Risk Control

In this lesson, we're going to talk about risk controls in energy commodity trading. Now you've seen my notes out there on the lesson content page, as well as the-- hopefully, by now, have read the case studies. But I'm going to walk you through the origins of risk control within the energy commodity business and then some of the recommendations and risk measures themselves.

In today's market environment, controls for financial trading have probably never been as important as they are today. The case studies illustrate the history of very huge losses by traders who really didn't know what they were doing, and there were no controls in place. And then, Enron, when they collapsed back in 2001, it was the largest bankruptcy of its time.

And of course, it resulted from their financial trading group and some false trades that basically were going on behind the scenes. But it's still occurring today, unfortunately. There are still people out there making huge mistakes by making decisions and taking speculative positions. And there's no real oversight over these people to, basically, realize what's going on and try to stem those losses.

As we've seen throughout the semester, and especially in terms of your own little speculative trading in the simulator, there is extreme volatility these days in energy commodity prices. We've talked about the fact that we are in a global commodity. Crude trades definitely is a global commodity.

And pretty soon, we will be trading natural gas as a global commodity as well. And we know that the geopolitical climate is sort of an ever-changing landscape, and it has a direct impact on the perception of future energy prices. So this volatility, this constant rapid movement up and down makes the oversight of financial derivatives and energy commodities even that much more important.

We've also seen a situation with the credit crunch, as the banks fell into the problems back in 2008. Not as many banks are involved in supporting the financial derivative markets as they used to be. And then, of course, from the standpoint of margin requirements, if you don't have sufficient credit, you're not going to be able to meet your margin requirements. And this will impact the cash flow of companies. Some companies either don't have or don't wish to put the cash out to cover a margin. That's going to limit the number of positions that can be taken, as we all know, in financial derivatives.

And then of course, weather. Weather can be extremely volatile, as we know. And weather is a key driving factor in terms of supply and demand for natural gas and for crude oil. And so we have events such as La Niña, El Niño, there are issues of global warming, and then we have unpredictable hurricane seasons. As we know, that can be a huge factor in terms of the interruption of supply for both natural gas and crude oil in the Gulf of Mexico and the United States.

Financial risk types-- these types, actually, several of them are what any particular company may face at any given point in time. Of course, the market risk-- what is going on in the market? Do you have a need for the commodity and you're exposed to higher prices? Are you a seller of the commodity, and therefore exposed to lower prices?

Operational risk-- if there's an interruption in operations, you may not be able to perform under the financial derivative obligations that you've entered into. Liquidity-- a lack of counterparties. In other words, if you wish to go out and hedge a commodity for a certain period of time at a certain volume, are there enough counterparties out there these days to get that particular transaction done?

Exchange interruptions-- although rare, exchange interruptions can occur. We've seen power outages. We have seen hacking. Back on 9/11, the New York Mercantile Exchange itself was shut down for several days. So it is a possible liquidity risk that's out there.

And then of course, the speed of the transactions-- we've addressed electronic trading. There is trading going on 24 hours a day, in essence. And you've got platforms like the Intercontinental Exchange, ICE Future Europe, NYMEX, GLOBEX, NYMEX's Clearport, and other international ones. So the fact that you can trade almost 24 hours a day but that you're trading electronically means that you can potentially lose more money faster than you could in the past.

Other types of risks-- legal, enters into this because you're going to enter into contracts, OK? The ISDA is the contract for financial derivative transactions. And that's the predominant contract there. It's a base contract. The NAESB is the North American Energy Standards Board. That's a bilateral or buy-sell agreement for the natural gas business.

And then, of course, within contracts, we have force majeure language. Again, force majeures is sort of an out. If any of a very long list of events occurs, then one of the parties may not have to perform under the contract. These can be things that are weather-related, acts of God, interruption of, let's say, the pipeline movements, freezing of gas or gas lines, et cetera. There's just a host of them. And of course, any one of those, if it excuses the counterparty, that represents a risk for the other counterparty to that transaction.

Credit-- I mentioned, this goes along with the counterparty liquidity issue. In the post-2008 economic collapse, where the banks found themselves in trouble-- and the banks then entered the marketplace after Enron and others had exited. And they were providing the financial liquidity that was otherwise going to be lacking. Well, as the banks exited the business over the last several years, that does, in fact, influence and impact counterparty liquidity. There are a few partners out there with which you can get financial derivatives executed, which is going to impact hedging.

And then counterparty solvency-- you have companies that you may be trading with or companies that you may be going through to execute hedge positions, and you may find out that, all of a sudden, that company becomes insolvent. The question then becomes, what happens to your positions?

Why risk controls? As I mentioned you guys already hopefully read the case studies. And then you've got an activity on those. Because of that, we have to put risk measures in place. Energy commodity trading in all its forms.

Basically the SEC and the CFTC came in at one point, and said that publicly traded energy companies will in fact have to institute some type of a risk control program. We'll talk about the types of controls. And then last, we're going to talk about some recommendations. If you were to sit down with the company, and make some recommendations for a risk program for them, I've got a list of things that you might want to be able to say to them or recommend to them.

And we talked about these case studies already. I added a fourth one down there. You can see as late as 2006, there was another trading company-- Amaranth-- and they lost $6 billion trading NYMEX futures. Again, not enough oversight.

Common issues throughout all of these, I think hopefully you have picked up on these in the case studies. They're really the single or multiple rogue traders. When we say rogue traders, we're talking about people who did things on their own. They made decisions on their own.

They were dealing in risky derivatives. These were not people dealing simply in the underlying derivatives. In some case, we know that we're doing option swaps, exotic options, and some other things.

Little or no accountability, this is the big one. OK, there's really no line of accountability where there's oversight. In several of these cases, in fact in the three case studies that you had, there was a total control over the paper trail. As we saw in the case study with the Nick Leeson, he actually controlled all of the accounting. So he controlled the executions through settlement, and then had his phony account set up.

And this is one of the issues-- this next point-- the lack of understanding and recognition by the executives of financial derivative trading and the risks involved. To this day, I still believe there are executives over companies where energy commodity trading exists-- financial derivatives are used-- where the executives truly don't understand the risks that the company is taking on with the various forms of transactions. Even if they're presented with a daily report from a risk control group, I don't know that they fully understand and can interpret those reports properly.

So some risk measures. These are standard risk measures. One of the most common ones, and one that hopefully is most well known is mark to market. Now that's the value of the portfolio at the close of the day based on the settlement crisis.

Now in FACTSim, the simulator, if you watched your position every day, if you had open positions, the simulator valued those based on the prices at the end of the day. So that is the mark to market. You are taking all of your open positions, because you have not yet closed them. And it's marking them against the settlement prices for the markets closing that day and putting a value on it.

Then we evaluate risk. This is a much more complicated risk measure. I don't expect you to understand it in its entirety. But it's what's known as the theoretical maximum loss on a total book for a given period of time, at a given confidence level, a defined holding period, at expected market conditions. Now I realize that's quite a mouthful.

There's a single number that comes out. What happens is, there is a first step in calculating value at risk. The mark to market calculations run on the entire book.

So you'll have a mark to market number. And then what'll happen is, that will be compared to historical prices. Then also within the value at risk system-- and again, this is a calculation that's done by software. It's not a hand calculation. There will be a Monte Carlo simulator.

And a Monte Carlo simulator is really a random number generator. So in essence the Monte Carlo simulator will come up with literally thousands of potential price scenarios, and those will get compared against the actual mark to market values for that particular day that the value at risk is run. And so this comparative analysis comes up with a single number, and that single number represents, again a theoretical maximum one day loss on the book as it exists.

Now the parameters-- because this is a form of statistics. It's a statistical analysis. The parameters are that basically the result is saying, OK, the maximum loss on the book as it exists today, comparing mark to market to these prices that have been generated by Monte Carlo simulator, the company could lose as much as $10 million. The confidence, the statistical confidence, in this case, on this VaR calculation is 98%. And then there also has to be what's known as the holding period. In other words, the VaR calculation is done at the end of the day on the book as it currently exists, with the mark to market as it was calculated for that day.

However, in the VaR calculation, there has to be an assumption of how many days you could hold those positions open. So you'll have the single dollar value, which represents the maximum loss, a level of confidence. And 98% usually would be the one to use because then you've only got 2% outliers on the other end. But you might have one-day, two-day, three-day, four-day, five-day holding period. That's up to the company to determine.

But the holding period that's chosen also represents, or should represent, the reality when it would come to liquidating the position. So in other words, it would be unrealistic to have a single holding day period because you can't liquidate your entire book within one day. To do that would then adversely impact the prices in the marketplace on that day, which in turn would adversely impact the mark to market at the end of that day.

Other risk measures, profit and loss. Now once you've calculated the mark to market, you're going to have unrealized gains or losses. And so at the end of that day, the profit or loss total is going to be the mark to market value. And what you normally do is it becomes a cumulative number each day as you go through the month. So the mark to market gain or loss on day one is added to the mark to market daily loss on day two, and so on. So you have this running total.

And then you also need to figure out the volumetric position. You want to know, from a contractual standpoint, what is your exposure. So this is the total of all the derivative contracts that you have out there that are straight up contracts. Maybe they're futures, maybe they're swaps. But then also, we touch briefly on the options delta effect. In other words, getting back to the options, if an option writer, let's say, writes a put or writes a call, they immediately have some exposure, which is quantified in the number of contracts that they might have to buy themselves or sell in order to fulfill the obligations under the options contracts if executed.

So this has to be quantified. There's a certain number of contracts that are represented when the delta calculation on the options is run. So for the true volumetric position of a particular book, it's all the open derivative contract volumes, in other words, again, things like swaps, forwards, futures, and then what the options delta calculation ends up being in terms of contracts. You have to add all of those together. Now you know the volumetric position for the book itself.

In terms of energy commodity trading, obviously, we know in April 1990 a natural gas contract was launched. In 1983 the Crude Oil Contract was launched. We know, too, that provider price transparency and market liquidity, you were now able to hedge your price risk. But it also added some more instruments for speculative trading. It led to the proliferation of various financial derivatives, as we know, options such as puts and calls, more exotic options, and then swaps, both Henry lookalike swing swaps and basis swaps

Now the Securities Exchange Commission and the Commodities Futures Trading Commission had mandated that publicly traded energy companies have to implement a risk control program effective with their fiscal year for 2001. So what happened here is they had to report their mark to market value under their earnings. So in essence, at the end of every day, they had to go in and calculate to the mark to market value of their open positions.

Well, the federal government then said that represents revenue. You've either got unrealized gains or unrealized losses, and you have to report those in earnings. Well, for Enron, that basically gave them the license to steal. Why? Because what Enron did was set up various shell companies, paper companies, and then they would calculate the mark to market earnings every day on these little companies. And basically those would show gains, and the more earnings that all of these companies were making in terms of in total showed up on Enron's books. And so this was leading to a higher share price.

So the state-- now also, the other problem that happened was the traders now have a large stake in mark to market. They want to manipulate the prices, set these forward curves, forward prices that we know are in the marketplace. Well, they were setting them for certain price categories for which they were reporting to the publications and others. So you can see they were starting to try to influence the cash marketplace, the cash publications, which was direct market manipulations.

Then another thing they would do is roll positions forward and backwards to gain mark to market value. So they had positions that could be liquidated and they could draw cash in, and then turn around and put those same positions back on. They would do this. Again, we're talking about fluffing books up so that the books really were not a true reflection of actual earnings or cash positions of the companies.

In the post-Enron world-- in essence, a little more than a year after Enron collapsed-- what had been the top five energy trading companies in the United States were gone. Wall Street became very leery of energy trading companies. You'll find more companies today that are named energy service companies. And Wall Street analysts, when they want to look at a company now, they're going look at the book size, in other words, total volumetric open positions, and then the mark to market related to that.

They don't really put much confidence in value at risk. They're not as interested in that because again, as I mentioned earlier, it's sort of theoretical. Also more and more companies adopted FAS133 hedge accounting, and what this did was allow them to shrink their speculative book. In other words, positions are not open if you can tie them to a physical transaction. And then, of course, there was the adoption of Sarbanes-Oxley. Sarbanes-Oxley is an extremely invasive and intensive procedures and recording of pretty much every single transaction, even down to the keystrokes in some cases.

And here's where I mentioned recommendations. If a company doesn't have a risk policy in place and they have to implement one, to me, first and foremost, executive training. They need to understand what energy commodity derivatives are and the various types and the types of risk exposures that are out there trading them. They have to establish risk policies and procedures. And within the policies and procedures, there has to be, number one, a statement of the purpose of hedging activity. What is it that you have that exposes you to price and market risk? Therefore you state why are you going to hedge.

Also, then, you start to establish risk measures and limits. What's the daily maximum mark to market loss that you're going to allow the trading company to have? What's the maximum VaR? You need oversight. There needs to be a risk control desk, and you need to have set positions within that desk and responsibilities for each one of them. There needs to be a risk oversight committee. This is usually comprised of an executive panel.

Trading policies have to have violation penalties in them. In other words, there has to be a situation where if a trader violates it, there is a penalty that they're very much aware of that's going to happen, which can include termination. Specific procedures, things like deal sheets, daily check outs, and those types of things.

And as I mentioned, adopt FAS133 hedge accounting. Educate both internal and external auditors. It's kind of an odd thing, but from time to time, you find auditors who don't really understand financial derivatives either, and yet they come into audit the books of companies that have financial derivatives on their books.

And then, of course, Sarbanes-Oxley. You have no choice but to implement Sarbanes-Oxley, even, as I mentioned, as complicated procedurally as it is.