Anticipating greater commodity price volatility, commodity trading firms, major oil and gas players, as well as companies with significant exposure to fuels have all been rapidly expanding their trading capabilities everywhere from the United States to Europe to the Middle East. Indeed, at least a dozen new trading operations were registered or announced last year in Switzerland alone.
Yet while many companies are increasing their trading capabilities, only a rare few are building out the risk and pricing resources needed for them to capture the optimal value from the higher risks they’re assuming in their expanded operations. As a result, they risk reducing the profitability of their structured products by up to 90 percent by potentially neglecting to take into account important factors such as market liquidity. To take advantage of volatile commodity markets, traders need to develop a single perspective on a wide range of different risks to evaluate the true aggregated impact on their organization. Doing so is critical to safeguard not only the profitability of traders’ day-to-day operations, but also their high performance over the long term.
There are several reasons why many firms are rushing to expand their commodity trading arms and to establish entirely new commodity trading operations. Leading commodity trading firms are building out global networks of operations to gain direct access to commodities, including their storage, refining and blending. That way they can fully exploit physical product knowledge in their trading. Others are moving into alternative commodity markets to develop more diversified portfolios. Large Asian and Russian oil and gas producers like PetroChina, Sinopec and Gazprom are branching out into the US, Europe and the Middle East to gain better insights into global pricing strategies.
At the same time, companies with significant exposure to energy like New York-based Bunge, the world’s second-largest sugar trader, are expanding their trading operations into physical oil in order to trade around their natural short position in fuel oil. By doing so, Bunge can improve the margins in its shipping operation.
Many companies’ risk and pricing capabilities trail far behind their ambitious expansions. Recent experiences from the financial crisis have highlighted weaknesses in risk quantification and valuation frameworks both in financial services companies as well as in commodity trading firms. Still, the common shortcomings have remained the same over the last couple of years as recent events have generally not led to structural improvements.
Worse, the recent ramping up of commodity trading operations is making the task of managing the risks embedded in them even more complex. Many companies are bringing together various trading operations with motley collections of risk management frameworks. Most need to be aligned for firms to capture the optimal value across their consolidated asset and customer portfolios.
Why then do so many commodity traders seem to ignore the need to evaluate their risks on a more comprehensive basis? Some don’t realize the magnitude of their risk exposure. Others don’t know that they are potentially forgoing opportunities for higher trading margins by inefficiently using their risk capital.
Adopting more comprehensive integrated risk and pricing approaches can resolve many of these issues. By developing deep insights into all of the fundamental value drivers in a trading portfolio, an integrated framework provides the radar for risk exposures across all trading activities. This enables risk managers to identify the tangible market and credit developments to which the firm’s financial performance and liquidity are particularly sensitive.
Profitability can be improved in a consistent way if the risk quantification methodologies used can capture the characteristics of the underlying asset base accurately. For example, a trading operation can understand the risks that it is facing and negotiate an appropriate margin for keeping the risk on its books. Deals that reduce the overall portfolio risk can be priced more aggressively than deals that increase risk, thereby creating an incentive for traders to develop an aggregated portfolio view on risks across all desks.
Indeed, price simulation engines that account for the key empirical properties of commodities paired with models capturing asset optionality are not only powerful tools in trading risk management, but also in strategic decision making as they help executives to understand the life cycle of a trading strategy.
This article highlights seven of the more common and onerous types of oversights that exist in commodity traders’ risk and pricing frameworks. We then suggest broad strategies for correcting these shortcomings and preventing new ones from springing up.
Seven Blind Spots
There are seven areas of risk that commodity traders often do not take into adequate account that can lead to dangerous underestimations of their true risk exposure:
1) Market liquidity – Many asset-backed traders hold positions that are more than 100 times their daily transacted volumes. As a result, the risk resulting from these long holding periods may be more than 10 times greater than what has been quantified with a standard VaR approach. One European energy trading company recently discovered this the hard way after it was hit with tens of millions of dollars of losses from a losing position even though its VaR was well within acceptable limits. The problem was that the firm had not accounted for the market liquidity associated with its losing position, which it suddenly could not close because other players were simultaneously trying to do the same thing. Oil and gas traders face a similar dilemma since they are often engaged in longer-term commitments that become costly to hedge in the absence of liquidity.
2) Methodology – Relying on insufficient and inconsistent methodologies can result in significant miscalculations of the value and the risk of a contract. A lack of adequate modeling techniques can create a structural impediment to capturing higher trading margins by forcing a trader to forgo the benefits of advanced market analysis techniques. For example, the profitability of oil trading in 2010 was reduced significantly when compared to 2009 and 2008, in large part because only a few traders had considered the risk of the forward curve flattening. As a result, many found it difficult to recoup the premium paid on large amounts of contracted storage capacity.
3) Diversification effects – If properly diversified, the market risk of a large commodity trading portfolio can be reduced by as much as 70 percent. However, many trading organizations lack the structural prerequisite for realizing such diversification benefits because they are unable to harmonize their risk quantification methodology across each of their trading books and risk types. As a result, they are missing out on potential savings: By increasing the scope of risks quantified and examining cross-commodity as well as inter-temporal correlations within a trading portfolio, Oliver Wyman recently identified $700 million in potential savings in risk capital for a large commodity trading firm. Further benefits were achieved after measuring the extent of diversification of the portfolio’s market and credit risk.
4) Physical characteristics of real assets – The risks in structured deals and associated hedging activities are often incorrectly represented because traders rarely take into account the flexibility and optionality of assets like power plants, natural reserves, storage or transportation infrastructure. It is common practice to hedge out the portions of risk that are not well-understood or to disregard them in less sophisticated commodity trading operations. This often reduces the profitability of deals by more than half.
5) Credit risk – Few organizations quantify expected or unexpected credit losses when they measure credit exposure, and even fewer reflect this in profitability calculations on a deal level. Yet taking credit losses into account can fundamentally change the profitability of a trade, especially for asset-backed traders, who have the bulk of their credit exposure with non-financial services counterparties. For example, the fact that a rating migration from BBB to BB may quadruple the expected loss is often not considered adequately upon the inception of a deal.
6) Liquidity and collateral management – At a time when the recently passed Dodd-Frank Act will likely increase the volatility in exchange-traded and over-the-counter commodities, many large commodity trading operations still have difficulty quantifying their true liquidity needs for a limited number of days ahead. This is in large part because they fail to examine all of their available sources of liquidity and commitments. In fact, many large operations have trouble assessing how much they are trading against open credit or third party guarantees. As a result, they have little understanding of the potential impact of collateral or margin calls on their liquidity.
7) Replacement cost – A combination of counterparty defaults and market turmoil may force a trader to source expensively at a spot price in order to compensate for physically missing forward volumes. Nevertheless, few firms consider the replacement risk that can result from the potential inability of a counterparty to deliver contractually agreed physical volumes. The impact may not only be limited to an opportunity cost but also could become a material loss.
Six recommended steps to develop a more comprehensive risk framework
Today, most commodity traders can count on missing out on potential margins because they are inaccurately measuring risks or inefficiently using their risk capital. Fortunately, they can take steps to develop a more integrated perspective of their portfolio and its potential impact on their organization.
1) Treat risk management as a risk-adjusted value creator. The main purpose of a business enterprise is to capture rewards equivalent to the risks taken. And yet, many commodity trading organizations take a compliance-oriented view of risk management. As a result, they miss out on the potential benefits of developing a more comprehensive risk framework. Trading and risk management teams need to raise top management’s awareness of the benefits of integrated risk and pricing frameworks. Maximum commercial leeway should be granted to traders under an effective governance framework that ensures that the targeted return is commensurate with a level of risk that is in line with the entire organization’s risk appetite.
2) Establish adequate risk quantification methodologies. Commodity trading organizations need to develop processes to ensure that key risks such as the seven mentioned above are all considered and that their risk capital is quantified efficiently, taking into account the benefits of diversification for an organization’s entire portfolio. These methods need to be tailored to a company’s asset portfolio and risk governance principles so that the company can stay in control of them and understand the risks that have been quantified.
3) Enable consistent integration into a governance framework. A comprehensive governance framework is necessary to ensure that a broader set of risk information is used appropriately to steer a trading business. Risk-adjusted performance measures need to be linked to traders’ compensation in order to encourage them to use risk capital more efficiently and ultimately achieve greater profitability. Risk-adjusted financial planning for the holding company ensures that its strategic plan remains feasible and that any financial impact from trading operations in adverse conditions will be manageable. This way, the organization can be sure that it has sufficient cash liquidity to prevent being forced to pull out of positions prematurely.
4) Institutionalize interactions between centralized risk management functions in an integrated framework. Critical information must be shared effectively. This implies that market and credit views will be synthesized and adequately reflected in liquidity risk metrics. A liquidity and collateral management team needs to ensure that sufficient liquidity is available to support profitable trading strategies.
5) Develop stable reporting processes. Day-to-day trading operations must be supported with current risk information. Data must be captured and stored centrally to ensure all information is simultaneously available across the whole trading portfolio. Processes need to be largely automated to reduce operational risks and to free up reporting teams’ time to investigate where specific risk exposures such as market, credit and liquidity risk reside in the trading portfolio.
6) Conduct ongoing model validation. An organization’s processes and competencies to manage model risk are vital elements in ensuring that risk capital efficiency does not come at the cost of additional model risk. This can be achieved by supplementing risk quantification tools with independent testing. Models optimized for capital efficiency should be regularly scrutinized through back testing and standardized validation routines.
Commodity trading organizations that recognize an integrated risk and pricing framework contains tools for creating value will develop a significant competitive edge, particularly in highly volatile commodity markets. Custom tailored risk quantification methodologies that incorporate the elements described above are crucial for revenue growth, profitability gains and financial stability.
Integrated risk and pricing practices will decrease operational risk dramatically. The combination of a centrally controlled methodology and an adequate governance framework reduces operational risk, particularly when a trading organization has experienced significant inorganic growth or undergone a period of consolidation.
Management teams as well as shareholders will also have a better understanding of what capital buffer is required to realize strategic plans in a way that permits the trading organization’s cost of debt to be stabilized. Unlike using a standard VaR approach for determining the appropriate level of the capital buffer necessary, a more comprehensive Earnings at Risk framework increases the accuracy of risk quantification, especially for positions that cannot be easily liquidated. It also has the potential to improve risk capital efficiency significantly when paired with adequate market price scenarios.
All of this will become increasingly important as commodity markets become more volatile in today’s fundamentally changed business environment.