The persistent volatility of energy prices is well known, and sustained price movements have fueled a boom-and-bust cycle in different energy sectors for decades. Effective commodity risk management inevitably gives way to price risk management. This, in turn, implies that an enterprise knows what price risks it faces and that it has decided to do something about it--even if that something is nothing.
In helping companies build, evaluate or repair commodity risk management activities in the decades since US energy deregulation began in 1980, a few enduring principles stand out. Our view is that effective price risk management is founded on a thoughtful, board-directed view of risk appetite considering the commercial strategies being employed. In turn, this top-down directive empowers the development of a measurable business case linked to a risk management policy and multi-layered limits to ensure that everyone in the organization is on the same page--from traders/risk managers to investor relations.
Next, the nuts and bolts of execution come into play--the people, processes and systems that carry out commodity risk management daily. Good separation of front-, mid- and back-office functions are basic, as is an effective trade/deal capture process. A system that serves as a single source for all stakeholders is essential and can add efficiency to a complex activity.
Risk oversight is a final essential. The ability to challenge positions and carry out stress testing ensures that the board-directed views on risk management stay aligned with the efforts in the trenches. People lose their jobs over surprises in this area.
Our framework for effective risk management directly addresses a company's capabilities that link risk appetite, risk policy and limits, commercial strategies, organizational design, oversight and reporting.
Who needs an effective risk management function? Contract-based commodity enterprises that are traders and marketers generally have a robust framework for buying and selling energy commodities, backed by clear policies, an effective organizational design and systems in place, with an active oversight function.