Risk Assessment and Management

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RISK ASSESSMENT AND MANAGEMENT

By their very nature, operations in the energy industry are characterized by high risk. Operating an oil well, a power plant, or petrochemical plant is considerably more complex and costly than running most other operations. Losses may be infrequent, yet when they occur they could be substantial. The risks involved in these kinds of operations can be classified under two categories—technical (engineering) risk and financial (price) risk. This article focuses on Financial Risk.

PRICE RISK

The price risk can be defined and understood in alternative ways. One can view the risk as the probable fluctuation of the price around its expected level (i.e., the mean). The larger the deviation around the mean the larger is the perceived price risk. The volatility around the mean can be measured by standard deviation and be used as a quantitative measure for price risk. At the same time, in the industry it is common to define "risk" referring only to a price movement that would have an adverse effect on the profitability. Thus, one would talk about an "upward potential and downside risk."

ENERGY PRICE DYNAMICS

Unpredictable movements in the price level are uncommon in energy markets. The magnitudes of these price shocks can be substantial: 1973 and 1979 oil price shocks, electricity price swings in June 1998, and 2000 oil price increases exemplify the potential magnitudes of these price fluctuations. Energy price dynamics usually consist of three components: deterministic part, seasonal and cyclical influences, and noise. In a market situation with no demand or supply shocks, the only uncertainty observed in the market will be due to noise. A number of variables, such as import policies, policy changes of industry organizations (e.g., OPEC); unexpected weather and atmospheric conditions, tax and regulatory policy changes, legal, environmental, and economic problems, and political and currency crises can affect the demand/supply for energy products and thus lead to large price swings.

DIVERSIFIABLE AND NONDIVERSIFIABLE RISK

Market-wide (governmental, political, legal, environmental, or economic) events may affect individual firms in the energy industry differently. The magnitude of the individual impact will be determined by the co-movement of the market and individual firms (systematic risk). At the micro level, companies are not only exposed to price and systematic risk, but also to firm-level, nonsystematic risk factors. At the market level, these individual firm-level risks can be reduced or diversified, making it possible to focus on price management only. But at the individual firm level, risk managers also have to address a number of engineering risk factors, such as windstorms that may damage offshore platforms, explosions or fire in the well, and vapor cloud explosions.

MANAGING RISK

Beause energy firms face a variety of potential risk factors that may lead to substantial price fluctuations, risk managers in energy industries combine traditional insurance strategies with financial instruments and hedging policies to manage the risk. The standard financial hedging instruments that are employed are futures and options contracts traded on several energy products, such as crude oil, heating oil, gasoline, natural gas, and electricity.

Energy companies' property/casualty insurance programs typically address a wide spectrum of exposures, such as political risk, earthquake, and workers' compensation. Traditional insurance contracts have been used in energy markets for years against property damage and casualty, for reducing coastal hurricane liability and similar cost reduction purposes. Due to the many great risks that energy companies face, they commonly have to reduce some of the total risk so that they can afford the insurance to undertake a project.

A recent financial concept that is becoming popular is reinsurance, a transaction whereby one insurance company agrees to indemnify another insurance company against all or part of the loss that the latter sustains under a policy or policies that it has issued. For this service, the ceding company pays the reinsurer a premium. The purpose of reinsurance is the same as that of insurance (i.e., to spread risk). With financial reinsurance in place, energy companies can use traditional excess insurance to address their higher levels of coverage. The combined risk management strategy uses a financial instrument in combination with an insurance policy. This improves the ability of energy companies to fund their own losses during periods of high prices and profits, yet in unfavorable market conditions, the companies can tap an arranged insurance capacity to decrease their financial vulnerability. This strategy is attractive for energy companies because it limits the probability of having to pay for losses to cases where the insurance is actually needed.

There are several other financial risk management tools used in energy markets. For example, option-trading strategies are employed to avoid the adverse effects of price movements. Companies can also protect themselves from volatile (or stable) prices by trading various option strategies. They can trade on the cost of processing products by buying and selling contracts on the raw and processed goods. Recent contributions to risk management in energy industries comprise instruments and strategies such as bidding hedges and weather swaps. A bidding hedge is used to protect against the financial exposures in a competitive bid to construct an energy facility (e.g., currency risks, interest rate, and price risks). Weather swaps allow companies to exchange a series of variable cash flows for a series of fixed cash flows dependent on an index based on weather statistics. One common application of this class of instruments is the temperature swap that attracts many energy companies' interest whose products are sensitive to weather conditions and temperature (e.g., heating oil).

Recent trends in energy finance can be outlined as follows: The focus of main energy sources is turning away from coal and other high CO_x emitting sources to natural gas. Investment in crude oil is slowing. Nuclear power plants remain unpopular due to high operational risk and high waste clean-up costs. On the other hand, investments in the electricity sector are growing at a rapid rate; they have increased from $500 million in 1988 to over $10 billion in 1997.

Ahmet E. Kocagil