Risk Management in Energy Markets

Literature Review - II Amandeep Arora Roll No 103 (PGDM-Finance) K. J. Somaiya Institute of Management Studies & Research

Literature Review II

Introduction
In 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 about various 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 Summary
The 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 resource scarcity. 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 2

Literature Review II became a buzz word in energy markets which face extreme uncertainty and hence have a strong need to manage risk appropriately.
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 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 the average 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 the same 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 refined products. 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 weekly crude oil storage number released by the Energy Information Administration (EIA) of the U.S. Department of Energy.

Literature Review II

Metallgesellschaft AG: A Case Study

Metallgesellschaft 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 the petroleum 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 businessthe 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 markets appears 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-tomarket 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 exchangetraded 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

Literature Review II 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. Representative Michael 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 Issues
A 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 other commodity 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 definite projections 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 traditionally been 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.

Literature Review II

References
1. Metallgesellschaft AG: A Case Study, By John Digenan, Dan Felson, Robert Kelly and Ann Wiemert 2. Carol Alexander, Report on Commodity Options, Chair of Risk Management and Director of Research, ICMA Centre, University of Reading 3. Sergey Pavlovitch Kolos, Report on Risk Management in Energy Markets, The University of Texas at Austin, August 2005 4. 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 for commodity market participants, March 2007