Industry takes first post-Enron steps towards modifying risk techniques

July 8, 2002
Countless energy companies' business practices will be forever changed by the fall of and subsequent investigation into beleaguered energy merchant Enron Corp.

Countless energy companies' business practices will be forever changed by the fall of and subsequent investigation into beleaguered energy merchant Enron Corp. For one, risk management techniques and tools used by oil and gas companies will have to be reassessed and modified to conform with the changing accounting and reporting environment.

Some of the heftier modifications are likely to occur in how companies manage risk through their successful information technology (IT) implementation and through changes in their energy trading practices. The process of IT implementation itself can entail a new kind of business risk for energy companies today. And in the continuing debacle surrounding energy companies' computer-driven commodities trading practices, energy trading will come under still greater scrutiny.

Click here to enlarge image

Meanwhile, in the downstream sector, refiners in the past few years have started to control other types of risk as well, the most important of which is risk to profits as a result from the exposure an operator has to volatile commodity prices, among other factors.

IT implementation

Upgrading its numerous IT systems remains one of the most important strategies tools for helping an energy company manage risk.

A company's IT risk management strategy can entail some of its most critical decisions, and companies should take time to make decisions properly. For example, software buying should never be done in a hurry regardless of any pressure to get the deal done quickly, according to David Dunkin, cofounder and chief operating officer of SolArc Inc., a Tulsa developer of energy-trading management systems. Dunkin said IT customers also must clearly define their IT problem and set reasonable expectations for a resolution to that problem.

Click here to enlarge image

"Always keep in mind that IT system implementation is a two-way exchange. Reputable vendors will bend over backwards to meet and exceed their customers' expectations, but it is incumbent on the customer to communicate what those expectations are," Dunkin said.

Dunkin said he is frequently asked why IT projects always seem to spiral out of control with delays and cost overruns: "For fast-moving energy marketing enterprises, by the time a difficult implementation is completed, the original mission and priorities that the software was intended to address may have already changed. With the amount of money typically spent on these projects, there is significant value in whatever companies can do to increase the success rate of their IT system implementations," he said.

Unfortunately, many projects get off to a rocky start simply by not setting reasonable expectations for the outcome, Dunkin added.

Companies making a software-buying decision have to satisfy the end-users along with the management, he said. Often the process can be highly politicized, requiring multiple levels of approvals.

Software vendors, Dunkin noted, sometimes treat this situation like a game. "When dealing with a byzantine buying process, it's tempting to cut corners and do whatever is necessary to close the deal. While the sales force may think there's nothing wrong with that idea, it rarely results in the desired long-term outcome: customer satisfaction," Dunkin said.

Selecting and implementing an IT system involves looking at three types of risk, according to Dutch Holland, founder and CEO of Holland & Davis LLC, Houston.

These risks are technical, organization, and business (Fig. 1). In order for a company to gain full value from the technology, all three types of risk must be addressed. "Beyond technical risk-which is the risk that this system won't work-there is organizational risk, which is the risk that, despite the fact the system works, the organization won't use it," Holland said. "The third risk is that even if the system works and the people use it, there's the risk that it, in fact, won't make the company any money or won't be any better than what is currently in use."

Holland explained that another problem when implementing IT risk management solutions is that companies sometimes are not prepared to use the new technology. Industry, Holland noted, is not yet looking at IT as the same kind of a critical, core asset that it would a piece of refinery equipment, or a pipeline, or any other hard asset. "You can still find examples of companies that have spent $50 million on an IT system, and users were not ready when the system was turned on, and they are gradually getting around to it, but they are not there yet," he said.

Unocal case study

Holland & Davis recently assisted Unocal Corp. with implementing new data management software so that the system, once implemented, would cause minimal disruption to the company's work process.

A key concern for Unocal, said Gary Skarke, managing director, Holland & Davis, was to standardize the process by which the company managed its vast amount of data.

"In working with the different groups at Unocal, there were some groups that wanted one kind of software, and another group that wanted another," Skarke explained. Previous attempts to select software failed to get high user involvement-"therefore the users did not buy into the solutions," Skarke said, adding that focus groups were involved in the selection process from the very beginning, which made it easier for them to embrace the new technology.

From the business-risk side, Skarke explained, a business case that was developed found that Unocal would benefit from using the technology.

Trading turnabout

Over the last few months-as regulators and government agencies work to dissect the controversial energy trading practices of Enron and other US energy merchants-energy companies are taking a long, hard look at their trading units as they were used to manage risk.

Over the next 18-24 months, there will likely be an increasing amount of emphasis placed on companies' hard assets and an overall shying away from energy trading, said Ed Bell, leader of the trading and risk management service line for Cap Gemini Ernst & Young's energy, utilities, and chemicals practice in the US.

"There also is going to be a huge human cry for accountability," said Dunham L. Cobb, risk management specialist with Cap Gemini Earnst & Young US LLC. "There are some people who have done improper things-no question about it. But I don't think that's the industry."

Cobb added, "This whole idea of 'bigger is better'-I think that that bubble has burst. We're going to have to create transparency around systems, to improve behavior to go along with the systems. Also, with better systems transparency, we will actually see who adds the value. It's going to be a huge reckoning within companies and within the industry."

Bell said, "Part of the problem for some of the energy merchants is that their systems are designed with a real bias towards the trading function and in the market-for the next period of time-trading is going to be deemphasized, and asset management is going to rise to prominence, and (those companies') systems are inadequate to deal with it.

"Trading will come back, but it will be beaten down for a while. Now, actually, is a good time-if you believe in the business cycle theory of business-to prepare for the next cycle, but do it right this time such that when the wave does come back, you're not exposing your company to any additional risk," Bell said.

In addition, it will remain increasingly important for companies to continue to know what their positions are on a daily basis. "Risk management is only as good as the data that you have, and how well you know what your business is," Cobb said.

Refiners' profits risk

Processing plant owners traditionally characterize risk management as ensuring availability of physical assets, either personnel or equipment-related. Regulations and standards for traditional risk management include programs such as Occupational Safety & Health Administration's Process Safety Management and US Environmental Protection Agency's Risk Management Program. These programs have resulted in refinery programs such as preventative maintenance, HAZOP (hazard and operability) reviews, and safety audits.

Refiners' management of price risk, however, has just started coming into its own in recent years.

Both problems and opportunities can be created by the dynamics of unplanned events in the refining supply chain, according to Chuck Moore, general manager petroleum division, Aspen Technology Inc., Cambridge, Mass.

These unplanned events typically result from:

  • Market volatility; i.e., price fluctuations in both commodities (crude oil and refined products) and transportation (vessels, pipelines, and storage) markets.
  • Operations issues; i.e., upsets or changes in planned refinery operations.
  • Logistics disruptions; i.e., delays or changes in shipping, barging, or pipeline schedules.

"Risk management is now viewed ellipseas a critical enterprise-wide requirement for many reasons, including satisfaction of regulatory requirements, gaining increased market valuation, better use of assets, and higher returns on risk capital," said Jeff Mantel, director, product marketing, for Houston-based iSpheres, which provides real-time decision-management applications.

As opposed to upstream companies, refiners and petrochemical producers are exposed to price risk on both sides of their operations, in terms of feedstock prices and product prices. Price risk is lower for companies with integrated crude production-refining or refining-petrochemical operations.

For nonintegrated operators, a worst-case scenario would involve high feedstock prices and low product prices, which results in low operating margins, a situation many refiners experienced in late 2001 and earlier in 2002. Operators can hedge this risk by using various commodity financial instruments. The types of financial products-such as futures, options, swaps, spreads-have increased as hedging has gained popularity (OGJ Online, Aug. 30, 2001).

"The hardware, software, and mathematical modeling technology have also grown. Today, the combination of powerful hardware, sophisticated software, highly refined mathematical processes, and the web has enabled risk managers to manage risk on extremely large trading books consisting of a wide variety of financial instruments," Mantel said.

Some refiners have become so successful at selling and trading these instruments that they have turned their trading operations into separate profit centers.

"Major oil companies recognize that if they fail to utilize the markets effectively, they are at a competitive disadvantage to companies that use the markets to increase netback and to reduce the cost of feedstock into their refineries," noted SolArc's Dunkin.

Dunkin said that "accurate and timely position management becomes more challenging as trading activity increases."

This increases the importance of software that tracks a company's overall risk management position.

Captured value

According to Dunkin, "For a downstream oil company engaged in supply and trading activities, there are four major areas that represent opportunities to capture value following the decision to trade: reducing hidden transaction costs throughout the life of the deal, supplying markets at low costs or high margins, managing inventories and exchange balances, and minimizing the impact of refinery performance variances."

Many companies recognize the value of supply and trading activities in the area of risk management. Companies have developed or acquired expensive and complex risk management systems to manage price risks across the aggregated trading enterprise.

However, the validity of risk reporting depends on the availability of accurate volumetric data. If a company can't track its physical inventory accurately, traders run the risk of making multimillion-dollar deals based on inaccurate information.

Trading and logistics

While trading commodities around a processing plant is important in managing risk, reducing the risk inherent in logistical operations is also a priority for trading operations.

"Trading and logistics are a mission-critical part of the petroleum supply chain. As each barrel of crude oil or petroleum product moves along the supply chain, the trading and logistics decisions that are made about it have a huge impact on profitability," Aspen's Moore said.

"Companies have traditionally considered risk and risk exposure in relation to a closed deal, with the focus on better understanding market risks, credit exposures, and settlement risks. However, none of these activities helps reduce the risk inherent in a bad or suboptimal set of trading and logistics decisions," he added.

Operators can manage risk and improve profits in physical trading by using "front office" systems, which are used by the frontline decision-makers on a company's commercial team-traders, schedulers, planners, analysts, and terminal operators-to identify and close the most profitable deals, reduce transportation and logistics costs, and improve responses to unplanned events.

Front office systems are complementary to midoffice systems-which focus on risk management and transactional processing after the deal is closed-as well as with back office systems, which handle the accounting issues associated with a deal. To effectively manage a deal through its life cycle and mitigate any associated risk, a company should have all three systems in place (Fig. 2).