Did you hear the story about the successful company with no liquidity?  No, you did not.

Recent failures of finance and commodity trading companies have again brought into sharp focus the incredible importance of liquidity.  Profitability is good, too, but many firms suffer losses and keep on chugging - for a while at least.  Inability to meet immediate funding demands, though, has swift and dramatic consequences.  You can be out of business NOW.

Although it is possible that many trading companies with significant problems may be able to eventually work things out, the simultaneous refusal of a large number of counterparties to trade with them on open credit can easily make collapse a fait accompli.

That is why the immediate response by many troubled firms to relieve market concerns is to raise large sums - or at least increase access to committed funds - and then crow about it as loudly as possible.  Their hope is to reduce or prevent a "run on the bank" like the one described by Jeff Skilling to explain the speed of Enron's fall.  Bear Stearns' approach was to immediately offer guarantees by prospective acquirer JPMorgan Chase to their trade counterparties; Enron's was to quickly get a $1.5 billon loan from Dynegy.  Obviously, that response doesn't always work.

Even firms not as firmly in the crosshairs understand the need to reassure the market at the first hint of even flimsy rumors.  Lehman loudly made it public knowledge that they not only had $30+ billion in cash and $60+ billion in available credit, but they were issuing billions in additional capital as well.  Just to calm any remaining doubters.

This is because many trading companies operate in the over the counter (OTC) market at reduced cost by maintaining large open credit lines with their trading partners.  They simply get to buy on credit in a manner not allowed on exchanges, which mark exposures to market every day - essentially "collateralizing" them anyway in a "pay-as-you-go" manner but reducing the magnitude of an unforeseen "liquidity shock" from the instant loss of open credit lines.  Maintaining the confidence of one's OTC counterparties is obviously critical.

Illiquidity often stems from collateral demands from trade counterparties for mark-to-market (MTM) exposures for fixed price deals.  This is to cover the difference between current market prices and the contracted amount the parties originally agreed to for deals which occur in future periods.  When market prices move away from those fixed contract prices, one party is exposed to the future performance of the other.  In fact, if a fixed price deal is struck while the market is open, one party will likely have some amount of MTM exposure within minutes.

Trading contracts often contain provisions permitting frequent - often daily - margining between counterparties if exposures exceed approved limits.  They may also permit the reduction or elimination of those approved limits upon a "material adverse change" in the condition of the parties or even in the case of events causing "reasonable" grounds for insecurity of a party.  This means that not only does a company have to worry about a.) suffering actual capital losses on completed transactions as well as b.) whether their current MTM position of ongoing deals will exceed approved open credit limits, but they also need to fret about c.) whether their existing limits will disappear on the whim of their counterparties who may be spooked by market rumors and bring current and future business to a halt until "adequate assurance" is provided.

It is ironic that the actions intended to mitigate concerns over a company's future performance can cause its immediate failure.  "We are not sure that you will survive, so we are gonna kill you now."

It is even more ironic that the fixed price positions put on by a company could spell its doom even though they may be part of a profitable hedge or may become profitable over time if permitted to run their course.  This is not baseball, though, where "it ain't over ‘til it's over".  When facing a liquidity crunch, it is not uncommon for companies to be forced to close out or sell off even positive positions at a discount in exchange for quick cash or to stop the bleeding.  In fact, a large part of hedge fund Amaranth's approximately $6 billion hit in 2006 (2/3 of the fund's value) was due to its being forced to immediately sell illiquid positions at fire sale prices and lock in losses.  The urgent need to trade was accelerated by collateral calls and the damage was done in only a few days.

It can't be stated too loudly or too often - liquidity is the mother's milk of a trading operation and must be managed with that in mind.  You can make a bad deal here or there and live to tell about it, but if you run out of cash or other collateral, you may be out of business even if the value of your trading book is positive.  It is critical that those running such efforts understand the consequences of the contractual terms they agree to and the market venues they choose.

Risk Managers, rejoice, you are getting smarter and better looking with each passing day!  Folks who help manage risk are enjoying unprecedented respect these days, much like “overnight sensations” in the music industry whose worth is finally discovered after spending most of their careers in dingy bars.  (That analogy turned out even better than I thought it would.)  I predict that 2008 will be the breakout year for those who provide enterprise risk management goods and services as entities race to implement greater controls and deal with decreased access to liquidity.

This epiphany has come about because the last 10 years or so have been a stunningly risky period for corporate stakeholders with one massive problem after another.  The most recent, the meltdown in the mortgage industry and its subsequent effects, may have been the coup de grâce for any remaining risk-tolerant holdouts.  The growing clamor for more effective risk controls has now turned into a deafening roar.

During the past decade alone, we have had an internet boom and subsequent bust; an energy bust and subsequent boom – with an “energy crisis” thrown in the middle for good measure; numerous geopolitical conflicts; prosecutions of corporations and their executives, both justified and overzealous; natural and unnatural disasters; deregulations and re-regulations; a credit market meltdown; and assorted other calamities.  That, my friends, is risk.  No wonder people are finally looking for help.

How would YOU like to be a corporate executive these days?  Using the energy industry as an example, where would you turn for help with risk mitigation?  The commodities market?  Please.  That is often the source of the problem.  Improperly structured market positions which fail to consider associated credit and liquidity risks can doom a company quicker than remaining unhedged.  A small producer who is otherwise profitably selling its products under fixed prices in a rising market could easily see margin calls deplete its liquidity, leaving none for operating needs.  And as we all know, net income doesn’t pay the bills – cash flow pays the bills.

How about the credit market?  As we have seen, it has contracted significantly due to the surprising collapse in the mortgage industry.  While it is still possible to get funding, the terms and conditions now reflect recent events.  Exacerbating the resulting liquidity shortage, more energy entities are transacting under contracts with risk-mitigating – but logistically challenging - margin provisions and face more collateral demands as described above.

Insurance products may or may not be cost effective, either.  Although coverage continues to evolve to address the risks of structured and other transactions, insurance companies have had their share of challenges lately, too.   For example, in addition to the billions in exposure for human-caused events like 9/11 and corporate malfeasance, insured losses for natural disasters such as earthquakes, hurricanes, and floods cost the industry a record $44 billion in 2004, nearly triple the previous year, and THAT record more than doubled to $94 billion in 2005, according to reinsurer Munich Re.  To top it all off, Lindsey Lohan started driving – sort of.

International energy matters continue to produce significant uncertainty as well.  In the last year alone, energy entities have been “strongly encouraged” to renegotiate their contracts or have had assets nationalized outright in Bolivia, Venezuela, and Russia, to name a few.  Additionally, there continues to be concern over the security of the gas supply from Russia to Europe, which is also moving quickly to deregulate its gas and power markets.  Think it is difficult to implement deregulation in the U.S.?  Imagine trying to do it while considering the demands of numerous sovereign entities with different languages and national interests.  How and when it will ultimately work is still to be decided.

For some, the prospect of increased regulation by government entities represents a considerable risk as well.  For example, as executives of numerous oil majors in the U.S. found out, even if you earn a return in line with other industries, you may still be hauled before Congress and threatened with criminal sanctions and a tax on “windfall profits”.  Additionally, hedge funds are being increasingly criticized by authorities for, among other things, failing to manage counterparty credit risks and for introducing systemic risk to energy markets.  Look for them to begin to respond by enacting greater controls fairly soon.

All of these issues, as well as many others, have contributed to the growing recognition of the need for entities to navigate the corporate minefields and effectively manage enterprise risk.  That will require investment in people, processes, and systems.  In fact, even if there is a significant effort already in place, it must be demonstrably effective and bring confidence and comfort to auditors and others.

 Whether the pressure is coming from regulatory entities who want to prevent abuse, investors and shareholders who want to know the risks they are assuming, employees who want to ensure that their companies are well run, or executives who are concerned with compliance demands, the value of a solid risk management effort has never been more appreciated.

So we salute you, Mr. and Ms. Risk Manager.  2008 is your year!

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.

Training, whether classroom or online, is designed for one purpose.  To change the knowledge, skills, or behaviors of the participants.  We at ROME believe that timely access to training is critical to the success of any software implementation, as well as, the subsequent changes in business processes.

It would be great to hear of your past experience with training or the lack of it and how it impacted the success of the project.

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.

• It is a long-running process that must occur on a regularly scheduled basis.
• The volume of data to be processed is high, usually on the order of thousands to millions of database rows.
• There may be complex logic or calculations to perform on the data.
• The process may require a large set of data from some other system that is delivered at a specific time in a large set.
• The process is run asynchronously from user interactions. It is not part of a user session in an online system. A user does not start it and is not waiting on it to complete.

• Stored procedures are typically implemented in the version of SQL specific to the database platform and are not portable to other databases. This may not matter for a departmental application but is usually not acceptable for an enterprise software product that must be supported on many different databases.
• The JEE platform provides complimentary technology such as JCA connections to other systems, Web Service calls to other services and other features that might be useful.
• Logic implemented in Java can reuse other application logic that is also present in the business layer tier of the application.
• Well-written Java code is usually easier to understand, maintain and enhance than a collection of stored procedures.
• JEE servers usually include clustering capabilities providing the ability to federate multiple, cheap, commodity servers to improve batch processing performance.

Prepared Statements
Most databases support the idea of pre-compiled SQL statements called prepared statements. A prepared statement is a SQL statement with placeholders for parameters that will be supplied later on with actual data values. The statement can be compiled once and then reused even if the parameters change. This saves compilation time on the database platform and improves performance. 

Batch processes usually involve multiple executions of the same SQL statements over and over with different parameter values. This is a perfect situation for prepared statements. Dynamic statements should always be avoided. 

Application Server Clustering
One of the benefits of using the JEE platform for batch processing is that one  can leverage its ability to cluster multiple application servers. If JMS is used as the transport mechanism to move messages from the dispatcher to the workers and the JMS implementation supports clustered, distributed queues (as many do), then the workers can reside on different physical machines. This provides a method to scale the performance of the batch process by adding application servers. A powerful cluster can be assembled using multiple, inexpensive commodity application servers and it can grow with the requirements of the batch process.  

Conclusion
While the JEE platform was originally designed for building enterprise web applications it has grown into a versatile Java server platform that can successfully solve many problems. Batch processing is a common enterprise requirement. The JEE platform can provide an excellent batch processing platform as long as care is taken to optimize database interactions.

The collapse of Enron produced a perfect storm when it became clear that many of the largest energy and financial services companies couldn’t accurately determine counterparty credit positions. We know that Enron collapsed in a chaos of complex contracts, thousands of counterparties and their collateral demands, and (lack of) cash. We’ve heard less about how lack of accurate data among its counterparties fueled a storm that rocked the company’s business partners and caused a few of them to capsize.  Back then—only a few years ago, but truly another era—managing credit risk and financial liquidity with comprehensive, enterprise-wide technology systems was a fairly uncommon business practice.Today, the energy industry is more aware than ever of the volatility that can occur when a company lets down its guard and doesn’t manage risk, and the industry is embracing technology that can protect it. It is also evident that too much concentration with any one counterparty is dangerous; that keeping track of transactions and understanding complex contractual relationships is essential to survival; and that a laser focus on financial liquidity (cash) requirements (including potential requirements) is crucial. As a result, comprehensive risk management systems have emerged as not only a key component of managing risk but a part of standard operating procedure for energy companies worldwide.

PERSPECTIVE OF RISK IS PARAMOUNT
Having an accurate view of a company’s credit risk is crucial. Investing in a comprehensive risk management and liquidity software solution has been the answer for many companies.This “vision from within” allows a company visibility into consistent reporting.System functionality stretches enterprise-wide to provide companies with the timely data they need, which matters not only for stability, but for survival. Whether by counterparty or by contract, comprehensive software solutions help companies manage their operations and position them to minimize the risk of, and even to take advantage of, market swings—sudden developments that are key to profitability in today’s volatile environment. Energy enterprises of all sizes have been thrown into a virtual pressure cooker by ratings agencies, as reflected by Standard & Poor’s new liquidity survey. Now these agencies (as well as, compliance with Sarbanes-Oxley and Basel II) and others like them require companies to report exactly what they owe and who owes them, and how that might change with significant market events.

MORE MARKET VOLATILITY
In considering a market that is inherently volatile it simply makes sense to take steps to manage that volatility and its associated risks. That’s why more companies are turning to technology. Risk management solutions created specifically for the industry allow companies to track all pieces of a business, including crude oil, natural gas and financial derivatives activities, as well as manage liquidity for a clear view of a company’s inner financial workings. With the right technology, a market participant can delve into the business of energy contracts, giving management immediate awareness of credit and liquidity risks that could potentially leak millions of dollars from the company, as well as expose non-compliance with regulatory or legislative requirements. What’s more, companies operating with technology on their side can manage all key counterparties and contracts while sharing that information across other company systems, like ERP, logistics or trading. Everyone’s informed, and everyone’s on the same page in the same book. That’s key, especially in light of Sarbanes-Oxley. Chief executive officers are now personally on the hook for the accuracy of their companies’ financial reports.With its increased reporting requirements and financial controls for companies in virtually every industry, the legislation is forcing companies to rethink strategy. If a company can’t comply with quarterly financial reporting requirements weeks after the fact, how can it create the information needed to manage the company dynamically in a volatile market? Having weathered the storm, companies now know what to expect, how to avoid hazardous waters and how to minimize risk. Some of the most respected companies have decided to utilize technology to help them gain a better perspective on their risk scenarios. These leaders have taken the long view because they are taking advantage of risk management technology. As a result, they: gain significant efficiency in reporting of exposure and available credit; can easily resolve margin disputes; can meet S&P liquidity reporting requirements; are discovering unassigned overpayments; have the ability to call for collateral on contracts where they haven’t been able to provide timely and accurate contract-based calculations in the past; can minimize the capital consumed by credit risk; and can minimize the potential for financial liquidity crises from volatile market events. One might call it a lesson in perfect forecasting, with a view in which storm clouds never gather.