1 + ENERGY TRADING RISK MANAGEMENT A Supplement to OCTOBER 2009
2 ENERGY COMMODITIES \ INTEREST RATES \ EQUITIES \ FX \ METALS \ WEATHER LIGHT SWEET CRUDE OIL (WTI) FUTURES AND OPTIONS Trade the global benchmark with liquidity and flexibility Trade Light Sweet Crude Oil (WTI) Products: Most liquid benchmark oil futures contract in the world More than 100 years of proven safety and security with CME Clearing Access around the world on CME Globex the most reliable electronic trading platform Mitigation of credit risk by clearing OTC transactions through CME ClearPort Traders around the world know where they can turn to manage risk and access market opportunities in the crude oil market. Because of its liquidity and transparency, our physically delivered Light Sweet Crude Oil (WTI) contract is recognized as the global standard pricing benchmark. It s just one part of the world s most extensive slate of energy products available on a single exchange. And now that NYMEX is part of CME Group, the world s most liquid crude oil market is growing stronger. Learn more at Spread credits that help reduce your margin requirements Both physically delivered and financially settled futures contracts are available CME Group is a trademark of CME Group Inc. The Globe logo, CME, Chicago Mercantile Exchange, E-mini and Globex are trademarks of Chicago Mercantile Exchange Inc. CBOT and Chicago Board of Trade are trademarks of the Board of Trade of the City of Chicago. NYMEX, New York Mercantile Exchange and ClearPort are trademarks of New York Mercantile Exchange Inc. COMEX is a trademark of Commodity Exchange Inc. All other trademarks are the property of their respective owners. This contract is listed with, and subject to, the rules and regulations of NYMEX. Copyright 2009 CME Group. All rights reserved.
3 Games traders play Using your ETRM system to detect rogue trades and bad marks Larry Hickey, Principal Advisor, Risk Limited Corp. Culling through 57 publicly reported instances of unauthorized trading and/or improper trade valuation between 1974 and 2009, recurring, actionable themes jump off the page. Your ETRM system may not be able to remedy a star trader culture, or independent prices sourced from a buddy or trades that haven t been entered. But in many cases, all the information necessary to detect the problem has been properly captured in the system. The key is knowing what to look for. Men The English language has no word meaning he or she and the phrase itself is clumsy and distracting to the reader. Many writers work around this by alternating the use of he or she when the person being discussed could be a man or a woman. But that compromise doesn t seem quite fair in this case. In reviewing published reports of 57 instances of rogue trading, I could find only one case where a female created the losses (Citibank 2003). There are two other cases in China where female supervisors were held accountable for their male underlings misdeeds (Hunan Zhuzhou Smelting Plant 1997, China State Reserves Bureau 2005). We ll omit consideration of the male Morgan Grenfell fund manager who showed up in court dressed as a woman. Rogue trading, it seems, is very much a guy thing. So he is used throughout this article. High delta options High delta options, which have a high likelihood of being exercised, have featured in several rogue trading episodes. For example, in the AIB incident, John Rusnak would enter offsetting deep in-the-money currency options. He sold the long-dated option and bought the short-dated one. In a bit of financial alchemy that went unquestioned, the premiums were identical. The back office was told that confirmations were unnecessary. He would then fail to exercise the fictitious long option. Rusnak went on to lose $691 million before being uncovered in High delta options arise most often when there has been a significant move in the underlying price. Of more particular interest to the risk manager are options that had a high delta when they were traded. The curious risk manager might run a report to see all open options with a time to expiration greater than a week and a delta above 80. We won t look at short-dated options because all options eventually have a delta of 100 or 0 at expiration and we we re not looking for routine options expiring in-the-money. The report should include the counterparty, trade date, expiration date, delta, trade P&L and value. The risk manager s local knowledge of what is normal is critical if we re to spot trades that seem to break the pattern. Does anything on the report strike you? Is a lot of value concentrated in a few trades? Do you see any pattern in the counterparties? Focus on the bought options. Are those counterparties real? They weren t at Barings in 1995 or at West LB in If a hole is to be discovered in your accounts tomorrow, it will look like a receivable today. Now, for each open high delta option, rerun the report as of the option trade date. We re looking for two things evidence of an off-market trade price which will show up as a large P&L number and/or a high delta. Options with a high delta when traded merit a closer look. With rare exception, at-the-money or out-of-the-money options are traded. When a broker goes out to market makers for a price, only the expiration date and strike - the price at which the underlying will be bought or sold if the option is exercised - is mentioned. Unless specified up front, strikes above the forward price are calls and strikes below are puts. The implied volatility price for a strike applies equally to the put and call. There may be a legitimate reason for trading a high delta option, such as closing out a specific position to reduce a credit exposure, but that reason should be clarified. Related transactions What about instances where the trade date P&L is large? Did prices move that day? If not, were there other related transactions, possibly with the same counterparty? Is there evidence that a gain on one trade was offset by a loss on another? Follow the money. If there is a disconnect between realized and unrealized P&L for the purposes of bonus or budget calculations, the possibility of gaming must be considered. Do these related transactions have the effect of moving P&L from one reporting period to another? Is P&L being moved into or out of the period used to determine bonuses? Both would be problematic, but into is more so. Robbing Peter to pay Paul is one thing. Robbing Peter to pay the traders is another. Out of may be sandbagging. Are bonuses capped in any way? Is P&L in the next reporting period worth more to the traders than P&L this period? continued on page 5 October 2009 Energy Trading & Risk Management 3
4 Triple Point Commodity XL Only real-time, multi-commodity solution to manage enterprise risk on a common platform Enterprise Risk Management Multi-Commodity Platform Advanced Business Intelligence Commodity XL Enterprise Solution Commodity XL TM is the leading multi-market commodity trading and enterprise risk management solution. It meets all requirements for supply, trading, marketing, procurement, logistics, scheduling, risk management and accounting in today s volatile and complex environment: Manages 4 key areas of financial exposure Delivers a multi-commodity platform Provides advanced business intelligence Integrates physical and financial operations Ensures compliance, control and auditability Delivers scalability with service oriented architecture Commodity XL Manage Multiple Commodities Commodity XL delivers unique functionality for commodities including power, oil, gas, coal, emissions, base and precious metals, agricultural products, biofuels and freight. It provides organizations with tools and systems to view multiple commodity positions in real-time and monitor ancillary costs of commodity movements. Commodity XL Make Proactive Business Decisions Commodity XL Management Dashboard TM mines vast amounts of trading, risk and supply chain data to deliver pinpoint analysis for superior executive decision-making. Its highimpact visuals give management a real-time, graphical display of key performance indicators (KPIs) across the entire business. Triple Point Technology possesses the widest reach and most comprehensive solution of any vendor in the market. Commodity XL provides transparency into risk measures and analytics, allowing organizations to holistically manage and mitigate risk. Commodity XL Key Functionality Trading Integrate physical and financial trading; improve trading efficiencies; use variable price models including fixed, index and formula Risk Management Manage 4 key areas of enterprise risk; measure market risk with VaR, sensitivity analysis and stress testing; analyze real-time exposure at overview and granular levels Supply Chain Schedule and move power, natural gas, liquids, bulk and packaged goods; control centrally through visual format; manage inventory, in-transit positions and costs Settlement and Accounting Update information based on pricing and delivery; track secondary costs including premiums, fees and transportation; produce provisional and final invoicing Patrick Reames, Vice President, Trading and Risk Management, UtiliPoint International Commodity XL Manage Enterprise Risk Commodity XL is the only enterprise solution that provides best-in-class functionality on a real-time, integrated platform across the four key areas of exposure: market risk; operational risk; counterparty credit risk; and regulatory risk. Commodity XL provides transparency into risk measures and analytics and allows organizations to holistically manage and mitigate risk a requirement to succeed in complex commodity and energy markets. About Triple Point Triple Point Technology is the leading global provider of multi-market commodity and enterprise risk management software solutions. Headquartered in Westport, CT, USA, Triple Point was founded in 1993 and serves clients from eight development and support centers located around the globe. Web: Tel: Energy Trading & Risk Management October 2009
6 Pipeline Scheduling and Crude Oil Logistics The New Systems Imperative: Addressing Hidden Logistics Risks and Operational Inefficiencies Dr. Wolfgang Ferse, Executive Vice President-Commodities & Energy Solutions, OpenLink Last year s turmoil and changing market conditions reinforced the need for stringent risk management and highlighted business inefficiencies in the distribution network that crude oil producers and other physical market participants cannot afford to ignore. As the industry seeks to cut costs and operate more effectively, pipeline scheduling, crude oil logistics and improved wellhead management are now taking center stage, explains OpenLink s Dr. Wolfgang Ferse Of course, some companies with sophisticated trading operations that already deploy integrated commodity trading, risk, and logistics systems, that can straddle physical and financial markets, have managed to generate handsome trading profits in this challenging environment. Despite such instances of savvy risk management and profit generation, the oil industry s P&L rollercoaster ride during the last 18 months has highlighted that reluctance to aggressively hedge downside risk during the bull market was far from uncommon. In addition, beyond this culture of upside participation, there is a more subtle risk management issue that many oil and gas producers have realized now needs to be addressed- the large hidden risk exposures, business inefficiencies, and systems redundancies associated with production, pipeline scheduling and crude oil logistics. One example, from an efficiency perspective, is the demanding task of managing ownership shares and changes in producing properties, changing marketing arrangements, and calculating estimated and actual wellhead volumes to the custody transport point of sales as well equity and royalty splits, comments Dr. Wolfgang Ferse, OpenLink s Executive Vice President of Commodities and Energy Solutions. We ve noticed a significant increase in interest among producer clients in modeling their deal life cycles in their entirety that is, including splits and also in improving wellhead accounting, with improved coupling to downstream marketing for energy trading, risk, and logistic systems, he added. OpenLink s ENDUR system has included integrated crosscommodity trading, risk management and logistics functionality for some time, explains Ferse. But, client awareness of the operational risk and inefficiency associated with the transfer of data between disparate trading and risk systems and off-system work arounds has grown, resulting in the current interest to provide a single, fully integrated solution for straight through commodity life cycle management. To address this, OpenLink has invested significantly over the last years to extend the life cycle coverage of its integrated system suite to cover the producer side as well. Multi-Modal Transport: Fixing Logistics Risk Management s Achilles Heel We re already seeing a dramatic change in the way organizations want to manage crude oil logistics in concert with trading and risk decisions, comments Ferse. Traditionally, the task of automatically capturing the data necessary to track the movement of crude oil though a pipeline, into storage and then onto a barge and/or other modes of transport, along a perhaps yetto-be-determined route, has been either outside the scope of risk management systems or been based on simplified information passed between the trading and the logistics world. For example, if the oil company decides to redirect a planned shipment and purchase fulfillment in the local market, the physical and financial risks change. OpenLink has regarded the ability to manage multi-modal transport in an integrated fashion as critical. Not having system support for multi-modal transport often results in incomplete risk analysis and reporting, let alone managing the optionality associated with location and storage. says Ferse. From a trader s perspective, another problem is that they cannot assess the P&L impact on their strategies based on real world operational events, such as shipping delays from pipeline disruption. This can be compounded with operational risks associated with the manual transfer of data and disconnects between different system outputs. With the days of cheap oil behind us, oil producers and other market participants are realizing an attractive return on investment from replacing multiple and complex legacy systems with an integrated solution that supports all segments of the value chain, and which have previously been inaccessible from both an IT and economic perspective. Contact Information: Marketing and Communications OpenLink Tel: +1(516) Energy Trading & Risk Management October 2009
7 continued from page 1 The snowball Really big losses don t usually start out that way. They start small and the trader tries to trade his way out. As positions expire, the losses will have to be rolled forward to avoid detection. As the losses mount, the positions being rolled forward grow ever larger. We saw this in the China Aviation Oil fiasco of 2004, for example. Run a report of your P&L on open trades grouped by counterparty. Look for unlucky counterparties; the counterparties to your profitable trades. Do one or two stand out? If so, pull up all trades with these counterparties over the past year. Is there any evidence of trades regularly being rolled over into bigger positions? Pull up all versions of these trades to see changes since inception. Has the quantity or delivery date ever been changed? Concentrated business Run a report of your trading volumes by broker. Is your business highly concentrated? Are any of your independent prices sourced from brokers with whom you are doing a large amount of business? In particular, does your portfolio contain a large, non-standard OTC trade? Who is providing the market price used to value this position? High Sharpe Ratio The Sharpe Ratio is a measure of excess return per unit of risk taken. Bernie Madoff s Sharpe Ratio of 2.55 was red flag # 28 in Harry Markopolos now famous November 2005 letter to the SEC. By comparison, the Sharpe Ratio of the S&P 500 is around.4. How are your traders doing by this measure? Run a report of daily P&L by trader. Store these results. At the period of your choosing, select an appropriate risk free benchmark and calculate the ratio of excess return to the standard deviation of the time series. You re interested in traders with high Sharpe Ratios. Run a report showing both sides of all internal trades for these traders. The total P&L of the internal trades must be 0. Is there evidence that P&L is being systematically moved to the high Sharpe Ratio traders through off-market transfer prices? If not, where is the free money coming from? Sandbagging Sandbagging, as used here, is hiding P&L for recognition in a later reporting period. Look closely at your time series of daily P&L by trader. Does P&L arrive either very early or very late in the reporting period? Can money be hidden anywhere? Has there been any change in reserve assumptions? If not, compare volatilities before and after the P&L arrival. Unlucky? Are all rogue traders unlucky? An unscientific survey of 57 publicly reported cases of rogue trading between 1974 and 2009 only turned up one instance* where the trades were profitable. If you were to bravely assume that companies will report ALL cases of rogue trading and, less bravely, that rogue trades amount to 50/50 bets, you would have expected roughly 23 instances of winning rogue traders. Let s see how your theory stands up to the data using a statistical tool called the t distribution. Well, it turns out that your theory can be rejected with less than a 1 in 20,000 chance of being wrong. A review of the cases shows that the vast majority amount to coin flips gone wrong, as you assumed. So winning rogue trades are simply not being reported. Is the root of the problem rogue trading or rogue management? *After a liquid lunch, a Morgan Stanley oil trader went short 5,395 oil futures on May 9th of this year. They were closed out at a profit the next day. Off market prices Over time, trade and market prices may diverge. That s normal. What s not normal is for them to be materially different on the trade date. Each day, run an exception report that flags any new trades where the trade price differs from the market price by some threshold. Who are the counterparties? What else have you done with those counterparties? A daily blackout Does your system have a defined cut-off point when no new trades are entered and reports are generated? This kind of daily snapshot instead of real-time monitoring is particularly susceptible to gaming. Run a report of all cancelled trades. Are there a lot of them? Is there any evidence that trades are being entered for the snapshot and then quickly cancelled before they can be confirmed? Fake trades have featured several incidents including Daiwa Bank in Short dated options Are short-dated options being sold? These can be particularly pernicious. If there is a reporting cut-off, the option may be sold afterwards and may expire before the next day s reporting. Or the dealer may delay entering the sale to achieve this same end. But even if the option is entered into the system and properly reported, the incremental risk may not be clear. Let s say a Value-at-Risk (VaR) report is run for a holding period of one day and 95% confidence level. This is based on price changes being normally distributed, essentially ruling out really big moves. But every now and then really big moves do happen. On Oct 19, 1987, the Dow fell 22.6%. Using a 20% volatility, that was an astounding 18 standard deviation move. That shouldn t happen even once in the history of the universe times the number of grains of sand on earth. So if a low delta overnight option is sold, VaR may only rise slightly. Remember that VaR is a measure of the loss at the 95% confidence point. It tells us nothing about what lies beyond. To get the full story, you need to run stress tests that show what happens when the impossible happens. Run a report of all sold options where the difference between the trade date and the expiration date is less than a week. Compare when the options were entered in the system with the trade date. continued on page 9 October 2009 Energy Trading & Risk Management 7
8 Staying at the forefront of the industry Providing innovative technology and anticipating market needs With 25 years of steady growth and deep industry knowledge, Allegro Development is the global leader in energy trading and risk management (ETRM) solutions. Allegro helps companies manage all commodities on a single, integrated platform that provides unparalleled visibility into all financial and physical positions, complete logistics functionality and advanced tools that enable strategic decision-making across the enterprise. Financial Risk Management Solutions Today s sophisticated and capital intensive commodity markets demand risk management solutions that drive instantaneous transparency into portfolios containing multiple commodities, instruments and currencies. Energy and commodity companies face a challenge in finding an integrated solution that can capture, measure and report in real-time across complex portfolios. Risk managers need the ability to quantify positions and exposures in real-time and act quickly on that information. Financial Visibility - Allegro s streamlined, highly automated processes for managing risk, price, and supply and demand curves allow managers to develop hedging strategies and estimate asset value. Drill-downs enable transparency of risk exposure at any level across physical and financial positions. Risk functionality is seamlessly integrated with physical logistics, enabling users to examine risk down to specific product deliveries. Position reports present managers with real-time reporting of exposure, limit management and profit and loss across the entire portfolio. Credit Risk - Allegro s credit risk solutions provide functionality to connect to major credit agencies to download the most current counterparty credit data available, thus reducing the time-intensive and error-prone task of getting the credit data into the system. The solutions provide a wide variety of credit analysis tools to evaluate not only the current state of a counterparty s credit status and liquidity, but to determine the potential future credit risk. These tools interact seamlessly with trade execution and contract management to improve data accuracy and overall efficiency of risk evaluation processes. more accurately determine how potential market changes will affect various types of risk exposure. Users can identify potential risk behavior, anticipate market moves, and act accordingly to achieve superior portfolio performance. The Allegro 8 platform With eight generations of software and continued market and global expansion, Allegro is committed to staying at the forefront of the industry with innovative technology and by anticipating market needs. The Allegro 8 platform is built on a service oriented architecture, allowing customers to select only the functionality they need, simplifying deployment and providing the scalability to adapt and expand into new markets as a company s needs change. Among the solution s many features: Real-time grid computing, which allows a network of distributed computers to work in unison, providing up-to-date valuation, scheduling and settlement. An interactive trading environment that enables traders and marketers to view existing positions and to dynamically optimize them based on live markets. Profit and loss, value-at-risk, mark-tomarket, exposure and other metrics are continuously updated. A platform for standardized connectivity components that allows seamless integration of functionality in any combination so that the scope of the solution matches the scope of business objectives. Award-winning software solutions: Ranked top ETRM Solution by Energy Insights, an IDC Company Positioned in leader s quadrant in Gartner, Inc., Report on ETRM Platforms Energy Risk Software House of the Year 2009 and for Asia 2008 Energy Business Awards, Gold Award for Excellence in Energy Technology Allegro is headquartered in Dallas, Texas and serves customers worldwide with offices in Amsterdam, Calgary, Houston, London, Singapore and Zurich, along with a global network of partners. Real-Time Analysis - Allegro s solutions allow risk managers to understand the impact of incremental positions on a portfolio, and by utilizing scenario analysis gain insight into potential risks and rewards. Allegro s risk capabilities include real-time simulations, volatility analysis (all Greeks) and pre-trade credit verification. The risk simulation what-if tool allows companies to To contact a regional office directly, please call: Europe +44 (0) North America Asia Pacific Energy Trading & Risk Management October 2009
10 Q&A on Energy Trading with Joe Raia Managing Director, Energy and Metals Products, CME Group September 17, 2009 In 2008, NYMEX became part of CME Group. Together, we offer the most extensive and liquid energy complex in the world, including Light Sweet Crude Oil (WTI), natural gas (Henry Hub), petroleum, and electricity products. Q. What are the biggest challenges facing energy trading companies today and how will CME Group help them address these issues? A. Uncertainty in the regulatory arena is our biggest challenge today, as far as what kind of regulatory changes will be made and when. These changes will definitely affect how we manage risk in the energy markets, and that applies not only to most U.S. companies but to anyone who has to manage risk. CME Group will be helpful in how the energy companies address these issues because of our close regulatory relationship with the CFTC. We have a good opportunity to manage that relationship and also make sure we have the right products and risk management procedures to help our customers. Q. What do you consider the most important advancement that CME Group has made in the past five years? A. It s not really just one advancement but several that have worked together to bring us to a position of industry leadership. With the innovative introduction of CME ClearPort seven years ago we began offering clearing to the OTC energy markets, and we also had the additional foresight to bring in electronic trading. Those were important venues to add, and then when we went to sideby-side trading with the CME Globex electronic trading platform three years ago, that really started the ball rolling toward the globalization of our products. We now offer more than 700 products on CME ClearPort, and have launched 222 products so far this year as we continue to address the hedging needs of our customers. Q. What services does CME Group offer that your competitors do not? A. We offer an unparalleled range of products across asset classes, outside of energy, that includes precious and industrial metals and agricultural commodities, Our customers also enjoy the benefits of cross margining when they trade different products and that makes a big difference in terms of the overall cost of trading. In addition, we are continually introducing new products and we make sure we offer the products our customers need to manage risk. We listen to our customers carefully and that is why we offer products and services that our competitors do not. The combination of all our products, our global distribution and our industry-leading clearinghouse, make us the largest clearing source globally and give us the ability to manage risk on a daily basis that is second to none. Q. Who is trading energy (electricity, natural gas, crude oil, and refined fuels) these days utilities, oil companies, banks, brokers, or all of the above? A. All of the above. We see with the globalization of our products and our niche products, like our Singapore products and European products, that our reach is 24-7 around the world. We have more than 10,000 global users on CME ClearPort. We are reaching end users who never thought of clearing products in the U. S. and now those companies are our direct customers in a unique marketplace, and are allowing us to address their risk management concerns. Q. Have most energy trading firms made the transition from Excel spreadsheets to sophisticated ETRM systems? Should they? A. Yes, they have I myself tried using spreadsheets back in the mid 80s and it was painful. Absolutely they should switch over to ETRM systems. But most of the switching over actually happened with Enron in the late 90s. When it defaulted in 2001 it pushed the whole marketplace to trading risk management systems and straight through processing, which systems and exchanges should have. Q. What are your leading products? A. Many of our contracts are benchmarks that set the price for these resources worldwide, including Light Sweet Crude Oil (WTI), which is our highest volume product, followed by natural gas (Henry Hub). Our zonal 5MW electricity contracts are also performing well since they were introduced late in Q. How do people access these markets? A. There are three ways to access to our markets electronically, through CME Globex, via a broker on the trading floor, and through CME ClearPort, which provides a range of OTC clearing services for transactions conducted off-exchange. For further information please call the CME Group energy and metals hotline at , or visit 10 Energy Trading & Risk Management October 2009
11 continued from page 5 Implied volatility VOLATILITY INCREASES AS THE OPTION BECOMES MORE IN OR OUT-OF-THE-MONEY Out-of-the-money calls In-the-money puts In-the-money calls Out-of-the-money puts 0 + At-the-money calls/puts Forward price-strike The smile The smile is a subset of improper valuation issues. Variants of this were seen Natwest in 1997, NAB in 2004 and BMO in The value of a standard option is function of the underlying price, the strike price, time to expiration, interest rates and volatility. Four out of five of these valuation factors are transparent. The volatility, the annualized standard deviation of the underlying price, is the only unknown. For this reason, options are actually quoted in terms of volatility, say 10%. The idea being that all the variables can be plugged into an agreed formula to yield the dollar price. The agreed formula assumes a normal distribution. But it turns out that markets behave somewhat differently than predicted by a normal price distribution. Markets tend to both sit still and undergo large moves more often than would be expected if the underlying process was normally distributed. Rather than adopt a more complex formula, the convention is to simply assign a different volatility to each strike. This is called the smile because the lowest vol is typically for at-the-money options, where the strike is near the forward price. Strikes that are away from the forward price are usually assigned higher volatilities. Note that this is not always they case, in which case the smile becomes the smirk. Offer Would you like a spreadsheet to help price out-of-the-money options? Price any strike for any date. Inputs are at-the-money volatilities, butterfly and risk reversal prices, interest rates, holidays, and weekend and holiday variance factors. The input information is used to build the volatility surface. To price an option, type in the expiration date, put or call, strike and underlying price. The output is the implied volatility and delta. Results are not reliable below five delta. The spreadsheet assumes vanilla options, no dividends and out-of-the-money volatilities >= at-the-money volatilities. If you d like to receive this free pricing tool, send an to What can go wrong? Well, if all strikes for a given expiration date are valued against a single volatility, there is an opportunity for gaming. By selling strikes away from the forward price an artificial profit appears if the sales are being marked against the lower at-the-money volatility. However, selling options will produce a short vega - the change in an option s price for a 1% increase in volatility - position and increase VaR. So the trader may buy in the cheaper at-the-money strikes, to flatten the vega exposure while still showing the artificial profit. This is called selling the wings and can be accomplished using a vega neutral call spread, put spread or butterfly. Keep in mind, that at-themoney options have more vega than out-of-the money options. So the trader is selling more out-of-the-money options than he is buying at-the-money options. VaR is still going up. Under certain market conditions, the fear is one direction only. Take stocks, for example. If conditions improve, markets may be relatively orderly and quiet as prices climb the proverbial wall of worry. Think of May to August of this year. If conditions worsen, markets are likely to be panicked and see violent price swings. Think of January to April of this year. The fear is down. Higher prices point to lower volatility and lower prices point to higher volatility. So out of-the-money puts trade at a higher price than out-of-the-money calls. The smile is now a smirk. In this environment, the trader need not take a position in the at-the-money options at all. He can show an artificial profit by selling the put and buying the call. The trade is roughly vega neutral. To determine if your portfolio is short the wings, run a report that shows your vega position by month. Now raise all volatilities by 1% and rerun the report. For each month, if your vega position went up or became less negative, you are long the wings. If it went down or became more negative, you are short the wings. If you are using a flat volatility and you are short the wings, your P&L is overstated. If you are concerned that the position is systematically short wings on one side and long on the other, run the report showing your vega position by month with the underlying price down by 1% and then up by 1%. If you re long calls and short puts, the second vega will be higher. If this is an equity portfolio, your P&L may be overstated. Market prices for this trade, called a risk reversal among other names, are readily available from brokers. Rogue traders are proving to be a persistent lot. The most recent incident at PVM Oil Associates, the world s largest OTC oil brokerage, was reported in July of this year. But there doesn t seem to be a lot of innovation among them. We see the same old games played time and time again. A savvy risk manager asking the right questions of his ETRM system has to be favored in heads up play. OGFJ About the author Larry Hickey started the first foreign exchange options business in Ireland for AIB in Hickey left the bank in 1998 for the deregulating US energy markets. One of his former colleagues at Allfirst Bank, then part of AIB Group in Baltimore, was John Rusnak, who was sentenced to 7-1/2 years in prison on Jan. 17, 2003, for hiding US$691 million in losses at the bank after bad bets snowballed in one of the largest ever cases of bank fraud. Rusnak was released from prison on Jan. 5, 2009, after serving less than six years of his sentence. For the past decade, Hickey has focused on risk management in an effort to prevent such behavior as Rusnak s. He has worked for several vendors in the ETRM space and continues to collect stories of how rogue traders exploit the very gaps those systems seek to fill. October 2009 Energy Trading & Risk Management 11
12 Risk Management in a New Market Era By David Newton, CEO, Amphora, Inc. There are many opportunities to realize returns through improved risk management along the petroleum supply chain. All energy market players need the right data at the right time for faster and more accurate decisions on fastpaced transactional opportunities. With the extreme price volatility and high trading volumes in the liquid hydrocarbons market, software tools must improve market participants trade floor knowledge of stock levels and feedstock/product qualities, even as they also address shorter-term trades and new deal structures. Optimizing stock levels for risk-free margins in storage plays, blending for better product value, and scheduling flexibility for commercial and arbitrage opportunities are key priorities. Better coordination of trading and logistics will help participants stay ahead of the market. Dynamic Limits The recent financial market upheaval illustrates the challenges posed in this complex new environment. Energy derivatives trade around illiquid markets with high volatility and are also exposed to underlying impacts of currencies and interest rates. Traditional risk management practices have focused on placing limitations on maximum exposure to identify and track opportunities and threats. However, there are many cases where the business processes to manage these limits are not updated to the complexity of today s marketplace for example, when oil moves $5 or $10 per barrel in a single day. Similarly, setting static limits on outright or spread positions may restrict market participants ability to squeeze out margin when the opportunity presents itself. Market participants must be able to combine actionable intelligence with detailed P&L attribution and separation of model components. Specifically, they must have the ability to accurately attribute P&L changes resulting from a variety of factors including those arising from market curve shift, deviations in delivered product quality, outturn losses, timing, additional costs, new trades, hedging and pricing events, and so on. Given this, a dynamic set of limits which react to changes in market price levels, changes to volatilities and other factors such as currency rates, interest rates and credit ratings is essential. Combining deep P&L attribution with the ability to set dynamic limits allows companies to better understand where money is being made or lost. Taking this further, the ability to perform what if and hypothesis testing around deal terms, risk, scheduling, credit, etc. is of critical importance for understanding the impacts of different scenarios on position, P&L and true cost basis. Examples would be to estimate changes in quality on supplies from a vendor as well as P&L trends on particular blending transactions, yield matrices, or credit term flexibility to certain counterparties. Contract Standardization Increasing pricing complexity around crude and refined products transactions requires greater scrutiny of the terms of every deal. However, a large percentage of physical trades have similar terms across counterparties, many of which book-out or net-out and never go physical. If data transfer standards are adopted, these deals can lend themselves to automation. The challenge to sharing this data is in reaching agreement between counterparties on a wide swath of physical contract details. This is why the use of industry data integration standards is essential. As market contracts get standardized, either through clearing on the exchange platforms, direct exchange trading, or subscribing to industry organizations such as ISDA or LEAP, the multiple combinations that must be managed are reduced. Further, new CTFC regulatory policies that push for stricter position limits on energy futures contracts may well require going beyond the current documentation requirements calling for new levels of reporting flexibility and transparency. Automated Data There is already a key part of the market that has provided full electronic information exchange. The ICE, Nymex and many brokerage houses today already have established standards for providing the market platform and trade information to their customers for the most liquid instruments. Most of these data flows are already tested and secured, and can be configured to enable significant automation of executed trades. Other areas for automation are letter-ofcredit and treasury management, specialized scheduling and tank management, specialized risk systems for value at risk and cash flow at risk, and specialized tax management systems. Market participants need actionable intelligence should a trading spike breach basic trading limits. The solution is to combine detailed P&L attribution, splitting out the components of the model used to calculate the measure, with a dynamic set of limits that better coordinate all functions in the petroleum markets. The resulting flexibility will accommodate new deal structures and create attractive new commercial and arbitrage opportunities for the market participants who employ these practices. David Newton can be reached at or Energy Trading & Risk Management October 2009
14 Q&A with Debra Bryson Product Manager - Energy Broker WellPoint Systems, Inc. Q. Is it true that more energy trading is taking place than ever before? Is there a difference in the type of risk management systems required for each type of trading activity? A. More trading is occurring today because there are a larger number of participants and despite continued liquidity issues in most energy commodity markets, the increased number of participants have resulted in more individual transactions. The ratio of physical to financial trades varies by several distinct variables: geo-political boundaries, North American geographies, seasonal production, facility capacity and storage options, storage capacity and the corporate or trading firm business models. The type of risk will vary by the type of trading activity. Firms trading product they own will have a lower risk profile while firms trading product as a commodity for hedging or swaps will have a higher risk profile. Q. Have risk management systems become significantly more sophisticated in recent years? Please elaborate. A. Risk Management systems have become more sophisticated as a reflection of today s innovative and aggressive trading business. As the requirements of energy trading and marketing companies trading portfolios have evolved to include more in-depth and real time physical asset position reporting and more corporate price strategy and margin portfolios risk management is at the forefront of executive management and accountability. It has also become necessary for systems to adapt and provide more hands on tools for analysis, reporting, auditing and approvals. Additionally, credit exposure is a key component of any risk management strategy. As a result of the challenges and governance requirements for today s corporate executives, trading software solutions have become more sophisticated and are in greater demand. Q. Do some energy traders still use spreadsheets or have most switched over to commercial software? A. Yes, certain small and large companies still use spreadsheets to track and manage their energy trades; isn t that a scary thought? The spreadsheets used are difficult to consolidate, create monthly reconciliation challenges, often lead to variances between marketing, production and accounting and are very difficult if not impossible to audit. Trading is inherently a risky business and the use of spreadsheets as a primary management tool only adds to that risk. A. Off-the-shelf software ETRM solutions are both available and advisable. However, due to the many nuances associated with this business, ETRM software cannot simply be plugged in. Systems should allow for configuration to meet your business needs not change your business needs to meet the software. Yet, be aware that excessive customization increases your implementation cost and duration. Traders have little time to devote to implementing new solutions, so look for one that is easy to implement providing a quicker payback and less disruption to your business. Q. Finally, we hear a lot about system integration, especially with regard to front-to-back office. How important is this? What if a user implements a front-office system from one vendor and has a different system for the back office (accounting, etc.)? Does this create problems? A. Integration is vital to today s energy industry when you consider the level and frequency of communication. ETRM involves front office (bidding, scheduling/nominations), middle office (price forecasting, simulations, risk management) and the back office (balancing, settlement, contract management). Think of the two or three systems speaking different languages and needing a translator. If something gets lost in translation, it can confuse the entire conversation and create significant problems. However, when you have a system that is integrated on an overall basis, the various sub-systems can speak to each other seamlessly, allowing for much greater ease in management of data flows. Integration provides more visibility into the logistics, operations and financial growth of your company throughout the entire deal capture process. In an ideal situation, a system would have the ability to work in the world we work in; a world of multi-commodity deals, forecasting, scheduling, nominations and contract settlement and all in multiple languages and currencies. Because we live and work in a complex world,the systems should mask the complexity, making our lives easier. Q. Is off-the-shelf ETRM software available and advisable for most energy traders or must it be customized for each user? 14 Energy Trading & Risk Management October 2009
15 Manage your Business Better. WellPoint Energy Broker (ENB) is an integrated oil and gas marketing solution focused on mid-stream companies. ENB provides dynamic and innovative marketing, scheduling and nomination software designed to manage complex pricing scenarios, streamline supply/demand analysis, and expedite contract and nomination confirmations. It also provides detailed administrative, management and executive financial reports. Manage the Business: Retain all historical data, denominated in any number of currencies, for comparative reporting Trace every transaction to its source document Evaluate variances between historical production and current month availability to assist in transactional decision making Understand your daily contractual, inventory, imbalance commitments Prepare accurate settlement documents and ensure timely journaling Business without Barriers.