Tag Archives: Natural Gas

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:

Holistic Risk ModelFigure 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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Prashant_MugshotAbout 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.

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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!

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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.

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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

ImagePrashant 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.