Lessons Learned ... Or Maybe Not

by Tim Simard

Will the lessons learned by the utility industry modify how it approaches hedging in 2005? And will these lessons stimulate changes that foster a healthier risk management environment?

Twenty years in the energy risk management business and I still can't come up with an easy answer to: "What do you do for a living?" At a cocktail party, for instance, there's no better way to ensure your social isolation than to launch into a description of the latest market and credit risk management techniques.

Yet there are some fascinating aspects to our business, as well as stimulating challenges that must still be met to instill a more sensible risk management environment in the energy industry.

Last year provided a great learning experience – we avoided the chasm of credit disasters that nearly swallowed the energy trading and risk management world in previous years, but the extended price movements in natural gas, coal and crude oil markets have caused a re-examination of corporate hedging practices for many energy companies.

Key influences in 2004
Our peers in the risk management departments at upstream oil and gas producers spent much of 2004 explaining to their colleagues and investors why they used hedges in the first place. But they still need to address the real problem behind the producer risk management programs: flawed implementation strategies that rely too heavily on attaining budget levels and meeting senior management price views.

Let's examine one of the common implementation strategies employed by oil and gas producers. If forward prices remain below the annual budget, no hedging is undertaken. If prices reach the budget level, or rise by a certain increment above the budget, then hedges are initiated. Look at the long-term impact of this strategy: In those years when prices do not reach budget levels, the company remains completely exposed to the full left-hand side of the price distribution. Yet the company will never have the positive exposure associated with complete participation in the right-hand side of the price distribution because hedges constrain this upside participation. Over time, the producer would realize an average price for its production that is substantially below the long-term exposure to spot prices.

The other problem with producer hedge strategies is the inclusion of management's price views or some form of technical trading signal in the hedge decision. Many companies also employ techniques that reference historical pricing patterns, meaning that if prices move a stated amount above an historic mean (e.g., one standard deviation) then hedges are established.

For producers, the lessons of 2004 should lead to one of two courses of action. If the true goal of the hedging program was to make money, give it up! There is no indication that producer management teams have any special prowess as commodity traders; furthermore, the investors aren't paying the management team for this skill.

The other alternative is to create a more formalized risk management approach that can defend minimum levels of acceptable cash flow over the course of the year. Hedges are established in a mechanistic fashion whenever the probability of cash flow falling below the acceptable level exceeds a desired confidence interval. This practice requires an investment in a risk quantification process that periodically estimates the distribution around annual cash flow (information that management would love to have to bolster its risk management applications) and the acceptance of a hands-off mechanistic approach that mutes the component of price view in the implementation process.

For 2005, a greater number of regulated utilities will have to defend their rate increases and their hedging activities in after-the-fact prudence reviews. And regulatory boards and customer representatives are likely to be in an ornery mood, given the materiality of rate increases in many jurisdictions across North America in both the power and natural gas sectors. Ad hoc hedge implementation procedures will come under intense scrutiny, and there will probably be cost disallowances based on the perception that a prudent utility would have established more material hedge positions.

Utilities will be asked to document their risk analyses to determine the dollar magnitude of risk tied to movements in fuel costs that they and their ratepayers faced. This whole process will provide further momentum to two underlying trends in utility risk management programs. First, utilities will press their regulators to recognize that their hedging activities are often performed on behalf of ratepayers, and second, the ratepayers' deemed risk appetite should govern the choice of hedging strategy. With the regulator and intervenor groups acting as representatives for these customers, there should be an obligation on the part of these groups to provide upfront input into the selection of hedge strategies.

The second initiative centers on risk quantification. Similar to the producer situation, utilities must be able to determine quantitatively the distribution around their annual fuel costs and the impact that alternative hedging strategies will have on this risk profile. If utilities are asking ratepayers for upfront input into the hedging decision, the utility must disclose a well-founded estimate of the magnitude of risk in the fuel cost profile. There is no question that the assessment of fuel cost risk for utilities involves very complex quantitative processes, given the variability and correlation around market prices, load and generation availability. However, utilities must enhance their risk quantification capabilities if they want to reduce the ongoing regulatory risk associated with cost disallowances.

Market movements created considerable stress for utility and producer risk managers in 2004, but steps can and should be undertaken to create a more solid risk quantification and implementation foundation in 2005.

Bio: Tim Simard is a principal consultant with RiskAdvisory. Having held senior positions at both Bankers Trust and Burns Fry Ltd., Simard has been at the forefront of the energy risk management industry since 1985. He has played a leading role in educating and advising the energy community on the merits and mechanics of risk management instruments and programs.