energy trading risk management - · pdf file november 2010 energy trading & risk...

+®

A Supplement to

ENERGY TRADING

RISK MANAGEMENT

November 2010

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.”


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.”


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.

To contact a regional office directly, please call:

Europe +44 (0)20 7382 4310

North America +1 888 239 6850

Asia Pacific +65 6236 5730

Email [email protected]

www.allegrodev.com

Optimize your business performance across commodities, business units, and all physical, financial, and logistics assets

Allegro Trading & Risk Management Solutions

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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


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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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

energy trading risk management - · pdf file november 2010 energy trading & risk...

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