The interest in Enterprise Risk Management (ERM) began to grow in recent years and continues to pick up speed.  As reported by Marine Cole in a recent edition of Financial Week, Standard and Poor’s may soon include ERM assessments in its rating evaluations of non-financial companies, a practice already in place at Moody’s.  In my opinion, this would be a welcome enhancement to their review of the trading risk management practices of energy companies with active trading efforts, which they described in a Commentary Report in April 2006.  That move was itself an expanded use of S&P’s “PIM Approach”, which has been applied to financial institutions since 2004 and refers to assessments of the risk management policies, infrastructure, and methodologies (PIM) of subject entities.  According to S&P Credit Analyst Terry Pratt, the PIM Approach, along with assessments of liquidity and capital adequacy, is used by S&P to evaluate an energy company’s trading risk position.

The reason I support a more holistic view of the risk management practices of energy firms is because, in over 20 years in the business, I have never seen – or even heard of – an entity which had completely nailed its risk management challenges.  Not even the financial entities, which are typically considered to be sophisticated at risk mitigation.  In fact, S&P Credit Analyst Prodyot Samata noted in 2005 that applying the PIM Approach to its review of the trading risk management efforts of numerous financial institutions found, surprisingly, “no concentration of best practices at any single institution”.

In my experience, even those entities which have taken significant steps to mitigate market risk do not typically address counterparty credit risk to the same degree.  It is simply not well understood that even balanced positions – those which bring such comfort to trade floors and risk control groups - often introduces credit risk on one side of the position and liquidity risk on the other.  Long after the traders have completed the transactions, these exposures must be managed every single day – sometimes for the years it may take them to roll off. 

In addition to the sheer volume of the growing pool of transactions which must be managed, consider for a moment the stunning breadth and complexity of the resulting credit task, with its dizzying array of possible entities, products, contracts, venues, tenors, pricing arrangements, and other variables which must be considered.

The participants in the “bizarre bazaar” which is the international energy market are amazingly diverse.  They have varying degrees of financial wherewithal ranging from the economic power of an entire nation to a trading operation with nothing more than a Cadillac and a car phone.  Their actions can be regulated as tightly as a parolee’s or as loosely as Paris Hilton’s.  Their motivations for transacting can range from blind greed to geopolitical interests to risk mitigation.  They trade products on their own account or via wholly-owned subsidiaries, partially-owned joint ventures, or agents, with other entities which have done the same.  They trade in venues including exchanges - such as the NYMEX, electronic trading platforms - such as the ICE, or “over the counter” (OTC) – such as the phone call, restaurant, or golf course.

The products themselves include hundreds of thousands of natural hydrocarbon compounds as well as the energy they can produce and ancillary services associated with their delivery.

  They are traded in physical or theoretical form based on the commodities themselves or their related derivative instruments.  The transactions can be for fixed or floating prices ranging in tenors from minutes to decades and volumes valued from a few dollars to tens of billions.  The contracts which govern the entire business relationship as well as the individual transactions themselves can be standardized, proprietary, or undocumented (i.e. verbal).

It is easy to see that it takes significant resources including personnel with the requisite knowledge and experience, well-developed processes, and robust systems to effectively manage the exposures which can arise under relationships with such a complex web of possible transactions.  Now compare that fact to the amount of resources which are typically allocated to the effort.  Between the time deals are entered into the multimillion-dollar trading system and the time they are processed by the multimillion-dollar accounting system, the Credit Department often handles things under the direction of an exhausted Credit Manager armed with a few young analysts and some spreadsheets.  

When credit risk is not properly managed, entities can be bankrupted within days – even despite a lack of market or other risks which may have been successfully mitigated.  Any effort which acts to consider energy trading risks holistically is definitely another step in the right direction.