ENERGY TRADING RISK MANAGEMENT - · PDF file November 2010 Energy Trading & Risk Management...
Transcript of ENERGY TRADING RISK MANAGEMENT - · PDF file November 2010 Energy Trading & Risk Management...
www.ogfj.com ◆ November 2010 ◆ Energy Trading & Risk Management� 3
Most areas of risk management are often thought of
as the necessary evil. That being said, it’s a funda-
mental task that encourages success. Wouldn’t it
be nice though if we could convert a risk management task into
a potential profit center? Unlike many of the other risk manage-
ment tools, the financial vehicle for energy price risk manage-
ment is very liquid and therefore affords the opportunity to
enhance the outcome.
Market landscapeThe post-Hurricane Ike [September 2008] energy market contin-
ues its wild ride. While the prompt crude market seems to have
found a niche between $70 and $80 over the last 12 months or
so, the nearby natural gas contract on the other hand has been
very fickle. This market uncertainty and continued volatility of
natural gas accent the need for E&P companies to re-review
their hedging strategy and concern.
Interestingly, the shale-rush continues its hype, even
though the current natural gas price curve alone provides very
little cushion (if any) above the all-in economics to support such
development. With the current market profile, it’s understand-
able why the oily shale plays are getting the most attention.
Not only by the drill bit, but via acquisitions, growth within
this tighter commodity price environment puts a greater weight
Hedging should be an allyOver the past six-plus years, the industry has seen an increase
in overall price volatility, which has brought the focus of hedging to the forefront for producers and their lenders.
Thomas Heath, Asset Risk Management LLC, Houston
4 Energy Trading & Risk Management ◆ November 2010 ◆ www.ogfj.com
to all cost/risk management plans, including but not limited to
the commodity price protection targets.
Although the healthy contango (upward sloping forward
curve) within the crude market comes and goes with the wind,
the back of the natural gas curve has continued to erode.
And, this lack of optimism not only promotes uneasiness for
producers, it also curtails a few of the derivative products likely
to be effective or reasonable. Over the past six-plus years, the
industry has seen an increase in overall price volatility, which
has brought the focus of hedging to the forefront for producers
and their lenders.
Producers hedge for various reasons: to lock-in future cash
flow on existing production, to lock-in anticipated cash flow
on production associated with acquisitions, to increase the
borrowing base within their banking facilities or lending syndi-
cates, and ultimately to reduce the impact of price volatility on
company profits.
Although tactics vary, some producers lock in a high per-
centage of their
PDP, while others
hedge only what
their banking
group man-
dates (in order
to assure the
funding needed
for their current
drilling pro-
grams). Produc-
ers even differ in
how they imple-
ment hedges,
with some taking
a systematic
approach to
execution timing
(as well as the
tenors of the
hedge), while others try to time the market and lay on hedges
opportunistically.
I’m not sure anyone, including producers, has the capacity
to conquer or perfectly time such a capricious market. A quick
look of the natural gas performance since 2004 shows how
dramatic the prices can move: we’ve been from the mid $4’s to
over $15, back to low $4’s and then a steady 12-month climb
to $13. It took less than 60 days for the market to completely
erase all of those gains—an incredible 95% reversal in two
months (and that’s all pre-Ike).
Since Ike, we have traded up to $7.50, down to $2.50, back
up to $6.00 before sliding again. It should come as no surprise
there has been a dramatic increase in hedging activity and in
response to those swings, which in turn support the liquidity
and transparency within the financial space.
STATIC versus DYNAMICEven though there are differing opinions on why, how, and
when companies should hedge, a few consistent themes have
emerged. Nearly every producer has some portion of its pro-
duction hedged. Nearly every producer has used fixed-price
swaps and/or costless collars to hedge that production. And
finally, nearly every producer has taken a passive approach
to their hedging programs by implementing the structures –
and enduring the good and the bad results for the life of the
hedge, in order
to obtain that
fixed price point
or price range.
For years,
some produc-
ers have tended
to implement a
“static hedge”
strategy, i.e.
they put their
hedges on and
rarely revisit
them throughout
term. So many
E&P companies
manage every
aspect of their
business down
to the bore-
hole, but often
neglect their hedge portfolios. The static hedge strategy offers
adequate protection at the time of implementation. However,
the volatility of the market can often negate the effectiveness
of the original hedge.
Another big drawback to the static approach, it puts a huge
burden on management to determine “when is the best time to
hedge or place the bet”? And as suggested above, few should
claim they can predict what’s going to happen tomorrow in
these markets, much less months over the horizon.
That being said, a more sophisticated risk-valued model
(called “dynamic hedging”) utilizes an active approach with the
ultimate objective to increase participation in the upside and/
or increase in the protection. Therefore the timing of the initial
hedge is not as absolute or critical for a dynamic program. The
dynamic approach utilizes volatility to transition or enhance in
“[Some] producers tend to implement a ‘static hedge’ strategy, i.e. they put their hedges on and rarely revisit them throughout term.”
www.ogfj.com ◆ November 2010 ◆ Energy Trading & Risk Management� 5
favor of the producer. It only makes sense that these hedges
should be continually managed in such a volatile environment.
Asset Risk Management (ARM), helps producers develop,
implement, and continually optimize/manage their hedging
portfolio, to facilitate or allow for additional upside participa-
tion or downside protection. Our team monitors over 50 active
clients, which include nearly as many public companies as
private.
Although we take the task of getting efficient execution very
seriously, our real value is monitoring and managing each indi-
vidual client’s hedge portfolio utilizing current market funda-
mentals. We absolutely take a view, just as any producer does
when they decide to hedge. We use that view to determine
what hedge structures make the most sense for the individual
client.
Our suggestions focus on the non-exotic, simplistic hedge
structures. Everything we do with our clients is “bank friendly”,
i.e. value building and risk reducing.
Our main objective is to apply,
adjust, and/or optimize each hedge to
the changing environment of the mar-
ket allowing for better performance
in terms of actual price realization
without compromising the downside
protection of the initial hedge.
Managed portfoliosProducers that hedge on their own are
more likely to miss (or not be aware
of) such optimization steps, and will
typically receive little to no upside
participation as prices surge upward
or miss the opportunity to increase
their downside protection as the prices
drop.
Accepting the fact, the crude and
natural gas volatilities and the underly-
ing prices will continue its chaotic
trends, a managed book is the ideal
way to leverage the opportunities and
capture value and/or de-risk the posi-
tions.
Actual exampleAs an example of an actual managed position, see Figure 1.
In this particular case, the producer was like many, had a fixed
price swap that was well in-the-money. Rather than looking to
eliminate the swap to take the value and create downside risk
should prices fall further, ARM was able to create a way where
the producer would not only would benefit from the existing
hedge, but benefit additionally if prices were to settle at $4.25
or higher. We continue to monitor and seek further opportuni-
ties to enhance the position.
Participating in the managed hedge program the producer
squeezes the most, if not all, of the upside as the market climbs
higher. Although it sounds easy to do, it takes quite a bit of
expertise to manage these portfolios.
ARM identified certain aspects of the company that would
affect what type of hedge structure would be optimal to
achieve the company’s goals and provide maximum flexibility to
optimize both the existing portfolio of hedges, as well as new
gas volumes. “…typically we look at the company’s risk appe-
tite, debt load, existing hedge portfolio, as well as where our
client truly starts experiencing pain from decreasing prices.”
In addition, we looked at the current market dynamics to
see what value could be extracted. As the market began its
drop at the beginning of the season, ARM took a view based
on the market fundamentals and technical influences and then
advised its client accordingly (without ever compromising the
original levels of price protection). As a result, this began to
open the upside for the producer in order to provide greater
participation, and continued to extract the value opportunities
presented by the vacillating market.
ConclusionWe hope the oil and gas industry has
matured beyond the era of simply
locking in a price and hoping for the
best. A static approach to hedging in
a dynamic market is at best a 50/50
chance. However, an actively managed
portfolio can increase those odds in
order to assure the maximum amount
of value is captured for sharehold-
ers. OGFJ
About the authorThomas Heath is senior vice president for Texas-based Asset Risk Management LLC. He has more than 25 years of energy industry experience, including creat-ing and leading a de novo energy derivatives desk for Union Bank, an affiliate of Bank of Tokyo-Mitsubishi UFJ Ltd. Formed in 2004 by former Natural Gas Clearinghouse and Duke Energy veterans Gil Burciaga and Zach Lee, Asset Risk Management assists E&P companies in developing and executing hedging strate-gies. For more information, visit www.asset-risk.com.
“Producers even differ in how they implement hedges, with
some taking a systematic approach to execution timing
(as well as the tenors of the hedge), while others try to time
the market and lay on hedges opportunistically.”
www.ogfj.com ◆ November 2010 ◆ Energy Trading & Risk Management� 7
A llegro is a global leader in energy trading and risk
management solutions for power and gas utilities,
refiners, producers, traders, and commodity con-
sumers. With more than 26 years of deep industry expertise,
Allegro’s enterprise platform drives profitability and efficiency
across front, middle, and back offices, while managing the
complex logistics associated with physical commodities.
Allegro provides customers with flexible solutions to manage
risk across gas, power, coal, crude, petroleum, agricultural,
emissions, and other commodity markets, allowing decision
makers to hedge and execute with confidence.
The Allegro 8 platformWith eight generations of software and continued market and
global expansion, Allegro is committed to staying at the fore-
front of the industry with innovative technology and by antici-
pating market needs. Among the solution’s many features:
• Ability to easily capture and monitor physical and financial
transactions
• Comprehensive risk management including real-time Mark-
to-Market (MtM) reporting, Profit & Loss, option valuation,
and simulation
• Improved decision-making with seamless integration of
current, futures and forward prices from a variety of data
sources, and the capability to view, execute and capture
transactions on the world’s leading commodity exchanges
• Supports capture, trade and tracking of all energy com-
modities, including emissions certificates and renewable
credits
• Hedge Accounting, Fair Value Disclosure, and FASB Com-
pliance Capabilities
• Derivatives management, real-time reporting, accurate
settlement and invoicing
• Complete credit risk visibility and counterparty analysis
• Fully integrated logistics capabilities for pipeline, rail,
truck, and vessel
Award-winning software solutions:• Ranked top ETRM Solution by Energy Insights, an IDC
Company
• Positioned in Leader’s Quadrant in Gartner, Inc., Report on
ETRM Platforms
• Energy Risk Software House of the Year 2009 and for Asia
2008
• Energy Business Awards, Silver Award for Excellence in
Energy Technology 2009
Allegro is headquartered in Dallas, Texas and serves cus-tomers worldwide with offices in Calgary, Houston, London, Singapore and Zurich. Allegro also leverages a global network of partners, including Deloitte, The Structure Group, Platts, IntercontinentalExchange (ICE), and Indra.
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8 Energy Trading & Risk Management ◆ November 2010 ◆ www.ogfj.com
News Briefs
Survey says energy trading firms not prepared for new regulationsFacing increased scrutiny from regulators,
energy trading companies acknowledge
the many risks entailed in failing to estab-
lish effective compliance programs, but
are currently challenged by compliance
costs and shifting enforcement priori-
ties, according to a newly released survey
by compliance software provider NICE
Actimize, a NICE Systems Company, and
international law firm Fulbright & Jaworski
LLP.
Of the 140 energy trading representa-
tives polled in the study, none believed
that audit and enforcement actions taken
against energy trading firms will decrease.
Yet in the face of increased scrutiny from
regulators, more than one-quarter of
the respondents believe their organiza-
tions are not devoting sufficient staff and
resources to compliance priorities.
“Similar to the risk management arena
a decade ago, the energy industry is
becoming convinced that the failure to
implement effective controls could lead
to significant risks, regulatory enforce-
ment, potential penalties, and reputational
harm,” said Jim Heinzman, managing
director of trading markets at NICE Actim-
ize in New York City. “The research indi-
cates that the industry recognizes the risk
and harm associated with not investing in
compliance, yet most organizations are
not currently using systematic compliance
programs but rather manual or first gen-
eration systems for compliance analysis.”
“We are at an inflection point in the
energy trading industry,” said Erik J.A.
Swenson, a partner at Fulbright & Jawor-
ski in Houston. “The regulatory require-
ments and oversight expectations have
increased, but the industry is challenged
with how to respond to the evolving
expectations. We expect firms to continue
to adapt to this new regime by implement-
ing new programs in the next 12 to 24
months as the regulatory front continues
to evolve.”
The research indicates that many in the
energy trading industry recognize that
regulators are increasing their enforce-
ment activity, resources and infrastructure.
About 80% of respondents believe regula-
tory audit and enforcement actions against
energy trading firms will increase. Nearly
40% of respondents believe regulators
already have the capability to examine
energy trading activity, while others
believe regulators will increase surveillance
capabilities in the coming years. Accord-
ingly, improved compliance programs
and infrastructure, including the use of
automated surveillance, may become a
significant industry need.
There is an apparent gap between how
respondents perceive their own compli-
ance capabilities versus those of the indus-
try as a whole. Only 14% of respondents
rate the energy trading industry’s readi-
ness to comply with new energy trading
regulations as “good” or “excellent,” yet
nearly two-thirds of respondents felt that
their own firms’ internal compliance and
control systems were capable of meeting
new requirements.
Fewer than half of respondents indi-
cated they currently have an oversight
system in place that monitors for suspi-
cious activity on a daily or intraday basis.
Collectively, this data suggests a discon-
nect between the industry’s understanding
of, and execution against, current and pro-
posed regulations that require daily, and in
some instances, intraday, monitoring.
To access the full survey results, go to
http://actimize.com/energytradingreport.
Financial services company touts opportunities in carbon marketCarbon Credit Capital has released an
executive report about the prospective
business opportunities that US companies
have in the carbon market. The report,
“Carbon Offsets: US Business Oppor-
tunities Executive Report”, provides US
companies that are large emitters of
greenhouse gases (as defined by the US
Environmental Protection Agency) with a
concrete plan to develop a low-cost strat-
egy to mitigate their future greenhouse
gas liability.
As the global carbon market reached
a total value of $144 billion in mid-2010,
the carbon market continues to be the
fastest growing global commodities
market world-wide. The report explains
the economics of the carbon market to
an audience of large to medium-size US
companies that are likely to be subject to
carbon emissions legislation in the near
future. The report demonstrates that if a
federal bill passes, power companies, coal
mining operations, cement, chemical, and
steel plants, can reduce their cost of com-
pliance and benefit from taking measures
in the near term.
In addition, CCC presents a cost-
benefit analysis of a company investing
in internal energy efficiency projects
and compares these to the lower cost of
domestic and international offsets as part
of a greenhouse gas (GHG) reduction
plan. CCC shows how offsets can be more
economical than allowances, and provides
practical steps for a company to forecast
the cost of meeting its GHG liability under
a federal bill.
Even though the US has not yet passed
federal climate legislation, the report
reveals that investing in carbon offsets
today provides companies with alterna-
tives that will save money in the short
to medium term. CCC believes this is a
cost-effective strategy for US companies
and lists several reasons: 1) there will not
be enough domestically generated carbon
offsets available to cover compliance
needs for capped companies; 2) a strong
portfolio of carbon offsets can create
“Similar to the risk management arena a decade ago, the energy industry is becoming convinced that the failure to implement effective controls could lead to significant risks, regulatory en-forcement, potential penalties, and reputational harm.” – Jim Heinzman, NICE Actimize
con’t on pg.8
www.ogfj.com ◆ November 2010 ◆ Energy Trading & Risk Management� 9
Q. We tend to think of the heyday of energy trading as the late
‘90s and early 2000’s – before the Enron crash. Is it true that
more energy trading is taking place today than ever before? A. Yes, and for a variety of reasons. Market participants and traders
are attracted to price volatility, and with the highly publicized run-up
in Crude Oil prices in 2008, we have witnessed energy commodities
emerge as an attractive asset class to a whole new breed of investors.
As a result, the concentration of trading that we witnessed with Enron
is now dispersed with a far more companies engaged in energy trad-
ing. Technology has also played a role in allowing for greater trading
volumes. The NYMEX merger with the CME has migrated the futures
market to be traded electronically, eliminating what had been a barrier
to price discovery and providing for greater ease in trading execution.
Q. Approximately what percentage of energy trading today is
physical trading versus financial (paper) trading? Is there a dif-
ference in the type of systems required for each type of trading
activity? A. The volume of physical trading still outnumbers that of financial
(derivative) trading, although the gap between the two is narrowing.
From a systems perspective, transaction management of a derivative
is far simpler than the requirements brought on by physical trading
activities. With multiple modes of transportation and storage, the
physical characteristics of a commodity creates significant complexity
for a system. Given the breadth of requirements driven by physical
trading, it is often a challenge to find a single software vendor that
delivers both transaction management (deal lifecycle) and risk man-
agement capabilities across multiple commodities and geographies.
Q. Do some energy traders still use spreadsheets or have most
switched over to commercial software? A. It is no secret that spreadsheets are hands-down the most
pervasive technology on an energy trading floor today. In decades
gone by, we envisioned a day where spreadsheets would no longer
exist but with the benefit of two decades in the business and see-
ing how this industry continues to innovate financial and physical
products – coupled with the complexity of evolving systems – it is
difficult now to foreshadow spreadsheets vaporizing from energy
trading floors in our lifetime. So, the challenge becomes how to cre-
ate a work environment of well-behaved spreadsheets synchronized
with the firm’s ETRM system rather than “replacing” spreadsheets.
With the few exceptions for custom developed systems, all energy
traders use some form of commercial ETRM software.
Q. Have risk management systems become significantly more
sophisticated in recent years?
A. Yes, although the changing
nature of the energy trading
markets means these systems
are often lagging the market
(and traders’/portfolio manag-
ers’ innovations) by a few
years. By and large, systems
investments by the large
vendors in the space have cen-
tered around (a) increasing the
number of energy commodities and geographies that the systems
handle in the energy complex and (b) updating the technological
underpinnings of the systems. Systems today handle integration of
electronic trading, cross-border/multi-currency, and have greatly
enhanced their risk reporting capabilities. From a risk management
perspective, today it is standard for systems to calculate value at
risk, option greeks, display risk measures in charts or heat maps,
and offer P/L change explanation reports as “out of the box” func-
tionality. This certainly was not the case just a decade ago.
Q. Finally, how would you describe the functionality of today’s
ETRM systems versus those of several years ago? A. The systems today support greater straight thru processing,
which allows for transactional efficiency and transparency of deals
through a deal lifecycle. Systems today also feature much more
robust measurement of risk, and embedded reporting capabilities
that allow the end user to manipulate date to slice and dice informa-
tion on their own (something that used to require a programmer to
do). Increasingly we are seeing vendors embrace visualization capa-
bilities, to bring different types of data and different technologies
together. As an example, several vendors can overlay their physical
inventory and pipeline information onto a Google earth map to
allow one to quickly ascertain position and price in a tangible way.
Don Jefferis, Partner
713-237-4810; [email protected]
Marty Makulski, Partner
713-237-4812; [email protected]
Houston • Denver • London
Q&A with Opportune Partners Don Jefferis and Marty Makulski
Don Jefferis and Marty Makulski jointly run Opportune’s process and technology practice.
Opportune
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10 Energy Trading & Risk Management ◆ November 2010 ◆ www.ogfj.com
News Briefs
additional revenues for companies that sell
carbon offsets at higher prices after regu-
lations are implemented; 3) early action
allows for careful planning and for the
opportunity to put together a high quality
offset portfolio and to gain experience in
the carbon market.
In the “Carbon Offsets: US Business
Opportunities Executive Report,” CCC
predicts that the US carbon market will
expand to $2 trillion to 3 trillion over the
next five years if a cap-and-trade scheme
passes Congress. Given the potential
growth of the US market, investing in car-
bon offsets is a way for US companies to
keep their cost of compliance lower during
the next 20 years, according to the report.
Carbon Credit Capital LLC is a renew-
able energy financial services and project
development company dedicated to using
carbon finance to catalyze greenhouse gas
(GHG) reduction projects in India and Latin
America. The company identifies offset
projects, attracts financing and brings its
expertise in carbon finance and clean energy
to project development teams in the US and
in the countries where it works with compa-
nies that are developing offset projects.
Cognito Analytics launches new media profiling serviceLondon-based Cognito, the specialist PR
and marketing agency for the financial
sector, said that its new media profiling
service, Cognito Analytics, was slated
to support Finextra and Swift’s first B2B
social media webcast on October 27
at this year’s Sibos, in Amsterdam with
participation from Citi, ING, SEB, and
SunGard.
Cognito Analytics enables firms in
the financial services sector to track and
monitor their media profile and compare
themselves against competitors.
Cognito has taken a leading interest
in how B2B social media is affecting the
financial industry and carried out research
into the level of adoption of social media
in the financial technology sector. The
research provided clarity on how certain
tools are being used in this niche market,
to provide a benchmark for future research
and to give companies more information
about what the leading firms in this sector
are doing.
Tom Coombes, Cognito’s founder and
CEO commented, “The opportunity for
firms to take advantage of social media is
huge. It is the next generation of com-
munication, and firms must embrace these
new ways of working. Our survey showed
more than 40% of companies are using
Twitter and 25% YouTube. We expect
these figures to increase as the media
landscape continues to change and social
media becomes an integral part of a firms
business.”
The webcast, titled, “Social Media
and Financial Services,” addressed the
importance of new communication tools
and their relevance to the financial sector.
Panel members included, Leslie Klein,
head of GTS Marketing; Kees Moens,
senior communications manager, Inter-
net, ING; Alyssa Gilmore, head of analyst
relations for SunGard, and Hakan Aldrin,
managing director for The Benche, SEB.
The panel was moderated by Elizabeth
Lumley of Finextra.
CommodityPoint issues report on software delivery mechanismsCommodityPoint, a division of UtiliPoint
International, has released a comprehensive
report on alternative delivery mechanisms
for Commodity Trading and Risk Manage-
ment (CTRM) software. The report looks at
the rising popularity in some segments of
the industry for delivery mechanisms such
as Software as a Service (SaaS), hosting and
leasing as opposed to the more traditional
on-premise licensing model.
The report is available for free on the
UtiliPoint and CommodityPoint websites
(www.utilipoint.com/reports/Alt_Delivery_
CTRM.asp). The research and subsequent
report were sponsored and supported by
Allegro Development, Aspect Enterprise
Solutions, IHS, Navita, Open Acess Tech-
nology International (OATI), and SolArc.
“While the traditional installed-software
model is still dominant in the CTRM space,
the rise and success of vendors specializing
in web-delivery of comprehensive function-
ality serving trading ard risk management
points to a growing acceptance of the SaaS
model. While much of these software com-
panies’ success has been found in selling to
those mid-sized and smaller trading com-
panies looking for an affordable solution,
we have seen several larger trading shops
adopt SaaS deliveried systems, perhaps
indicating a weakening of many of the
long-held objections to that model,” said
Patrick Reames, CommodityPoint manag-
ing director for the Americas.
“Our study shows that delivery mecha-
nisms such as SaaS are being utilize more
than one might have originally thought,”
said Dr. Gary M. Vasey, CommodityPoint’s
managing director for Europe and the
AsiaPacific region. “While there is signifi-
cant resistence to SaaS, hosted and leased
models among many larger traders who
express a strong desire to retain control
over data and access to applications, a
majority of respondents to the survey
see value in exploring other options. For
vendors offering or specializing in delivery
of SaaS/hosted CTRM solutions, the find-
ings of the study appear to point to a very
bright future.”
“While the traditional installed-software model is still dominant in the CTRM space, the rise and success of vendors specializing in web-delivery of comprehensive functionality serving trad-ing and risk management points to a growing acceptance of the SaaS model. While much of these software companies’ success has been found in selling to those mid-sized and smaller trad-ing companies looking for an affordable solution, we have seen several larger trading shops adopt SaaS deliveried systems.” – Patrick Reames, CommodityPoint
con’t from pg.6