Development of alternative approaches to risk in the energy markets

In response to this market price uncertainty, many oil companies modified traditional
investment analysis approaches to include scenario analysis rather than forecasting
analysis as well as starting to lever off their hedging and trading operations. The use
of a scenario approach in investment decisions was an early indication that even oil
majors accepted that they could not predict future price movements with any
certainty.
Meanwhile the financial engineers on Wall Street were solving the same issue from
another direction, notably the development and refinement of the derivative pricing
models using quantitative approaches. Option pricing models through the 1980s
began by stripping out the observable forward markets from market uncertainty.
Although relatively straightforward in nature, these models facilitated a key move
away from a fundamental analysis approach and allowed the application of some
proven statistical concepts to the markets, most notably the measure of market
uncertainty through the use of volatility estimators.
With the exception of a small group of specialized oil traders, the energy markets
were much slower than the financial markets in embracing these quantitative
approaches. The reasons for this are many and begin to signal many of the risk
management issues associated with energy, notably: . . . energy markets are immature
and often still partly regulated, complex in their interrelationships (both between
products and regional delivery points), constrained by lack of storage, subject to
large seasonal swings, mean reversion, subject to large investment cycle issues,
delivered products tend to be very complex in nature . . . and the list goes on. On a
continuum the complexity increases exponentially as we move from the money
markets to the oil market to the gas market to the electricity markets.
In the last few years an increasing number of practitioners and academics have
began to take on the challenge of developing and modifying quantitative approaches
for the energy markets. The reason for this is simple: while the complexity is much
higher in these markets, the underlying assumption in the quantitative models that
the future is essentially random rather than predictable in nature is particularly
relevant to an increasingly commoditized energy sector. The quantitative approach
is also particularly useful when aggregating a diverse book like an energy portfolio.
For instance, Value-at-Risk (VaR) allows us to aggregate separate oil, gas and power
books daily on a consistent basis. It is difficult to do this without applying a statistical
approach.
The development of risk management professionals within the energy sector has
also accelerated as energy companies have developed their commodity trading experience
and embraced the middle-office concept. An independent middle office is
particularly important in the energy sector given the complexity of the markets. A
combination of market knowledge, a healthy dose of skepticism and a control culture
focused on quantifying the risks provides an essential balance in developing markets
with little historical information and extreme volatility.
Each of the three principal risk management areas – market risk, counterparty
credit risk and operational risk – are relevant to an energy business. There is not
enough space in one chapter to describe the markets themselves in any detail so I
shall focus primarily on those parts of the markets that impinge on the role of the
risk manager. In addition, the examples used will relate primarily to the power
markets, in particular in the USA. This is not to imply that this is the most important
market or the most developed, but quite simply because it provides useful examples
of most of the quantitative problems that need to be addressed by risk management
professionals within energy companies, whether based in Houston, London or
Sydney.