of trust with a merchant now becomes much more defined. You will know in a free market at the Nymex where Chicago basis or Rockies basis is trading, for example. That makes for a fairer market for everybody. Investor The amount of information available already can be overwhelming. Collins Yes. And that's the risk. Financial engineering is just like physical engineering: If you don't understand the details of what you are engineering it can explode on you. Investor How many people do you think really understand this type of financial engineering in the energy patch? Collins What I'm thinking is that there are 500 people in the energy patch that really understand it well. Investor That seems a small number, considering the size of the oil patch. It seems like a function of the maturity of the markets; a lot is yet to settle out. Collins It actually has settled out in terms of a standardization of products, at least in natural gas and crude. Power is still a rapidly changing and developing market. What hasn't settled out, and I don't think ever will, from the standpoint of merchants, is who's got the team that you can trust and can pick up the phone and execute a neat package? And who has a venue where you can place a trade electronically or through an exchange? There was a time when it appeared there were 50 new companies trying to get in the business of being an exchange. Investor The trading community includes a lot of different players: banks like Banc of America; merchants like the former Enron and Dynegy; even other exchanges like the IntercontinentalExchange. Are these other players your partners or your competitors? Collins I don't view them as competitors. In fact, I view them as a very important part of our food chain. The point of our exchange is to provide a highly standardized, highly centralized pool of liquidity that doesn't give either the buyer or the seller financial risk in executing on a product-by financial risk here I mean the risk of default. You don't have to worry about getting paid when you trade on the exchange. Investor As opposed to trading with Enron. How has Enron's crash affected you? Collins We've seen a growth in volume. Enron had made some inroads and was becoming a marketmaker to a lot of our traditional customers. The Enron model of trading is called "one to many." There's one liquidity provider to many, many participants. I think the marketplace has recognized that the one-to-many model is extremely risky. Investor That seems like an understatement. Collins When I was a trader at El Paso, we would use Enron as a standard to which to compare other companies' creditworthiness. We'd say things like, "These guys are as good as Enron." We may have anticipated Enron missing a quarter, but we never anticipated the implosion of the Enron system. Investor Is it the clearinghouse structure of Nymex-a kind of many-to-one model-that distinguishes it from the Enrons of the world? Collins Yes. We allow you to trade as freely as you want to trade in a fair marketplace that gives everyone equal access. All we do is guarantee that you'll get paid according to your trade. We have a 130-year history of successfully managing that process. Investor Your Internet-based trading system is Nymex Access. When did you launch that? Collins Our technology was rolled out four days after September 11. What Access does is allow a customer to approach the exchange electronically through a web-based format. One can either execute electronically or through the pit. Ultimately, what we are going to end up with is a very extensive reach that looks a lot like Enron Online. It will encompass those products and other OTC products, and give the customer the same functionality, the same guarantees and the same protection as Nymex. Investor Will electronic trades eventually take the place of open outcry? Collins I don't think so. It is likely that there will always be a pit. The reason is that the energy community has a certain quality to its volatility that requires the human process of open outcry. It happens to be a very efficient mechanism for exchange. People make the assumption that it couldn't possibly be as efficient as an electronic platform, but the reality is that, in terms of the actual price distribution process, the open outcry pit is more efficient. Investor Why is that? Collins It is in part because we have a dedicated marketmaker forum, and partly because the actual dispersion of that liquidity can happen nearly simultaneously in the open outcry market. There is an intense queuing process that occurs in electronic platforms. In other words, you really won't have 20 people all trading at the same price at the same time. What you'll have is 20 people all getting in line behind each other. For instance, as a trader, I could pick up two phones, put in orders with three or four guys, pick up two more phones, put in three or four more orders in the pit, and have the entire order completed and disbursed among a broad group of people nearly instantaneously. The same process would take me 15 minutes to execute online. I think the trading community is recognizing this now. Investor How would you describe the forces at work on the price of oil and gas? Collins I've seen the energy markets from nearly every vantage point-the only thing I haven't actually been yet is a regulator-and I'll tell you this: the common perception that there is a particular entity to blame for a particular price is unwarranted. As an example, I point to the Federal Reserve and ask Alan Greenspan how difficult it is to control the value of a dollar versus a given currency. Certainly there is no one in the world who has more power to collude on the price of the dollar. Our energy markets truly are free markets and the price mechanism provides a point of information to leadership in companies as to where they should be investing their dollars. If natural gas for a two-year period going forward is trading at $1.80 on Nymex, I think it is very prudent that North American gas producers reconsider their gas investments that don't pay a return on $1.80. Some day the typical push and shove of supply and demand will change that and the price will go up and you'll reevaluate your investment decision. The forces of supply and demand regulate a free market very well. Investor What about government intervention? Are you seeing a push to regulate the energy markets? Collins There is not currently-in crude and natural gas-any serious initiative I know of to regulate the price, partly because the market continues to prove that it does its job. Our market is the fulcrum of the amazing American model of price distribution. Where I think there is risk of regulation is in the power industry. A handful of special interests believe that whole problem in California was that we had free prices that were exploited by a small group of people. The reality is that the California marketplace did not properly plan investments around growing demand. The actual rules or structure of that marketplace were not appropriate to serve a free market and, in fact, penalized companies for responding to a free market. As a result it was a quasiregulated system that didn't work. No one is going to pass up the opportunity to sell gas at $60 as long as the government will let you. And if the government will let enough guys sell gas at $60, the price won't be $60 anymore. It'll be $5. I think there is a big body of intellectual knowledge around the American system of free enterprise that speaks to the right course of regulation. Over time, I have confidence it will prevail.