Companies active in the energy marketplace should employ Enterprise Risk Management (ERM) to accurately account for and value the market, credit, and operational risks they face and help appropriately establish their entity’s true risk-adjusted value.

Consider the case of an investor deciding between two companies in which to invest.  If they both had exactly the same assets, but one was located in an area prone to natural disaster, it would be wise to discount its value to accommodate that fact and deem the “safe” company the more attractive option.  This is a simple example of a risk-adjusted valuation.  Although such analyses have long been part of smart investor’s evaluation process, the move to identify and address – or at least disclose – risks of every imaginable type has never been greater.

In recent years, energy industry participants have begun to employ increasingly sophisticated processes to identify, measure, and if desired, mitigate market risk.  Well before the significant price volatility which recently occurred in numerous energy markets, trader limits, Value At Risk (VAR) calculations, advanced hedging techniques and the like were common concepts even on the trade floors of most physical market participants who, historically, have suffered the consequences of volatile markets and often view boom and bust cycles to be as natural as the seasons.

To a lesser degree, but closing fast, has been the push to address counterparty credit risks – including those which come about as market risk-mitigating efforts are translated into credit risk.  This makes great sense.  If you addressed your long or short market position by putting on an offsetting trade with a nearly-bankrupt company, have you really hedged yourself?  You could probably have avoided that dangerous scenario if you monitored your counterparties more effectively through automated scoring, potential future exposure (PFE) calculations, daily account monitoring, and other benefits typically offered by robust credit management systems.  Additionally, they can provide a holistic report of the company’s trading activities versus the view from trading systems, which is often presented on a portfolio basis. 

Although most entities have long been concerned with counterparty creditworthiness, they have not typically translated those concerns into the investments necessary to thoroughly address them.  It is an absolute fact that billions of dollars in credit exposures are tracked on spreadsheets throughout the industry.  However, the collapse of high-profile counterparties, increasing control requirements, and the recent availability of quality third-party software solutions make the sophisticated handling of counterparty credit risks quickly approach industry-standard status – if it cannot already be considered so.  Again, even physical market participants who have typically been less impressed with the theoretically pure, more financially oriented, Wall Street-style risk management than with traditional relationship management are seeing the value of actively managing credit risks.

The assault on operational risk, the last bastion of relatively unacknowledged and unaddressed exposure has now begun.  While there are several loosely similar definitions of operational risk, one useful view is that these are the risks of loss, according to the Basel Committee, “resulting from inadequate or failed internal processes, people and systems, or external events”.  For example, your VAR measurement identified a significant exposure to volatility in the market, you identified and entered into a mitigating trade of 10,000 barrels of Brent crude with a counterparty whose weak creditworthiness was identified and supplemented with a letter of credit, but your operations personnel failed to notice that the trade confirm showed a 100,000 barrel volume and your tape recording system malfunctioned.  The very act of implementing processes to address operational risk would likely identify these and other critical business functions and help ensure that they receive appropriate attention.

The company which puts in place an ERM system to actively manage its marketing, credit, and operational risks will not only be rewarded for having the foresight to do so, but will avoid being penalized for failing to employ what is increasingly becoming standard business practice.