June 2019

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Risk: Navigating energy volatility: Understanding the principles of commodity risk management

The persistent volatility of energy prices is well known, and sustained price movements have fueled a boom-and-bust cycle in different energy sectors for decades.

Echols, J., Crowley, G., Opportune LLP

The persistent volatility of energy prices is well known, and sustained price movements have fueled a boom-and-bust cycle in different energy sectors for decades. Effective commodity risk management inevitably gives way to price risk management. This, in turn, implies that an enterprise knows what price risks it faces and that it has decided to do something about it—even if that something is nothing.

In helping companies build, evaluate or repair commodity risk management activities in the decades since US energy deregulation began in 1980, a few enduring principles stand out. Our view is that effective price risk management is founded on a thoughtful, board-directed view of risk appetite considering the commercial strategies being employed. In turn, this top-down directive empowers the development of a measurable business case linked to a risk management policy and multi-layered limits to ensure that everyone in the organization is on the same page—from traders/risk managers to investor relations.

Next, the nuts and bolts of execution come into play—the people, processes and systems that carry out commodity risk management daily. Good separation of front-, mid- and back-office functions are basic, as is an effective trade/deal capture process. A system that serves as a single source for all stakeholders is essential and can add efficiency to a complex activity.

Risk oversight is a final essential. The ability to challenge positions and carry out stress testing ensures that the board-directed views on risk management stay aligned with the efforts in the trenches. People lose their jobs over surprises in this area.

Our framework for effective risk management directly addresses a company’s capabilities that link risk appetite, risk policy and limits, commercial strategies, organizational design, oversight and reporting.

Who needs an effective risk management function?

Contract-based commodity enterprises that are traders and marketers generally have a robust framework for buying and selling energy commodities, backed by clear policies, an effective organizational design and systems in place, with an active oversight function.

Enterprises that hold self-images as asset-based companies offer different challenges. A key strength for many companies is the effective placement and operation of capital assets (i.e., refineries, distribution, pipelines, midstream, etc.) or the successful ability to explore or exploit oil and gas reserves.

For asset-based enterprises, the price risk DNA that is dominant in traders and marketers can be nominal. The lack of deep valuation and price risk management skills is not necessarily a fault. However, the ultimate question is whether the company’s inherent commodity-related risks are understood and acceptable, as per the board’s guidelines. If not, then embarking on a workable commodity risk management framework is needed. This begins with understanding how market price changes impact a company’s results, as well as determining whether such inherent commodity risk is acceptable.

For company leaders, it helps to envision risk management as a strategic objective that can provide a competitive advantage and not simply as an operational requirement. Yes, costs exist (i.e., systems, people, etc.), but understanding risk ultimately leads to improved processes, increased efficiency and better decisions, all of which drive profitability. As the old saying goes, “The best offense is a great defense,” and we contend this certainly applies to risk management for energy commodities trading.

Lender considerations

Asset-based lending in the sphere of energy commodities can present complex considerations, depending on whether the counterparty is involved in trading and marketing or whether the counterparty owns and operates assets, and earns at least part of its revenues based on commodity prices.

Traders and marketers

For counterparties involved in trading and marketing, the traditional borrowing base is built upon agreed percentages of eligible receivables and inventory. However, significant losses in trading can occur quickly in volatile markets, potentially reducing the counterparty’s expected future cash flows and increasing the lender’s risk exposure significantly in the days or weeks following the most recent borrowing base report.

Therefore, a lender’s understanding of its counterparty’s risk management framework is essential. Evaluating the framework involves assessing the counterparty’s understanding of risk appetite and the relationship between that risk appetite and its risk policy, its risk limits and the organizational design and oversight in place to monitor risk-based transactions. The existence of a comprehensive risk policy, well-defined risk limits and clear responsibility for risk oversight can provide a lender with insight into how a counterparty can react to adverse market outcomes and avoid or limit losses.

Lenders should also develop reporting protocols with their trading and marketing counterparties to ensure that lenders understand the counterparty’s positions and results on a frequent basis.

Asset-based counterparties

For counterparties operating assets with a revenue stream derived, at least in part, from commodity prices, lenders face increased risk as commodity prices decline. This is not only due to the exposure held directly by the lender’s counterparties, but also to their counterparties’ customers, who could also face severe financial distress in a volatile price environment. The resulting domino effect can be disastrous for lenders that underestimate commodity price risk.

Determining whether such a counterparty actively assesses its exposure to commodity prices is an important first step. To the extent that such exposure is more than nominal, understanding how the counterparty measures and monitors such exposure is like understanding the risk framework for trading and marketing companies. Is there a risk policy with defined limits? If so, are the limits against meaningful risk measures well understood and consistent with the counterparty’s risk appetite and business strategy? Is there clear accountability for risk oversight?

Stated broadly, counterparties with unmanaged commodity price exposure can effectively transfer such exposure to lenders that would otherwise be protected by the value of the collateral. Put simply, linking effective commodity risk management to the long-term assessment of a lender’s risk is essential. This risk is often underestimated, particularly by smaller lenders that may lack expertise, but even larger institutions with in-house commodity risk management capabilities may not have the proper communication channels to filter important guidance to loan officers. Regardless, the primary objective of any sound risk management framework for getting the right information to the right people at the right time may not be achieved, and the consequences can be severe.

Managing energy price volatility effectively requires the development of a well-ordered framework of policy, execution and oversight. Lenders are well-served in understanding whether their counterparties display the core capabilities needed to be effective at managing energy price risk. HP

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