frequently asked questions

Understanding Hedging & Energy Risk

Risk management is the process of identifying future risks and taking action in order to mitigate those potential risks. Energy companies have substantial risks attributable to the volatile energy markets and therefore must have a way to address those risks.

The acronym ETRM stands for Energy Trading and Risk Management. ETRM systems manage a energy trades from inception to delivery and settlement. Most ETRM systems focus heavily on physical trades for their actual movement, scheduling, and final invoicing. InstaNext focuses on the Risk Management aspect of ETRM where most ETRM systems fall short due to features and/or feasibility. InstaNext can be an Add-on to an existing ETRM system or a stand alone risk management system.

Hedges come in different varieties and each has its own set of advantages and disadvantages. There are exchange traded hedging instruments as well as over the counter hedging instruments. Hedges are used by companies to help eliminate market price risk which can be very volatile. Hedges are a sort of insurance policy that allows the owner of the hedge to recoup some of the dollars lost when market prices become unfavorable. At the same time hedges will also cap or reduce the upside profit potential to the owner.

Energy companies hedge for a variety of reasons but hedging in general is done to reduce uncertainty and protect cashflow. This may be required by a companies lenders or board of directors depending on the companies risk management policies.

Commodity price risk is the risk associated with the price of a commodity moving in an unfavorable direction. In the case of a crude oil and natural gas production company, it is the risk that prices may fall. Since production companies find, recover, and sell crude oil and natural gas if the price falls by half then they will receive half the revenue for their sales.

There are many factors that determine the price of crude oil in the market place which make it impossible to predict. Some items that can impact the price of oil globally are the decisions made by OPEC, overall production/consumption numbers, as well as government regulations.

When it comes to risk management and hedging things get complicated quickly and the market does not wait for you to react. Using an excel spreadsheet may have worked in the past but in order to stay competitive in today’s market you need real-time information. Spreadsheets are very error-prone and may take hours to update and when you need to make decisions the seconds count.

APIs (Application Programming Interfaces) allow software systems to interact with each other.

A 3way (three way) collar as it applies to an energy company is an option hedging strategy that consists of a collar (bought put – sold call) and an additional (sold put). This sold put allows the owner of the collar to use some of the proceeds to pay for the collar but it comes with some risk. The sold put is usually referred to as the “trap door” which means that if prices fall below the sold puts strike level then you are no longer hedged.

Energy derivatives are valued using a variety of models based on the types of derivative instrument. The value of an energy derivative can be ascertained using underlying market data such as forward curves, volatilities, and risk free rates. The derivative details and market data from specific date and time can then be entered into a model which will then compute the derivatives value. This is commonly referred to as the Mark to Market (MTM) of the derivative.

A Mark-to-Market (MTM) of a derivative is a theoretical value at a given point in time. The Market to Market tells you what a derivative’s value is based on the underlying market conditions.

To start a proper risk management program the first thing that must be done is identifying your risks. After identifying your risks you will then need to decide on your risk policies which will determine what level of risk is acceptable for your organization. Once you have a policy in place it is just about getting board approval and executing the policy.