NAVIGATING ENERGY VOLATILITY: Understanding the Principles of Commodity Risk Management
BY JOHN ECHOLS AND GREG CROWLEY
Lending in commodity sectors has always been a risky business, but since the 1980 energy deregulation, market volatility has increased. Borrowers who fail to create effective risk management plans can create headaches for their lenders. John Echols and Greg Crowley make a case for effective commodity risk management.
The persistent volatility of energy prices is well known. Roller coaster prices 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 a company knows what price risk it faces and that it has decided to do something about it — even if that something is nothing.
In the decades since U.S. energy deregulation began in 1980, a few principals have stood out when helping companies build, evaluate or repair commodity risk management activities. Effective price risk management is founded on a thoughtful, board-directed view of risk appetite in light of the commercial strategies being employed. This top-down directive empowers the development of a measurable business case linked to a risk management policy and multi-layered limits that ensure 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 on a daily basis. 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 often essential to control and can add efficiency to a complex activity.
Finally, risk oversight is essential. The ability to challenge positions, valuations and carry out stress testing and scenarios 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 Effective Risk Management Strategy?
Traders and marketers in contract-based commodity businesses generally have a robust framework for buying and selling energy commodities, backed by clear policies, an effective organizational design and systems in place along with an active oversight function.
Asset-based companies offer different challenges. The effective placement and operation of capital assets such as refineries, distribution, pipelines or midstream, or the successful ability to explore or exploit oil and gas reserves are key strengths for many companies.
Understanding Market Changes
For asset-based enterprises, the price risk DNA dominant in traders and marketers can be nominal. The lack of deep valuation and price risk management skills is not necessarily a fault. But the ultimate question is whether the inherent commodity-related risks in a company are understood and acceptable as per the board’s guidelines. If not, it is necessary to embark on a workable commodity risk management framework.. Understanding how market price changes affect a company’s results is a start. Companies must also make decisions about whether inherent commodity risk is acceptable.
The history of trading failures over the past decades is another factor. In most of these cases, some elements of the principles, which we believe to be essential, were violated. Principles such as segregation of duties, applying risk limits that appropriately account for both size and concentration of exposures, independent valuation control and a well thought-out hierarchy of ETRM system permissions allowed some traders to evade trade capture, take oversized positions in illiquid markets or bypass valuation controls, which resulted in large losses going undetected for long periods of time.
These examples occurred during a 50-year period, from 1970 to 2018. While they cut across many asset classes, one can find examples for energy trading losses dating as long ago as 1993 and as recently as 2018. These notable cases, and many others that never make the headlines, have driven our views on building an effective price risk management framework. Deregulation of energy pricing throughout the world has driven huge change in the upstream, midstream, downstream, power and every other energy sector. We believe the skills to manage risk in a deregulated world are still being learned.
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, there are costs involved, such as systems and personnel, 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.
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 borrowers 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 borrower’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 borrower’s risk management framework is essential. Evaluating the framework involves assessing the borrower’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 its 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 borrower 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 borrower’s positions and results on a frequent basis.
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 clients, but also the borrowers’ customers, who could also face severe financial distress in a volatile price environment. The resulting domino effect can be disastrous for lenders who underestimate commodity price risk.
Determining whether such a borrower 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 borrower measures and monitors such exposure is similar to 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, borrowers with unmanaged underlying commodity price exposure can effectively transfer such exposure to lenders that would otherwise be protected by the value of the collateral associated with the loan. Our view is that 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 who may lack expertise in this area, but even larger institutions with in-house commodity trading and risk management capabilities may not have the proper communication channels needed to filter important guidance to loan officers. Either way, the primary objective of any sound risk management framework for getting the right information to the right people at the right time is not being achieved and the resulting 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 borrowers display the core capabilities needed to be effective at managing energy price risk. •