Energy Financial Risk Management

Energy risk management is important because energy is a commodity that is growing in demand worldwide, and speculation related to energy will continue to be active. The activity will be continuously high due to opportunities for energy producers as well as natural and man-made circumstances that influence energy investing. Companies can benefit from establishing an energy risk management program which starts with the support and education of top management and is followed by a careful analysis of a company's risk objectives and energy needs. Companies can also benefit from outside counsel on implementing risk management strategies.

Keywords Asset Valuation; Corporate Finance; Energy Deregulation; Energy Derivatives; Energy Finance; Financial Risk Management; Risk; Risk Management; The Federal Energy Regulatory Commission

Finance > Energy Financial Risk Management

Overview

Managing Energy Risk

Energy finance has to do with financial analysis, valuation and trading of positions in oil and gas exploration, production and distribution as well as power companies and energy trading. Energy finance can be highly specialized and complex, requiring specific financial knowledge as well as industry knowledge. According to Chevron Oil CEO John Watson, even on the most seemingly attractive projects, one needs to bake in a big margin of error (Helman, 2013). Some investors look to hedge or find protection against energy risk by investing in certain types of financial instruments that offer protection against price fluctuations. Energy companies may try to protect themselves against price fluctuations by investing in long term energy contracts or by employing trading staff who regularly engage in hedge trading in the energy market (Gerston, 1999).

Investment in the Energy Market

Zaccaria (1999) noted that market volatility is a major risk related to energy investing requiring the cautious to deploy some type of insurance against this risk. Insurance can come in the form of "hedging tools" to protect against rapid price changes. Left uninsured, companies face negative effects on "earnings, cash flow and stock price performance." Complex financial instruments are the typical weapon of choice in energy risk management. These include New York Mercantile Exchange (NYMEX) contracts, over-the-counter (OTC) contracts, call options and weather derivatives. Derivatives are financial instruments that are based on some underlying security. The speculative nature of these tools does not make them complete sources of hedging insurance and one tool may create risk not covered by other tools. Some of the risk may be due to unforeseen energy-related events that cannot be predicted such as supply shortages, power failure or power problems related to natural occurrences. If an option is selected as an investment hedge, the timing of the options expiration may leave the investor exposed.

Energy Insurance

Energy insurance may provide a better vehicle for the risk demands of the energy market. Insurance is needed in energy speculation to cover the natural variance of risk in a market like energy. It also is viable no matter what size the energy company might be. Zaccaria (1999) found that the cost of insurance was much less than risk protection from options in addition to the benefits of being a flexible and familiar choice in risk protection.

Energy Regulation

Another risk in the energy market is the deregulation of the utility industries. Gersten (1999) suggests an "energy risk management program" for companies with high energy consumption needs. Energy deregulation is a risk because it becomes more difficult to predict energy prices. For those who consume a lot of energy, high fluctuations in price could be devastating and unplanned. Companies can insure against energy risk by purchasing insurance or by using electricity based derivatives contracts that provide a hedge against price changes. There are also forward contracts which are similar to futures contracts that are not traded on futures exchanges and are privately negotiated that provide similar protection. Gersten noted that anyone can face energy risk if the energy is purchased from a deregulated supplier and the companies may be unable to pass this cost on to customers. The reason deregulation makes more risk is that demand varies widely and the competitive market's response to demand will be changes in price.

One impact of state deregulation has been power production being separated from distribution resulting in greater exposure to distributors who must purchase large amounts of energy (Gersten, 1999). Unplanned weather changes such as hotter than normal summers or colder than normal winters have become the norm making power consumption needs unpredictable. Under these circumstances, energy companies must provide the required energy to support the demand regardless of how much the energy costs at the moment.

Managing Energy Risk

Energy companies, banks and hedge fund managers are interested in managing energy risk. Energy companies are interested because they have the most to lose from exposure to energy risk and have little opportunity to pass this cost onto customers. Banks and hedge funds are interested because they often engage in financial transactions in the energy market. Both may employ energy traders who regularly monitor energy market activity and construct hedge and risk vehicles to insure against risk.

The Changing Energy Market

Managers of energy risk must understand the changing energy market. Deregulation and the increasing globalization of energy markets can affect energy companies and the level of risk present in the market. Global competition over energy resources creates geopolitical tensions between the world’s major powers (Navon, 2011). Globalization affects the energy commodity markets and can create change in geographic markets. For example, emerging countries have an increasing demand for electricity as they seek to modernize their societies. Developed countries have an increasing demand for energy as their cultures demand more conveniences and create a greater dependence on energy. A few years ago, many business districts in the United States were closed after dark and sometimes on weekends. Today, the United States has a 24 hour, seven days-a-week marketplace increasing the need for energy. Technology improvements have made technology a necessity instead of a luxury in homes, schools and businesses. So, despite improvements in the energy requirements of technology equipment, the increasing quantity of equipment in use has made if possible to work, play, learn longer and has increased the demand for energy. Global warming and unpredictable weather also change the demand patterns for energy. Control of various energy products such as oil can have fluctuations based on political scenarios and muscle flexing by countries controlling oil production.

In the late 1970s and early 1980s, deregulation efforts began in the electric and gas industries to reduce the monopoly and control that energy companies had over these markets. Thottam (2006) noted that Enron — most famous for poor management, illegal practices and causing workers to lose pensions and jobs — should really be thanked for pushing deregulation as a tool to reduce energy costs and for establishing smarter energy risk management. Enron was one of the first companies to use software for energy risk management. Prior to deregulation, electric cooperatives — groups that purchase and manage wholesale power — managed risk in energy prices through negotiating rates on the federal and state level (Tudor, 2003). Energy risk is most potentially damaging to power suppliers who have 70-80% of their normal business risk coming from energy risk (Tudor, 2003). Not having an energy risk management plan in place is potentially costly for energy firms. Tudor gives an example of how dangerous having no plan can be. In the 1990s, cooperative purchasers of power paid a daily or monthly price based on the price of power or natural gas. At low prices, contracts of this type were not risky but when prices multiplied to more than triple the normal cost, the high costs underscored the need for some risk management plan. Another example is of power companies that had agreements that were for a term of a few years and the companies then had to grapple with massive increases once the fixed price contracts expired. Passing that type of cost on to the consumer is impossible because the government would step in before allowing massive increases for consumers.

Creating a Risk Management Plan

Tudor suggests proactive risk management that begins with an analysis of the risk culture of the company and the decisions the company makes. Any change of cultural has to start at the top and must be supported by top management. In order to perform a risk-oriented analysis of management decisions, one must determine if a decision will create risk or lower it. Tudor (2003) suggests six steps to create an energy risk management plan. They include:

  • Establish a corporate culture that emphasizes risk awareness.
  • Identify, analyze and evaluate every risk area faced by the company.
  • Develop a formal policy to establish authority, responsibility and accountability regarding each risk area.
  • Develop procedural mechanisms to monitor and control the risk areas of the company.
  • Develop and disseminate formal risk management reports.
  • Establish specific time intervals to review risk management results and actions taken.

Ignoring risk won't make it go away. Allowing for risk and insuring against it requires a concerted effort that is steeped in a risk aware culture and an understanding of what risk means for a firm. Companies in risky industries such as energy must make risk a priority before it can be effectively tackled. The difficulty with the suggestions for a risk management program is that such a plan increases cost and the complexity of the approach along with making management processes more complex. Tudor noted that there are energy risk management software programs available, some of which are costly. Even if the programs are acquired, they may not have the complete functionality needed by the user, and additional cost may be incurred with software customization. AcuRisk is an energy management software product that looks at assets and portfolios and offers strategies to maximize earnings. AcuRisk goes farther than other software products in an attempt to create a comprehensive picture of the company's business (Productivity Software, 2003).

An energy risk management program has to begin with education of the parties involved in order to help everyone, regardless of responsibility, understand energy risk. Policies have to be in place to make sure everyone knows what to do and who is responsible. The company must establish an approach to the tasks related to identification of risk and understanding what the ramifications of the risk are. Companies may also want to engage third parties to monitor the company's compliance with risk programs. Utility Week (2005) reported on the use of middlemen or intermediaries in Britain as a response to increases in energy costs and the complexity of energy contracts. Many engaged in creating energy risk management programs will have to engage other knowledgeable intermediaries to protect their interests. Energy risk management products have become more complex and increasingly sophisticated while the energy market remains unpredictable, so the need for intermediaries will increase. Firms must have more sophisticated risk management to lower the chance of low-likelihood, but catastrophic, disasters associated with Arctic exploration, ultra-deepwater drilling and shale gas extraction (Marsh, 2013). Finally, reporting on risk activity is the only way to truly measure compliance and progress (Tudor, p. 20 — 21). Once a company begins to track energy risk management activity it becomes clear if this activity has paid off or needs to be revised.

Viewpoint

The Dangers of Energy Risk Management

Electric Light & Power (2007, p.34) calls risk "…any event or condition that could potential cause outcomes to differ from expected outcomes, either negatively or positively." Energy risk management is defined as "…the professional practice of measuring, hedging and communicating the risk posed by commodity markets (such as electricity and natural gas) and controlling the personnel (such as traders) who transact in those markets." Risk is inherent in any business but can have a greater impact in the energy market. Traditional utility risk management was more concerned with safety and insurance risk reduction while post deregulation risk management often looks at the market risk associated with trading in the energy market.

Inaction

There are several dangers in energy risk management. First, there is the danger of assuming that you are doing all you can and taking no action in energy risk management. This is dangerous because you can be lulled to sleep during a period when there are limited risk considerations such as during times of market stability. The devastation that can occur during times of instability can be unexpected and quite damaging. Since it takes time to put together a high quality energy risk management program, there may be additional delays as a company tries to recover from the results of being unprotected from risk.

Lack of Experience

Another danger is that the energy risk market is a newer market so there is less tangible experience available in achieving success than one might find in other financial markets (Bacciocco, 2001). Energy risk is very complex and education is required to prepare companies to even begin to address this risk. It is expected that the energy market will mature and appear to be more like the traditional financial markets that have experienced financial advisors available. However, at this point, there are few "established market makers and brokers" in the energy risk market (Bacciocco, 2001, p.20).

Unpredictability

Energy risk management is a requirement for companies to survive and the market is very unpredictable. This lack of predictability exists even though energy demand is consistently increasing. Herbst (2007) noted a four year increase in oil prices; up 30% in 2007 alone with the anticipation of continued hikes in oil prices coupled with increased demand. Global demand is strong in several geographies including China and India and is expected to remain strong in Europe and the United States. Companies will only increase their capabilities in energy risk management with practice which is inherently dangerous. Though the energy market is less "sophisticated" than traditional financial markets, energy risk management is still complex and requires resources, capital and time to achieve the knowledge base needed and the comfort-level with the process (Bacciocco, 2001).

Price Volatility

Vasudevan & Higgins (2007) identified price volatility as a danger because it causes difficulty in planning and budgeting for companies. Natural gas is an example of how continuing rises in prices causes problems for investors who are in the market to control energy costs. Volatility in energy prices can affect a company's gross profit margin and earnings which causes these measures to be volatile as well (Vasudeven & Higgins, 2007).

Poor Buying Practices

Loveday (2005, para 1.) reported on UK companies losing over 1 billion because of "poor energy buying practices." It is recommended that companies have an energy buying strategy, make certain that management is actively engaged in trying to reduce energy risk and that board members are accountable for decisions that are made regarding energy risk. Managers of these companies will need assistance in coping with rapid change. The complexity of energy risk management has created career opportunities for those who can demonstrate skill because of the requirement to remain ahead of energy market risk and energy market changes (Anderson, 2005). New energy risk strategies are emerging daily, some from energy management based vendors and others from traditional financial products vendors. This danger means companies must choose the strategies based on energy industry knowledge or based on financial product knowledge and it may be difficult to determine which is best (Bacciocco, 2001).

Energy Risk Management Alternatives

Companies have several alternatives for energy risk management (Evans, 1998):

  • First, companies can develop their own internal energy risk management policies and employ traders to manage their energy position in the market.
  • Companies can also decide to avoid energy trading altogether and use traditional utility risk management strategies ignoring post deregulation energy risk management solutions.
  • Software solutions can be deployed to develop hedging strategies for money management.
  • Insurance can be purchased to provide protection against energy risk.
  • Companies can elect to utilize external financial experts to manage the company's energy position. If a risk management program is selected, the support and education of senior management is required to make it successful.

Alternatives within Specific Industries

Traditional responses to the deregulation created volatility of the 1990s has been to install smart meters (dependencies built into customer contracts based on price increases), reducing plant open times and investing in low cost lighting (Anderson, 2005). When traditional methods don't work, companies must come up with creative alternatives to suit their specific industrial needs. For example, the chemical industry requires a heaving dependence on gas and oil for chemical processing. Chemical companies have decided to join together in energy buying pools in order to reduce utility bills. These same companies are also purchasing energy contracts and financial instruments to lock in known energy rates for a period of time (Graff, 2005). A group of manufacturing companies in the Chemistry Council New Jersey formed a buying pool for purchasing electric power due to high electricity rates in New Jersey. Chemical trade groups in Texas also organized buying pools. Vasudevan & Higgins recommended strategic energy risk management for any firm in manufacturing or process industries. These industries are heavily exposed due to high energy costs and due to the fact that in any production situation, if cost is added further into the system it magnifies cost across the system. Vasudevan & Higgins (2004) call this ripple effect "shock" and note that shocks increase operations cost and are passed right along to the earnings and bottom line of a company. The inability of companies in manufacturing and process industries to continually increase prices and pass along shock to consumers makes risk management a requirement. Global competition for manufacturing and process companies has reduced their ability to raise prices and in some cases has even caused them to have to lower prices.

Some companies may choose to engage energy procurement firms to develop specific energy purchasing strategies to reduce risk and save money. These strategies may involve negotiation of special pricing, volume discounts or helping companies form buying pools with others in their geography or industry (Graff, 2005).

Hedging Options

Graff describes several hedging options for energy risk management. They include swaps, call options, put options and collars. Each has various advantages and disadvantages except the put option which has no disadvantages. A collar is a combination of a call (contract to buy) and a put (contract to sell). Collars give buyers the right to buy at a specific price while agreeing to pay a minimum price no matter if prices go below that minimum price. Call options and swaps may have some danger for the investor if energy prices fall.

Requirements for Risk Management Strategies

Successful companies will use increasingly sophisticated tools for managing energy risk. Bacciocco (p. 20) cited an AMR research report suggesting the minimal requirements of energy risk management strategies include:

  • Robust analytics that tie in with enterprise applications: Companies will need to use risk strategy systems that are compatible with the enterprise applications to which the company is already committed. Not doing so could mean duplication of data, errors or re-entering of data.
  • Trade management capability: This capability will allow companies to manage high volumes of transactions and do a better job of tracking trading success.
  • Integration with marketing and operations systems for demand data: Integration across functional areas can maximize the company's use and control of important data.
  • Performance ability for analysis across markets and commodities: Energy management must increasingly take into account additional commodities, geographies, geo-political conflict, globalization and other factors. Failure to do so limits the reach of an energy risk management program. Herbst reported on the risk due to countries fighting over control of oil fields, another factor expected to increase the price of oil.

Conclusion

Vasudevan & Higgins (2004, p. 74) defined strategic energy risk management as "the development of a systematic method to analyze exposure…to risk". A company can then determine how to manage risk based on the company's ability to handle risk and depending on what objectives the company has from a growth and financial perspective. Company management must be in synch regarding what the goals and objectives are and what decisions are made regarding risk, how and by whom. Systematic implies that consistency will net rewards in the management of energy risk. A risk management program must begin by quantifying the company's tolerance for risk by looking at the amount of variance in gross profit margin that can be accepted across product lines, operations, business units and the company as a whole (Vasudevan & Higgins, 2004). After a comparison with historical data and completing a detailed analysis, a company can proceed to establish a range of earnings that are tolerable. Next, the company should create a map of energy usage by location over time and assign this usage to products, departments, business units and the entire organization. These numbers should be analyzed for seasonal trends and compared with historical data. This information can be used to create a distribution of energy costs and create a strategy for hedging these costs using financial instruments based on the company's objectives, risk tolerance, usage of energy and the current situation in the energy market. Implementation of a strategic risk management program starts with an analysis of cost involved (Vasudevan & Higgins, 2004). If the costs are too high, the strategy cannot be implemented.

Finally, companies should look to all possible outlets for managing energy risk. These can include traditional risk management methods, adopting an energy risk management program, employing internal and external experts, and looking at all forms of internal energy usage — not just one (Graff, 2005). The more comprehensive the company's efforts, the better the results will be. Energy risk management is here to stay and companies that remain viable will need to engage in risk management activity on a continuous basis.

Terms & Concepts

Asset Valuation: Determining the value of an asset or company.

Energy Deregulation: Restructuring of energy industries to make them more competitive and provide opportunities for new entrants as providers and lower costs to consumers.

Energy Derivatives: Derivative contracts (often futures and swaps) based on oil, gas and other energy securities.

Energy Finance: Financial analysis, valuation and trading of positions in oil and gas exploration, production and distribution as well as power companies and energy trading.

The Federal Energy Regulatory Commission: Regulatory body over energy industries.

Risk: Uncertainty. In financial investing, the uncertainty regarding the return on an investment.

Risk Management: Creation of strategies to avoid risk, in the financial sense, using trading of financial securities as a means to reduce risk.

Bibliography

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Gersten, A. (1999). Hedging your megawatts. Journal of Accountancy, 188, 47-54. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=2624898&site=ehost-live

Graff, G. (2005). Energy buying for the risk-averse. Purchasing Chemicals, 134, 40C4-40C6. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17929148&site=ehost-live

Helman, C. (2013). The world's biggest gusher. (cover story). Forbes, 191, 62-68. Retrieved November 26, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85639723&site=ehost-live

Herbst, M. (2007). Why oil could be headed even higher. Business Week Online, 5. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26098884&site=ehost-live

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Middlemen drive 60% of deals and figure will rise. (2005). Utility Week, 24, 10. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=18571736&site=ehost-live

Navon, E. (2011). Managing energy risks in the 21st century. Revue Management Et Avenir,, 293-309. Retrieved November 26, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=60679267&site=ehost-live

Primer on energy risk management. (2002). Electric Light & Power, 80, 34. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=7057180&site=ehost-live

RCM Acquires e-Acumen's ACURISK management software. (2003). Productivity Software, 16, 6. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=10094638&site=ehost-live

Thottam, J. (2006). Show Enron some love. Time, 167, 14. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=19472629&site=ehost-live

Tudor, D. (2003). What is energy risk management… and who needs it? Management Quarterly, 44, 16-21. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=11815243&site=ehost-live

Vasudevan, S. & Higgins, B. (2004). Strategic energy risk management for end users. Journal of Structured & Project Finance, 10, 74-78. Retrieved October 1, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=14742856&site=ehost-live

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Suggested Reading

Kramer, A.S., Lee, D.S. & Biek, J.A. (2007). Energy derivatives through federal and state tax glasses. Journal of Taxation of Financial Products, 6, 15-36. Retrieved November 13, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25089848&site=bsi-live

Marquardt, K. (2007). Power of a different sort. Kiplinger's Personal Finance, 61, 55-56. Retrieved November 13, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=25295469&site=bsi-live

Sankey, P. (2007). Counting the cost of under-insurance. Reactions, 27, 14-15. Retrieved November 13, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=27078111&site=bsi-live

Taival, D. (2007). Financing options to meet building performance and business goals. U.S. Business Review, 10, 14-15. Retrieved November 13, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=26183808&site=bsi-live

Essay by Marlanda English, Ph.D.

Dr. Marlanda English is president of ECS Consulting Associates which provides executive coaching and management consulting services. ECS also provides online professional development content. Dr. English was previously employed in various engineering, marketing and management positions with IBM, American Airlines, Borg-Warner Automotive and Johnson & Johnson.