By Teresa Kroh, Director, Opportune
Teresa Kroh of Opportune details five ways companies can be prepared before undertaking a risk management implementation.
Opportune is often engaged to lead a client through the process of standing up risk reporting functionality along with the necessary risk controls and hedging processes for companies that use an ETRM system to track their asset-backed trading/marketing activity. Whether risk reporting is a known requirement before the initial implementation or is the second phase of an ETRM system implementation, there are many ways that a company standing up risk management systems for the first time can be well prepared for the design and collaboration sessions with its chosen implementation partners.
When leading clients through the decisions and designs necessary to be successful in the output of their risk management implementation, I recommend beginning with the following five areas of exploration and definition. Only after these topics have been thoroughly explored can system design begin.
1) Goals Of Risk Management
The objective of engaging in risk management differs by client and must be defined before proceeding with any other information gathering and design. Is the goal to mitigate risk associated with priced-in inventory or possibly to hedge all floating price risk? It’s possible the goal is to lock in fixed price margin-based sales or to manage location basis risk. Each of these goals implies methodologies that must be used during implementation. Define the output objectives early and point back to them often when questions regarding implementation options arise.
2) Risk Controls
Well-defined risk operating controls are necessary to ensure stated risk management goals are being met and that traders are operating within parameters that reduce financial risk to the entire organization. Are the controls defined to monitor total position risk or to limit the mark-to-market (MtM) or even value at risk (VAR) exposure? Knowing the controls before implementation allows the system to be designed to help measure risk according to the defined rules.
3) Forward Valuation
To measure the MtM or VAR exposure for future delivery or forward-pricing contracts, the methodology for assigning a value to forward periods must be determined. The equations to calculate forward price curves will be constructed to follow the chosen methodology. Any contract pricing that’s based upon published prices that don’t have a forward component (Platts, OPIS, Argus) will need to have a forward valuation methodology. Some contracts based on a futures market price will necessitate a forward-valuation methodology because the market isn’t active enough to facilitate accurate forward pricing.
To produce an MtM value for asset-backed trading activity, the market value for each of the products traded at each of the physical locations at which activity occurs must be stated. The methodology usually points back to the same forward curves used for assigning a value to contract pricing but considers the product value for each location based on logistics and illiquid markets.
There are many sources for forward-market valuations, including futures, published market information and broker-supplied forward curves. Sometimes the best source of the market intelligence — and therefore the market value — are traders within the company, and in those cases, traders may publish their marks to the system. Defining the methodology and the underlying math calculations to value each of the pricing components used and the markets in which the company participates is a discussion that can begin long before consultants enter the conversation.
4) Book Structure
During the conversations defining the goals of risk management, there will usually emerge a set of measurements that the risk organization would like to report. For example: the MtM valuation of the Northeast portfolio or the priced-in inventory position of the supply group vs. the marketing group. These desired measurements help define the necessary book structure. If the desire is to report by region, then the region must be one of the books that’s easily carved out of the entire corporate risk book. The same goes for supply vs. marketing: There must be well-defined rules for when physical products and contracts are owned by individual internal organizations.
5) Transfer Pricing
Once a book structure is defined, determining the financial and practical methodologies for moving positions between internal reporting books is necessary. The price at which a position — physical or financial — is transferred between risk books is known as the transfer price. The supply organization needs to be measured on its profitability and, therefore, will sell inventory to the marketing group at an agreed-upon pricing structure based on the date of a transfer before the marketing group then sells to a third-party organization. This allows each book to be independently measured based upon the factors that can be optimized.
The thoughtful design of the book structure along with the pricing that is used when product is transferred between books will drive market-based trading decisions and drive profitability across the organization. The hard work for designing and implementing risk reporting based upon ETRM system data can begin early and should be driven from the top of the organization.
Come to the collaboration session with as many of the answers to these design questions as possible and the implementation process will not only proceed in an orderly and fast-paced fashion, but all system design will also heed the originally stated objectives stated by the goals and the risk controls.
Teresa Kroh is a director in Opportune’s process & technology practice. Kroh has spent more than 30 years in the oil and gas industry in various roles, including project management, software implementation, IT management, process analysis, software design and development. She has more than 20 years of experience in all aspects of ION RightAngle, with an emphasis on trading and risk management.