Transforming Risk

1.0 Introduction

Recently we have had discussions with different clients on improving the risk function. While each approached the issue from their unique perspective, the underlying need relates to strategically transforming aspects of their risk function.

What were the challenges these clients were facing?

1. “My CRO seems to be spending too much time chasing data rather than doing analysis and proving insights.”
2. “Our counterparty proposed a modification to our plain-vanilla options. We are unsure how to value it.”
3. “I have 4 analysts who are spending 1.5 to 2 hours each to generate my end-of-day P&L report. How do we improve the efficiency of the process?”
4. “How do we improve the confidence in our energy/ commodity trading and risk management (E/CTRM) system generated risk measures?”

2.0 Implications

What are the implications of these questions? If we think in just tactical terms, we may not be able to fully comprehend the overall implications of these questions.

In the first instance, what the executive leaderships is asking is beyond the ability to generate quality numbers or reports. The executive leadership is striving for insights and understand whether the risks being taken are aligned with the overall business strategy. Is the defined risk appetite aligned with organization’s level of risk tolerance? Can the CRO support planned or unplanned Merger & Acquisition (M&A) activity? Or will it be a case of risk lagging the business objectives?

In the second instance, the CRO has identified specific gaps in her capability – gaps related to exotic option valuation. But at a holistic levels, the question also exposes gaps in risk policy (can we do such deals? What aspects of the risk policy will we have to modify if we do such transactions?), risk modeling (do we have the right models to value and report?), E/CTRM / risk systems capability (can the risk system handle such deals? What customizations will we need to do to such systems?), and human capital (can we manage these instruments?).

The third instanced related to efficiency of risk operations bringing into questions of business processes, E/CTRM systems usage and gaps, and human resources.

In the final instance, the reliability of overall risk infrastructure – risk programs, E/CTRM systems, business processes, transaction and market data, and human resources – is in question.

3.0 Holistic Risk Model

How do we address these challenges? An ideal approach would be to look at the risk function in a holistic function. (Spoiler Alert! I am a consultant and as you might have guessed, I am introducing a model. Hazards of being a consultant. 🙂) Our Holistic Risk Model (HRM) (see figure 1 below) can provide one lens to view and address these challenges. HRM is a 5-layered model that aims to combine both the strategic and operational elements of a risk function. The 5 layers are:

• Business Strategy & risk strategy layer
• Policies and Regulations layer
• Enterprise Risk Management / Risk Programs layer
• Risk Organization, Business Process, Human Capital Layer
• Risk Systems and Technology & Risk Models and Risk Measures layer

The issues raised by the above-mentioned 4 questions could be addressed using the HRM as shown below:

Figure 1: Holistic Risk Model (HRM)

Thus, these questions span across multiple layers and solutions to address these challenges need to span these layers as well. However, the first layer – business and risk strategy – will generally determine what solutions will be appropriate for an organization.

Let’s explore that in a little detail – an organization needs to know and understand what drives its competitive advantage – Is it trading? Is it logistics? Is it physically assets? Is it structural advantages accrued being a dominant player in one aspect of a value chain?

This will drive a company’s risk appetite and its risk strategy, which in-turn will have bearing on its risk culture, risk organization and investments in business processes and risk systems.

Let’s take the first client – If one is not aware of its business strategy and the importance of growth via M&A, then the solutions designed for addressing its need for insight may miss the point. The key will be designing processes which facilitates quick integration of new businesses; generation of management reports and ensuring data quality throughout the value chain. Governance structures to improve transparency and facilitates communications will be needed. Also, having a risk policy which factors addition of new businesses (and hence risks) will be crucial.

In the second case, while the immediate need is tactical – improving quantitative capability, the client will need to revise its risk policy to facilitate the trading of complex options. Quantitative capability – both human capital as well as systems – will have to be added or strengthened. Management capability in terms of managing newer risks may need to be upgraded.

In the third and fourth cases, the number of prioritized initiatives aligned with the bottom two layers of HRM could be in play – from immediate quick wins to improving data quality at source to designing of specific reports to development of a reporting data-mart to changing business processes to periodic training to designing key performance indicators (KPIs) to change behavior. However, the differences in company strategies will result in different solutions being relevant for the company. For example, one of the clients believes in “moving on aggressively” – analogous to moving to build the third floor even when the second floor is not fully complete. The other client has a process driven approach and therefore is at a loss to understand why the investments in E/CTRM systems have not paid off.

4.0 In conclusion

Moving beyond tactical considerations to a holistic risk model based approach can help you transform your risk function to a key pillar of business transformation.

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About the author: Prashant Shah is a Principal at AXCELERUS, a specialized E/CTRM consulting practice with global client-base and solutions for the full spectrum commodity transacting value chain.   Prashant focuses on risk management activities, risk reporting, front, middle and back-office processes and energy transacting/risk management (ETRM) systems.

Prashant can be reached at prashant.shah@axcelerus.com.

The Case for Independent Verification and Validation (IV&V)

The concept of Independent Verification and Validation (IV&V) is not new and is generally understood as part of any significant IT projects. Many firms employ it, especially in mission critical projects. In addition, the service is commonly used when things are going, let’s say, south. However, in the Energy/Commodity Trading and Risk Management (E/CTRM) industry, IV&V is few and far between when it comes to E/CTRM implementation, upgrades and system integrations.

Why is it so?

We believe the fundamental reason is that, when budgeting for E/CTRM projects, IV&V is not typically on the radar. Often viewed as an additional cost, and frankly, senior management may think it is not necessary. It can be perceived as consultants trying to “up sell” additional services, or thought that current project dynamics might be upset by bringing in other 3^rd party consultants to perform the IV&V. Also, many times, the E/CTRM project budgets are lower than the thresholds to trigger mandatory IV&V as per an organization’s IT policy.

But does it have to be so? Can IV&V consultants be an integral part of the E/CTRM projects and actually help drive the delivery time & cost to remain within budget?

Empirical evidence seems to suggest so. Georgia Technology Authority’s Enterprise Program Management Office (EPMO) observed that in 2008, IV&V provided a tangible benefit of $29.6 million on an investment of $2.1 million.

We strongly believe that IV&V should be integral part of any E/CTRM project plan & governance activities, utilized to drive the following key objectives:

• Independent measurement and validation of project objectives, progress, and risk
• Compliance validation with agreed requirements and internal standards
• Independent testing & verification of required customizations
• Early detection and remediation of project variances, issues, and risks
• Evaluation of adequacy and competencies of stakeholder and vendor involvement

Governance, in a typical E/CTRM project, utilizes Steering or Working Committee meetings to evaluate project progress, issues management and stakeholder management. In the event (often likely) of disagreements, it may be a case of vendor versus client manager view-points with considerable energy and resources spent aligning potentially conflicting perspectives. IV&V, being integrated with the project activities, opens up another channel to manage stakeholder dynamics through independence, open communication, and teamwork to successfully achieve project objectives. The IV&V process can thus provide a non-adversarial forum to facilitate faster resolution of issues, and help in managing project schedules.

IV&V also supports the evaluation and management of E/CTRM customizations. “Are they really needed?” is a question with which an independent and objective IV&V evaluation can help. All too often vendors or business stakeholders do not fully comprehend the limited ROI for time and costs for customizations that provide only limited benefits or competitive advantages. In fact, eliminating “unnecessary” customizations can potentially provide project savings far greater than the investment in IV&V services.

In conclusion, companies should consider the benefits an IV&V can bring to an E/CTRM project in minimizing the potential for higher costs and blown deadlines, as well as, the potential value added perspective in managing costly and unnecessary customizations.

About the author. Prashant Shah is a Principal at AXCELERUS, a specialized ETRM/CTRM consulting practice with global client-base and solutions for the full spectrum energy transacting value chain. Prashant focuses on risk management activities, risk reporting, front, middle and back-office processes and energy transacting/risk management (ETRM) systems. Prashant can be reached at prashant.shah@axcelerus.com.

Navigating the ETRM/CTRM EcoSystem (TM)

Introduction

When was the last time you thought of an ecosystem? Specifically, an energy/ commodity transacting and risk management (ETRM/CTRM) EcoSystem^TM?

Usually, for most business and information technology (IT) personnel involved with ETRM/CTRM, the thought of ETRM/CTRM as part of a broader ecosystem is an after-thought. Their focus may primarily be on implementing an ETRM/CTRM solution for a specific business need. This siloed approach often ignores the wider organizational ETRM/CTRM EcoSystem^TM. The result can be a complex, sometimes redundant web of IT systems.

What is an ETRM/CTRM EcoSystem^TM?

ETRM/CTRM EcoSystem^TM is an interplay of all systems, business processes and people that are important for the successful functioning of an E/CTRM system through its transacting value-chain.

Let’s take an example of a typical ETRM/CTRM system and its interactions and interconnectedness with other systems. An ETRM/CTRM system may interact with any of the following systems:

• Other ETRM/CTRM applications
• ERP/ GL systems
• ERP / Inventory management applications
• Price curves applications
• Advanced risk analytics applications
• Credit applications
• Derivative Accounting Applications
• Fax/ Email applications
• Data marts and Operational data stores
• Data warehouses
• Reporting Applications
• Instant messaging systems
• Electronic Trading Exchanges

In addition, there are business processes – (a) internal to company and (b) each application specific – that together are instrumental in making these systems effective in meeting business needs. A transaction approval process, a confirm process, an end-of-day risk reporting process, and an interface to corporate accounting and financial reporting process are examples of business processes that form part of the ETRM/CTRM EcoSystem^TM.

People form a critical component of the ETRM/CTRM EcoSystem^TM. Systems and business processes are expected to help people become more effective in their work. However, for people to effectively use the systems and business processes, they need to understand and be trained on the interconnectedness and interplay of the various components comprising the ETRM/CTRM EcoSystem^TM.

Navigating the ETRM/CTRM EcoSystem^TM

As with any natural ecosystem, “habitats” exist within the ETRM/CTRM EcoSystem^TM – these “habitats” are the key IT systems – ETRM/CTRM, ERP, Data Warehouse, and others. Specific people have a stake in these habitats. These are our stakeholders. These habitats are interconnected and their interactions are facilitated by business processes – the value chain that is important for managing end-to-end transacting processes. However, as in natural habitats, these ETRM/CTRM EcoSystem^TM habitats also compete and cooperate in the ecosystem. Competition is for funding, functionality, resources and people time, while cooperation is driven by expected business benefits.

So, how do you navigate such an ETRM/CTRM EcoSystem^TM? One optimal approach is to take a holistic view of the ETRM/CTRM EcoSystem^TM. The goal is to maximize cooperation and lessen competition among the various habitats.

The holistic approach begins with mapping comprehensive business requirements for the entire ETRM/CTRM EcoSystem^TM. Many times, the focus is on developing application or business unit specific requirements only. The next step is developing an “aligned” functional design on which the stakeholders agree. This looks across the entire ETRM/CTRM EcoSystem^TM to improve cooperation across the ecosystem and reduce competition for housing key functionality in various habitats. It is vital to obtain agreement on, for example, where cash will be posted, where the sub-ledger will be housed, where the inventory will be managed and so on. There will be trade-offs and resulting implications of these trade-offs. A key objective is maximizing the company’s competitive advantage when planning for customizations and enhancements.   Design and pre-design phases are where the greatest flexibility exists in managing trade-offs. A tool such as CTRM-IQ^{TM (1)} can facilitate and expedite this process.

An additional element is the management of ETRM/CTRM EcoSystem^TM implementations. Components of the ETRM/CTRM EcoSystem^TM are best managed as part of a program. This helps in managing release cycles, customizations, and turning on key functionality.

The key to the ETRM/CTRM EcoSystem^TM for an existing portfolio of systems is to view all IT systems in the ecosystem as “habitats” and understand the functions they serve. It may be prudent to “move” some habitats. Tools, such as AppRat^{TM (1)} can assist in mapping and understanding the interactions among these habitats.

Conclusion

ETRM/CTRM systems form one habitat that are part of a broader ETRM/CTRM EcoSystem^TM. Understanding the dynamics among key habitats helps in addressing many of the complexities of the web of IT systems and creating a holistic approach to managing key ETRM/CTRM systems.

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About the author.

Prashant Shah is a Principal at AXCELERUS, a specialized ETRM/CTRM consulting practice with global client-base and solutions for the full spectrum energy transacting value chain.   Prashant focuses on risk management activities, risk reporting, front, middle and back-office processes and energy transacting/risk management (ETRM) systems. Prashant can be reached at prashant.shah@axcelerus.com.

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These materials and the information contained herein are provided by AXCELERUS, LLC (“AXCELERUS”) and are intended to provide general information on a particular subject or subjects and are not an exhaustive treatment of such subject(s). Your use of these materials and information contained therein is at your own risk, and you assume full responsibility and risk of loss resulting from the use thereof.

Shale Gas Conundrum – Low Natural Gas Prices!

Introduction:

Feb 25, 2003: $18.48; Dec 15, 2005: $15.39; June 19, 2008: $13.09; Aug 17, 2012: $2.70; July 2, 2013: $3.58

Good News: Natural Gas Prices are low!

Bad News: Natural Gas Prices are low!

Confused?  You’re not alone; there are enormous, opposing, marketplace agendas at stake on both sides of the current and forecasted US gas price situation. While the industry may tout the benefits of low natural gas prices to the consumers and other stakeholders, they are also worried about the long term impacts of low natural gas prices which has already started to turn away investors and depress normal cycles of exploration and production. Go to any natural gas industry conference and the talk is largely about “unsustainable” low natural gas prices and need to increase demand and thereby prices.  Looking back 5 years ago when gas prices spiked at above $12 and now with sub-$4 prices, how the times have changed!

Past bets:

Consider the chart above: In the Pre-2006 scenario, natural gas prices were consistently trending upward (B,E in chart) with abnormal spikes during the winters of 2001, 2003, 2005 and 2008 (C,D,F, I in chart). The spike of 2002-03 made the industry acutely aware of the impending demand-supply gap in natural gas. The industry responded with two different solutions – first was to make big bets on natural gas imports and Liquefied Natural Gas (LNG) terminals. This was the bet the big oil & gas players made. Second was the bet the independents made. They began quietly testing unconventional technology to extract gas from various shale formations. And they struck gold!

With the advent of shale gas and especially the huge supply of Marcellus shale gas, the demand-supply situation in natural gas changed. The floor prices of 2006-2008 suddenly became more of a ceiling post 2009. The euphoria of unconventional gas supply quickly gave way to the concerns about “unsustainable” low natural gas prices. And the need to increase the consumption or demand of natural gas. And the need to manage supplies coming to the market.

Lower Volatility:

One major fallout of low natural gas prices for the past 3 years has been the reduction in volatility of gas. Consider this, between Jan 7, 1997 to July 1, 2010, there were 587 times when the price of natural gas changed more than 5% over a day, averaging about 43.5 such moves in a year. Between July 1, 2010 and July 2, 2013, there were only 56 such moves, averaging about 18.7 a year.

For larger movements of 10% or more change in a day, there were 124 times such movements occurred between the 13 year period (Jan 1997 to Jul 2010) while only one such movement occurred in past 3 year (Jul 2010 to Jul 2013) time period.

Great right?  Lower volatility means more stability in prices, yes, but also less opportunity for traders to make money on price movements.  Again, two very different perspectives.

Radical Surgery Needed on Hedging Programs:

With low natural gas prices and low volatility, natural gas companies need to rethink their trading and hedging strategies and policies which govern these strategies. Consider this – a 10% move at $4 equals 5% move at $8. We know from the above table getting a 10% change is much rarer than 5% change.  Also, the increase in natural gas liquids (NGLs), especially ethane, portfolio has its own implications. Specifically, natural gas companies need to address some key questions:

• How has your hedging program changed over the past 3 years?

1. Did you curtain your hedging activity?
2. Did you exit the market?
3. Are you largely unhedged?

• How has the portfolio of instruments utilized for hedging changed?
• How has your risk management changed over the past 3 years?
• How do you adjust to this era of low volatility?

Less Trading and Fewer Participants:

It is unlikely that the shale gas industry, which is largely focused on the upstream end of the industry, will make huge investments on natural gas trading. Entry of new gas trading participants is expected to decline dramatically compared to previous years and we are already seeing evidence that existing gas market participants are shrinking their trading and hedging programs, their investments in gas trading and risk systems, their staffing and their risk management approach.

Barbarians At The Gate:

If stock prices decline significantly in the gas trading industry group due to low natural gas prices and low volatility, you can expect another round of mergers and acquisitions; perhaps even from some unlikely sources who would like to lock in a supply of low-priced gas capacity for the near future.   Asset rich gas companies are especially susceptible to this transaction – especially given the large numbers of planned conversions from oil/fuel oil to natural gas a cheap energy supply as a new driver.

And as in all good trading stories, we do expect the current uncertain environment to continue!

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About the Author

Prashant Shah is a Principal at AXCELERUS, a specialized ETRM/CTRM consulting practice with global client-base and solutions for the full spectrum energy transacting value chain.   Prashant focuses on risk management activities, risk reporting, front, middle and back-office processes and energy transacting/risk management (ETRM) systems.

Prashant can be reached at prashant.shah@axcelerus.com.

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These materials and the information contained herein are provided by AXCELERUS, LLC (“AXCELERUS”) and are intended to provide general information on a particular subject or subjects and are not an exhaustive treatment of such subject(s). Your use of these materials and information contained therein is at your own risk, and you assume full responsibility and risk of loss resulting from the use thereof.