When discussing risk management, there’s an understandable instinct from energy producers and consumers of energy to keep it simple:
- Where are prices going?
- What’s our Value at Risk?
- What volume % should we hedge each year?
- Should we hedge now or later?
These are important questions. But they are insufficient ways to manage corporate risk. No one person knows where prices are going at any given time. They could go up, they could go down, or they could remain static for a period before going the direction market “experts” believe it will go. Sure, those experts can make educated guesses based on a plethora of market intelligence, but rarely does one know what the market is going to do at the exact moment risk strategy decisions are made.
To measure and manage the ups and downs that market volatility creates within a portfolio on a daily basis, the energy industry has accepted a tool widely used by banks called Value at Risk (VaR). Over the last ten years, we have learned that VaR is not an optimal risk measurement tool. It assumes a normal distribution, with limited boundaries based on historical prices and volatilities. Relying on this risk methodology leads to a severe mispricing of tails, and the tails are precisely what the market should be quantifying when managing risk.
The shortcomings of VaR inspired Mobius to create its own proprietary risk measurement methodology. The M(β)risk™ model, or M-Risk for short, is not confined by the bounds of normality when generating thousands of possible price scenarios. The MRisk model provides clients with a holistic view of risk, helping to drive efficient and effective risk management decisions. In addition to measuring risk through an updated risk model, we recommend a deeper set of questions be asked when creating risk management strategies in order to maximize revenue and minimize market risk.
The questions we recommend:
- What is the position by commodity?
- What are the correct locational prices for these positions? Are there additional locational options that have value?
- What commodities and locations within the portfolio deliver the highest revenue? Which ones pose the greatest risk?
- What is the current market value of the portfolio?
- What is the risk management objective in terms of revenue/cash-flow (how much revenue needs to be locked up to meet forecast/capital plan)?
- What is the most efficient use of the next hedge dollar to achieve these objectives?
- What is the market giving/telling us in terms of opportunities – rich/discounted price curve, contango/backwardation, volatility/skew opportunities, better bids/offers from market participants?
- Are there fundamental risks not being priced appropriately by the market?
Once these questions are answered, the next step is to synthesize the information to construct the optimal hedge strategies, efficiently execute on those strategies, and routinely measure and report on the performance of the risk management program.
As our Chief Risk Officer, Paul Smith, routinely reminds us, “Hope is not a strategy. While you may be right on price forecasts, you will almost always be wrong on the path to get there. When you find yourself on the wrong path then you will invariably make poor decisions in a reactive manner.” The very foundation of any reliable and sustainable risk management program starts with establishing comprehensive responses to the above questions and utilizing MRisk to drive a strategy that meets the ultimate price goals and objectives of the stakeholder.
Mohit Arora
Mohit has more than 20 years of quantitative analysis, trading, structuring, and risk management experience across the energy spectrum (crude, products, natural gas and NGL’s). Prior to joining Mobius, he was designing option strategies and trading crude and product options at Koch Supply & Trading. He also constructed portfolio risk mitigation option structures for the crude, products/fuel and NGL desks. Before Koch, he traded crude and products at AAA Capital Management, with a focus on options. He moved to AAA from Entergy Koch/Merrill Lynch Commodities where he developed and traded natural gas option strategies, proposed trades as well as enhanced return/index strategies to hedge funds and was the primary hedge structurer for corporate clients (producers, consumers and refiners). Mohit received his BTech from the Indian Institute of Technology Kanpur and a dual PhD (Aerospace Engineering and Scientific Computing) from the University of Michigan, Ann Arbor.