Optimization in energy
VOLATILITY REQUIRES BETTER PHYSICAL ASSET MANAGEMENT
DAVID LEEVAN, OPENLINK AMERICAS, HOUSTON
THE BEST DEFENSE is a good offense. The people who go into the ring just trying not to lose almost always do. Fortune favors the bold. And so it is with managing your energy portfolio.
Trying simply to hedge risk isn't enough. Successful enterprises need to be aggressively leveraging all of their assets in order to stay ahead of the game. Nowhere is this more applicable than with energy companies. The energy sector deals with shifting prices constantly and has been working on managing its holdings for some time. But the industry needs to do a better job managing its physical assets, particularly during times of high price volatility, and increased regulatory and political change.
A recent analysis found that energy companies with medium-sized physical asset portfolios can lose between $3.9 million to $7 million per year due to price volatility. It's easy to understand why. Energy companies need to hold onto different kinds of assets in order to operate efficiently. If a power producer doesn't have enough gas, coal or oil to power its plant, it can't provide power to its customers. But like any other commodity, prices mean that buying, selling, and holding at different times can make for different results.
Finding yourself long in a falling market or short in a peak price market can have serious consequences. So to avoid losing money, companies need to coordinate their risk hedging work with their asset management work, and that's where there's a big gap in execution. Many companies recognize now that they have failed to integrate hedging strategies and asset portfolio management, even though they understand this is needed.
WHEN KEEPING IT REAL GOES WRONG
The need to simplify and streamline risk management and asset portfolio management into one easy solution is understandable but it can lead to missed opportunities. Energy companies often lose out on extra value that their physical assets can bring because they have simplified their physical energy assets by using a "real option" model that enables them to utilize existing Energy Trading and Risk Management (ETRM) software. ETRM software is powerful, but in today's environment it may not be enough when companies are dealing with ever more complex commodity (power, gas, coal, oil, LNG, NGLs, etc.) portfolios.
For the last decade, it has been considered gospel that companies that trade energy have needed an ETRM solution. An ETRM system will cover all parts of a trade's lifecycle, from deal capture through settlement, and these features have been upgraded and refined to handle whatever the energy trading industry can throw at them. But when it comes to bringing together physical asset portfolio management with trading, an ETRM will not give the full picture.
An ETRM system will only consider one physical asset at a time, while a peak in demand may be most efficiently met by utilizing many assets, including buying in the markets. ETRMs, which are great for ensuring a risk management plan is being followed, are not focused on extracting value from physical assets. So an ETRM needs a bit of help to give the full picture to a company with a portfolio of real assets.
LET'S GO TO THE PPO
In this instance, what's needed is a physical portfolio optimizer (PPO) to supplement the work your ETRM is doing. When an ETRM is integrated with a PPO, all the assets in an energy company's portfolio will be optimized, by considering the performance of each unit as well as looking at trading conditions. An integrated solution will determine optimum usage of various assets depending on unit availability, demand, market prices and contractual requirements (e.g. maintaining a certain level in reserve, or meeting a supply contract). The trading arm can then do what it does best.
Because energy companies have unique complexities with the physical assets they manage, the PPO solution is required to optimize across all asset classes, network constraints and products. The PPO's function will model the detailed characteristics of all the assets in the physical asset portfolio, provide simultaneous optimization of all asset classes in the company network and provide simultaneous optimization of products such as energy and ancillary offerings.
From experience, OpenLink has found that a co-optimized approach will typically yield a 1% to 3% margin uplift. With the cost of operations for energy operations running in the tens of millions of dollars, these savings can bring large PnL benefits.
Price volatility is a constant for energy traders, and having a good trading system by itself is no longer sufficient for energy companies that manage a portfolio of physical assets. The interconnectedness of the world means that volatility can arise from various places. It also means that all players need to be prepared with an integrated approach. Energy companies ought to have an integrated system in place to manage their physical assets to not only prevent losses, but to generate operational savings on a permanent basis.
A volatile marketplace shows no mercy to timid players. Using an integrated solution for physical assets will provide energy companies with the tools they need to maximize value.
ABOUT THE AUTHOR
David Leevan is Director of Analytic & Optimization Solutions for OpenLink Americas. He has more than 14 years' experience providing portfolio analytic and risk management solutions to the energy industry. He holds bachelor's and master's degrees, respectively, from the University of California, Los Angeles and the University of Colorado Denver.