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Risk Management in EnergyMarketsLiterature Review - II

Amandeep Arora

Roll No

103 (PGDM-Finance)

K. J. Somaiya Institute of Management Studies & Research


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Literature Review II

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IntroductionIn the last submission of research paper, various historical developments in the field of energy risk

management were highlighted. There emergence of various stick exchanges along with new types of

contract that can be customized to ones risk appetite were also elucidated. In addition to that, I

highlighted various hedging instruments and option trading in energy markets. The criticality of the

managing risk in energy markets was also highlighted with the view to develop some perspective aboutvarious stakeholders in this market.

This dissertation concentrates on summarizing the past literature on the issue. It also highlights the issues

of risk management in the past with citation of actual instances where companies failed in managing their

exposure to energy risk. SarbanesOxley Act came into being as U.S. legislative response to recent spate

of accounting scandals (Enron, WorldCom, Global Crossing, Adelphia Communications) is also

highlighted upon in this paper. In commodity markets in general, and energy markets in particular, the

model corporation produces and/or consumes in future time a random quantity of a commodity. Using

combinations of several types of contracts, the firm seeks to reduce its downside risk while maximizing

profits.

Literature SummaryThe ever increasing number of practices and strategies has been brought forward to manage the risk

associated with energy markets. The evolutionary process of risk management that occurred in oil and gas

markets presages the growth of energy risk management usage globally. Major oil companies now buy

and trade on the spot markets to meet supply needs that were previously met by their own production and

their involvement in paper trading have increased over time. Price volatility will increasingly be managed

through a wide variety of existing and emerging financial instruments for the short and longer term.

Because risk management tools are now widely accepted and available as means to reduce financial risks

in commodity markets, their application in energy markets will only increase over time.

Electric power is a market that never closes

where prices change hourly, half hourly and

quarter hourly. It is the most volatile

commodity ever created and therefore its

financial markets are smaller as compared to

oil and gas markets. Managing risks associated

with the energy industry is becoming

increasingly complicated due to factors such as

government regulations, public policy,

financial concerns, and energy resourcescarcity. In order to address these issues,

impacted companies often implement

energy risk management strategies.Figure1 Price fluctuations in short-term transaction of Electricity

There is extremely high correlation between different energy commodities which makes it essential to

understand the impact of one commodity on another. Hence, strategies like arbitrage and hedging have


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Crude Oil Natural Gas CER Electricity USDINR Dollar Index

Crude Oil 1

Natural Gas -0.1903 1

Certified emission reduction (CER) 0.7639 -0.1533 1

Electricity -0.3059 -0.2976 -0.3895 1

USDINR -0.6869 -0.2388 -0.5435 0.5971 1

Dollar Index -0.5389 -0.0659 -0.5960 0.4258 0.5524 1

Source: MCX; RBI; ICE

became a buzz word in energy markets which face extreme uncertainty and hence have a strong need to

manage risk appropriately.

Table 1 Correlation Matrix - Non-Agri Energy Commodities (MCX Spot prices)

In India, Multi commodity exchange (MCX) set up in 2003 is a state-of-the-art electronic commodity

futures exchange. It has permanent recognition from the Government of India to facilitate online trading,

and clearing and settlement operations for commodity futures across the country. On 6th February 2007,

the CERC issued guidelines for grant of permission to set up power exchanges in India. In 2008, India got

its dedicated power exchange i.e. Indian Energy Exchange (IEX).

Today we are still only hedging about half of the global commodity price exposure of the physical energy

markets. To put this statement into some perspective, the annualized notional value of all energy

derivatives is over $3 trillion, compared to a physical energy market of $5 trillion annually. Commodities

usually trade at least 6 and up to 20 times the physical market.

Options in energy futures

As energy futures contracts become more liquid, exchanges usually launch option contracts. NYMEX

provides a variety of option contracts range which investors can choose in view of their investment

strategy. Aside from the traditional European and American style options, they offer:

Average price options (also called Asian or average rate options) - These are settled against theaverage of prices for an underlying commodity for a specified period.

Calendar spread options - This contract is on the price differential between two delivery dates for thesame commodity. It helps market participants manage the risk of changes in the price spread.

Crack spread options - The crack spread is the difference between the price of crude and refinedproducts. This contract helps refiners and other market participants efficiently manage the risk of

changes in this differential.

Inventory options - NYMEX offers clearing services for over-the-counter options on the weeklycrude oil storage number released by the Energy Information Administration (EIA) of the U.S.

Department of Energy.


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Metallgesellschaft AG: A Case StudyMetallgesellschaft AG, or MG, is a German conglomerate, owned largely by Deutsche Bank AG, the

Dresdner Bank AG, Daimler-Benz, Allianz, and the Kuwait Investment Authority. In December, 1993,

Metallgesellschaft AG revealed publicly that its "Energy Group" was responsible for losses of

approximately $1.5 billion, due mainly to cash-flow problems resulting from large oil forward contracts it

had written. The Metallgesellschaft AG(MG) affair of 1993-94 conveyed three central messages to thepetroleum industry: one pertaining to the relationship between hedging and speculating, one pertaining to

corporate governance, and one pertaining to commodity market dynamics.

On the message of hedging vs. speculating, MG's US oil subsidiary, MG Refining & Marketing

(MGRM), designed an innovative program aimed at rapid expansion in a mature but evolving business-

the marketing of petroleum products. MGRM used a strategy combining over-the-counter (OTC) and

futures instruments that contained a speculation on the relationship between near and distant prices. That

speculation went against MGRM for a time, causing it to incur very large margin payment requirements

and other cash flow disruptions.

Regarding the issue of corporate governance, the extent of MGRM's activities in financial energy marketsappears to have caught its parent-and within the German system of corporate finance, its parent's banking

shareholders-by surprise. When MGRM's speculation moved against it for a period of time that may have

been short-lived, it suffered large "mark-to-market" losses and large margin payment calls. The mark-to-

market losses initially remained paper losses, but the margin calls were a drain on MG's cash flow that

were larger than MG's management was willing to tolerate. According to some critics, MGRM's parent

terminated the strategy so abruptly as to increase the size of the losses far beyond what would have been

incurred with amore-patient unwinding.

On the aspect of market dynamics, MGRM's open interest in the oil financial markets-both exchange-

traded and over the counter became extremely large. When a single company commands such a large

share of open interest, markets can become dysfunctional in one of two ways: the company can obtain the

power to squeeze other participants, if those participants remain fragmented and disorganized; or the

company itself can be squeezed, if other market participants begin to trade against the company in an

organized manner. In MGRM's case, the speculative part of its strategy-the reliance on near-month

contracts to hedge the bulk of its long-dated positions-required a rollover of its long position in the

exchange-traded markets. This rollover was so large that other participants-especially funds that were

adept at trading-anticipated its actions and, by "herding" their trades (not by design, but by widespread

identification of the rollover), precipitated a change in the market structure from backwardation to

contango. The emergence of that contango, in turn, caused the "rolling stock" aspect of MGRM's strategy

to go from a source of trading profits to a source of trading losses.

This case indicates the consequences of speculation in energy markets. It also highlights the role played

by corporate governance in energy markets. MG's disaster in the oil markets should be seen as a reminder

to the corporate community to understand the nature of their position in financial markets and to

understand the ramifications of market movements on your financial positions. It should not be seen as a

warning sign to corporate CFO's to stay away from derivatives markets. These markets provide

tremendous value to their users. The swaps and futures markets provided MGRM with an opportunity to


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transfer their market risk. They successfully did this. They failed, however, to accurately estimate the

funding risk of their hedge position.

Sarbanes-Oxley Act (SOX) of 2002

This act set new or enhanced standards for all U.S. public company boards, management and public

accounting firms. It is named after sponsors U.S. Senator Paul Sarbanes and U.S. RepresentativeMichael G. Oxley. The Sarbanes-Oxley Act came into force in July 2002 and introduced major changes

to the regulation of corporate governance and financial practice. It set a number of non-negotiable

deadlines for compliance. The Sarbanes-Oxley Act is arranged into eleven 'titles'. As far as compliance is

concerned, the most important sections within these eleven titles are usually considered to be 302, 401,

404, 409, 802 and 906. An over-arching public company accounting board was also established by the

act, which was introduced amidst a host of publicity.

Other IssuesA lot of other issues are present regarding which an investor needs to be cautious while investing in

energy markets which are as follows:

1. The high correlation between various commodities in energy markets is higher than any othercommodity market. Hence one needs to study and clearly understand the relationship between

different factors to successfully trade in this sector.

2. The volatility of some energy commodities like electricity makes it very difficult to draw definiteprojections for future.

3. As we saw in Metallgesellschaft case, market risk is the pre-eminent risk in the energy markets.4. The increased regulatory guidelines have put stringent constraints for individuals with high risk

appetite who find it difficult to comply with it

5. Potential for market abuse - These markets are any more susceptible to market abuse than any other.It is vital that appropriate measures are in place at firms and exchanges to detect and prevent improper practices

6. Suitability of investment- Retail participation is currently limited and commodities have traditionallybeen regarded as too volatile for retail investors. However, there is some interest in making more

products available. A lack of experienced market professionals who fully understand the subtleties of

the commodities markets may also be an issue. Consumers may be at risk of taking up investments

whose risks they do not sufficiently understand.


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References

1. Metallgesellschaft AG: A Case Study, By John Digenan, Dan Felson, Robert Kelly and Ann Wiemert2. Carol Alexander, Report on Commodity Options, Chair of Risk Management and Director of

Research, ICMA Centre, University of Reading3. Sergey Pavlovitch Kolos, Report on Risk Management in Energy Markets, The University of Texas at

Austin, August 20054. Report on One Hundred Seventh Congress of the United States of America at the second session on

23/01/2002

5. Emmet Doyle, Jonathan Hill & Ian Jack. Growth in commodity investment: risks and challenges forcommodity market participants, March 2007

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