COMMODITY RISK MANAGEMENT & TRADING
Energy Risk: Staging a transformation

Energy risk management has transformed since the early 1990s. Author Pauline McCallion interviewed Darilyn Jones, senior vice president of risk control at Sequent Energy Management, and other risk managers about the challenges they faced in the early days and how they compare with today’s issues.

Risk management in the energy sector has evolved greatly since its beginnings in the early 1990s.

The first energy risk managers faced a steep learning curve, thanks to huge changes in regulation, increased competition, growing market activity and product and technological innovations. Today, while energy markets might be constantly changing, those seismic shifts no longer face energy risk managers.

The role of the risk manager has also evolved enormously, and there has been a sea change in the way risk management is viewed by corporations. Once widely seen as little more than a checklist exercise, now it is usually seen as a vital function at the heart of decision making.

The biggest challenges for energy risk managers in the early 1990s centered on deregulation in the gas and power markets and how to adapt to the new environment this was bringing about. At this time, crude oil was already a global market attracting both physical and financial players, but the rest of the energy sector was only just beginning to follow suit.

In the US, the 1992 Federal Energy Regulatory Commission (Ferc) Order 636 completed a gradual process of deregulation of the US natural gas sector. This process was also implemented in the US power market in 1996 with Ferc Orders 888 and 889. Europe followed a similar path, first with European Union (EU) Directive 96/92/EC in 1996, which established a set of common rules for electricity markets. In 1998, Directive 98/30/EC did the same for the EU gas markets.

While regulated entities had previously been concerned simply with maintaining service, deregulation introduced a fresh challenge as energy companies strove to maximise profits and manage new risks in these changing markets.

"Risk management in the early 1990s was focused on the physical management of the commodity," says Paul Campbell, energy and resources practice leader for regulatory and capital markets consulting at Deloitte & Touche. "That was really all you could control and there were no opportunities to financially hedge something. Deregulation saw other companies begin to enter the market - companies that only wanted to take on financial risk and were not as interested in owning physical assets."

And so entered the financial players such as Phibro-Salomon and Goldman Sachs. While these Wall Street entrants brought different expertise and much-needed liquidity to commodity markets, the period was not without teething problems.

"The first wave of people coming out of Wall Street (to work in the energy sector) weren't so successful because they saw this as a financial market," Campbell says. "They had financial backgrounds and assumed prices and risk models would be similar to what they were used to in financial markets."

The power market posed the biggest challenge because of the impossibility of storing most forms of electricity and the huge price spikes that happen due to peak demand surges. While a standard crude oil supply curve slopes smoothly upwards, for power the curve slopes upwards before spiking at times of peak demand, when the expensive peaking plants kick in.

"That was a big learning curve for people," notes Campbell.

Education
In order to address the problem of financial players lacking physical knowledge and physical players lacking financial expertise, there was a drive within the energy market to develop educational programmes that would produce risk managers with all-round expertise.

"In the mid to late 1990s, the main MBA schools started generating more energy risk programmes," says Glenn Labhart, principal at Labhart Risk Advisors and chairman of the Global Association of Risk Professionals (Garp) Energy Committee. "Some companies established alliances with universities and helped to develop programmes in return for being able to take on graduates."

As more focus was placed on risk management, the function itself began to become more integrated within companies across the energy sector. However, this took time.

"Because the early companies were focused on physical risk management, the financial execution and the financial management of risk were typically isolated within the treasury group," Campbell says. "The chief risk officer (CRO) concept didn't really start emerging until the late 1990s, so from a management perspective, anyone who understood anything about risk was typically in the commercial operations. It took a number of years for the risk positions to migrate out of commercial when the energy side took more interest in financials."

Having held the position of CRO at Dynegy from 1997 to 2004, Labhart agrees: "We were a rarity back then."

Outlining the changing role of the risk manager, he says it began as a function of accounting with responsibility for overseeing and accounting for derivative transactions and futures margins. "By the mid to late 1990s, companies started bringing in people like me or Vince Kaminski (who moved to Enron from Salomon Brothers in 1992), who were more attuned to risk. They reported directly, in an administrative sense, to a chief operating officer or chief executive of a corporation."

One huge catalyst that shaped the early evolution of energy risk management was the recommendations of the Basel Committee on Banking Supervision. The Bank for International Settlements established the Committee as a forum for international co-operation on banking supervision. The 1988 Basel Capital Accord and the 2004 revision, Basel II, laid out comprehensive measures for capital adequacy, which the Committee sought to align with the risks banks faced. The recommendations were designed to encourage the identification of current and future risks, and develop practices to manage them. Although it was created with banks in mind, the early risk managers in energy took inspiration from the framework to turn trading organizations into finance and risk organizations.

Darilyn Jones, senior vice president of risk control at Sequent Energy Management, adds: "The risk management models were coming from the banks. The energy sector adopted the Basel model. We didn't have a regulatory function on the marketing side, but Basel became the best practice. So even today it's just a norm that we look for best practices from places such as Basel, Garp and the Sarbanes-Oxley Act of 2002 -- measures around the accounting or financial functions that impact the risk function."

The new focus on financial risk management also resulted in product innovation, as companies tried to control market risk and take advantage of the greater flow of liquidity that instruments such as derivatives had introduced. Campbell says: "As the gas market started to deregulate, people realised there were some large price dislocations: they couldn't get any sort of certainty on prices and were forced to wait until they settled at the beginning of the month, or were stuck under a very long-term price contract with no way to move around it."

Jack Dybalski, vice president and chief risk officer at US utility Xcel Energy, also highlights this as a problem that needed to be addressed as energy markets developed. "When I think of my early days in the business, prices didn't move that much because the markets couldn't readily respond to the underlying changes in supply and demand," he says. "That was a big change during the 1990s."

Various initiatives were developed to help address such risks. For instance, Enron's Gas Bank, which it began to develop in 1990, allowed the firm to act as an intermediary between buyers and sellers of gas. It combined aspects of the physical market with the developing financial side of the energy sector, providing a way to manage risk as the market deregulated.

"It looked like a trading book and it really was, but it wasn't necessarily designed to be that way," says Campbell. "(Enron) were the first people that stepped back and created an opportunity for, say, a small utility in the North East to buy or pool gas and essentially lay off some of its price risk."

Volumetric Production Payments (VPPs) provided another route to new sources of credit for utilities. These arrangements allow producers to access capital without giving up control of their operations. This sort of agreement also often involves the investor using derivatives to hedge against the risk of lower output, boosting financial activity further in the energy sector.

The increase in instruments available and the resulting influx of data created a more robust toolbox for those managing risk in the energy sector. In turn, this encouraged further activity.

"Supply breeds demand breeds supply," says Stephen Maloney, managing consultant at Towers Perrin. "More sophisticated tools and more intelligent, better-trained users created a virtuous circle."

Much of this product innovation was linked to trade finance expertise. "Certain banks that had commodity trade finance programmes were of great assistance to the industry," says Labhart. "They were able to bring their expertise to help people structure transactions. These programmes allowed people to have working capital in the refineries, or generation assets."

The ability to create more complex trades has, throughout the evolution of risk management, sometimes put a strain on the relationship between trader and risk manager. While traders attempted to use their skills and knowledge of the financial and physical markets in order to generate profits, risk managers were like "traffic cops" for futures and derivatives, according to Labhart.

"As the markets matured, risk managers began to formulate risk strategies that challenged the timing of the traders' strategies. This created tension between the traders' fundamental view versus the risk management view," he says. "In the end, both views were right; it was the entry and exit point of actual strategy that was the important consideration. Timing became the key and remains so in today's market."

Today, there is generally a greater mutual respect between traders and risk managers, as they are more attuned to the other's role and reason for existence. Traders are now able to enter and exit the market in a more efficient way and the risk manager is more aligned with this pattern of trading. And on the other side, most traders now understand the requirement for the risk manager to perform checks and balances, according to Labhart.

The market has also developed to encompass new types of risk. Increased activity attracted more people to the market and the threat of credit risk began to loom large. While the recent crisis in the financial markets shows that credit is an ever-present risk, the energy markets had already learnt a huge lesson seven years earlier with the 2001 bankruptcy of Enron -- the largest and most complex bankruptcy in US history. Everyone was caught out by the speed of Enron's demise. The company went from posting a third-quarter profit of $292 million in October 2000, to a third-quarter loss of $618 million in October 2001. Less than two months later, on December 2, Enron filed for Chapter 11 bankruptcy protection.

In the fallout that followed and wiped out the US merchant utilities, questions about risk management in energy trading had never been asked with such vigour. However, it was the lessons learnt from this and other crises that have formed the basis of some of the best practices in risk management in place today. "In general, people have gained a better, broader awareness of risk as they have seen other companies fail," says Campbell.

Hedge funds
Another big change in energy markets since the early 1990s has been the influx of hedge funds.

"One thing we didn't have in the 1990s were many hedge funds actively trading energy," says Peter Fusaro, chairman of energy consultancy Global Change Associates. "Today we are tracking more than 200 energy hedge funds."

While they have increased market liquidity, they have also demonstrated some of the risks inherent in energy trading with prominent collapses such as the $6.5 billion losses of Amaranth Advisors in 2006, which came hot on the heels of the collapse of MotherRock.

Labhart believes hedge funds have taught the industry some important lessons. "Hedge funds have contributed to liquidity, but they've also taught the industry - by example, in the case of Amaranth and others - that liquidity is a crucial factor to take into consideration. During times of price volatility, you need to concern yourself with liquidity because you may not be able to get in and out of the market easily."

Sid Jacobson, managing consultant, global energy at PA Consulting, agrees that experiencing failures can be critical to the advancement of risk management in the energy sector. "People improve their infrastructure tools and processes so (such events are) often a good catalyst," he argues.

Software advances
One part of the energy risk management tool box that has progressed considerably over the past 15 years is the technology supporting energy risk management. In a bid to keep up with changing practices, energy trading risk management (ETRM) systems have had to continually evolve.

"In 1994, ETRM systems didn't really exist," says Campbell. "There were logistic systems that were good at moving cargo or gas along pipelines or oil to different terminals, but they didn't really have a good risk management aspect."

"The first generation systems 15 years ago were usually proprietary systems and pretty basic," remembers Jones. "They were able to deal with simple transactions and generally were not integrated at all. There was usually a system that could deal with scheduling, a system that could maybe capture simple financial derivatives -- futures, maybe swaps -- but nothing that could really handle options because they were often done on spreadsheets in the early days."

Basic office applications, such as Microsoft Word or Excel, were used to generate and store the necessary data for energy risk management. "Today, we have systems that can automatically generate and fax confirmations, as well as e-confirm platforms, and Confirmhub-type platforms that help us with the matching process and simplify and automate a lot of it," Jones adds.

Many firms began by developing their own systems in-house rather than using software created by a vendor as is the norm nowadays. "During the mid to late 1990s, the best systems were developed in-house and they'd move their way to the street as companies sold the software," Campbell says. For example, energy trading company Aquila developed its RiskWorks software in 1995 and 1996 before SunGard Energy Systems acquired it in July 1999.

Campbell continues: "There just wasn't a lot of common intellectual capital about how to (develop these systems). Today, people have been using trading systems for about 15 years and so understand what goes into making them work. But back then, that community didn't exist, so a person who understood software and understood energy worked for a trading company."

Jones highlights this transfer of knowledge from within trading companies to external technology specialists as an important market evolution.

"Companies are not necessarily spending as much time and energy on developing proprietary systems," she says. "That's where things have changed since the 1990s, when more people were trying to develop their own thing. Today there is a fair share of vendors out there who offer packages people can buy off the shelf and then integrate with their own systems."

However, challenges remain. Although these systems have come a long way in integrating a range of functions under one program, no one package is able to cover every facet of energy risk management. Spreadsheets also continue to be widely used to collate data in some instances.

While software vendors often discuss the possibility of full integration and phasing out spreadsheets, Labhart is skeptical: "No one system can provide everything at any one time. Spreadsheets will always be used and should not be considered a bad thing." He believes risk managers should work to understand how traders use such tools in order to assess liquidity and strategic intent.

The role of risk manager
As risk managers developed and improved on their tools, they also took on more and more responsibility. From the early 2000s, the role of risk manager continued expanding to encompass a range of functions within an organization.

Jacobson recounts the role of risk manager at most energy firms progressed from simply looking after trading in the early 1990s to having responsibility for enterprise-wide strategies.

"Most energy companies no longer see risk management as either a trading function or a compliance function," he says. Rather, risk managers provide much-needed checks and balances, as well as strategies to oversee the proper governance of the organization.

Dr Chris Donohue, managing director of the Garp Research Center, adds: "The role of the risk manager has matured with the risk management profession. It now has a bigger seat at the table and is an integral part of the business, as opposed to just being a requirement that has to be completed."

As such, the development of enterprise-wide risk management (ERM) strategies has been important within the energy sector. Although this approach is becoming more prevalent, it is still in its early stages at some firms. Xcel Energy began to establish an ERM strategy four years ago, but needed to look outside the energy sector for inspiration about how to manage risk beyond trading and transactions, according to Dybalski.

"One thing the industry needs to recognize is the growing importance of the enterprise risk management view," he says. "It also needs to realize that the transaction side of the business, while very important, is not everything."

Energy risk management has come a long way in the past 15 years, embedding itself within the day-to-day functions of energy companies in the process. Risk managers in the sector recognize the need for this evolution to continue as the constantly changing energy market continues to present new challenges and opportunities.