Commodity price risk management: When to hit the brakes

Risk Management / 05.17.19

Commodity price risk management: When to hit the brakes

When you’re driving down the highway, you know when to put on the brakes. Minor puddles or road imperfections are inconsequential and won’t slow you down, but other risks may require braking. If you can see them far enough ahead, just covering the brake or maybe light braking is enough as a first response. But sometimes, a risk presents suddenly – a car cutting into your lane – and that calls for a more aggressive response. In sum, your braking is responsive to and proportional to the degree of risk in front of you, and how imminent that risk is.

This risk-responsive approach applies equally well to energy price risk management, yet for some reason we often do not apply the same thought process, even though it should seem natural to us.

A pithy and powerful definition of “risk” comes from the International Organization for Standardization (ISO): Risk is the impact of uncertainty on objectives. Just the presence of uncertainty is not enough for there to be risk. There is risk only if the uncertainty is significant enough to have a material impact on the organization’s ability to achieve its objectives. Uncertainty that has no material impact is just noise.

Looking at energy price risk through this lens sets the organization up with two key questions to ask:

  • What degree of energy price change would have a material impact on us?
  • How likely are we to experience that degree of energy price change?

The first of these questions is introspective. Each organization must assess for itself its own risk tolerance. The answer will vary depending on the business the organization is in, its financial position, even its own culture and attitude toward risk. In Jupiter’s experience, it is imperative to involve senior management and representatives of various functional areas in arriving at an answer – and in fact an understanding – around this question.

Note here that the degree of risk I face is unique to me because it depends on the risk tolerance that is particular to my organization. No one can tell me what risk management measures my organization should be doing unless they first understand my organization’s tolerance for risk. There is no “one size fits all” risk management recommendation.

The second question involves looking out at market conditions. But this market analysis is not about trying to divine the future path of prices. Prices are uncertain, and risk is about that uncertainty, so the prevailing level of uncertainty in prices is exactly what we need to measure to assess risk. Pretending someone can foretell where prices are going simply assumes away the problem!

There are sound analytical techniques that enable us to specify a range of possible price outcomes and establish a confidence level that prices in some future period will fall within that range. The level of price risk in the market changes over time, just like the risk in traffic changes at different points along our journey, so we need to measure risk continuously. It is also important to recognize that risk is about the potential for prices to change, not about the current level of prices or even the current price trend. A low-price market can be a high-risk market, so we should not be sanguine simply because prices are low.

Effective risk management is not about trying to lock in a target price or divine fundamental and technical indicators to spot the bottom or predict the timing of a price change. It comes down to:

  • identifying what range of pricing outcomes are unacceptable to our organization
  • establishing a confidence level we want to have that we will avoid those unacceptable prices
  • applying analytical methods to quantify the amount of risk in the market from time to time

With our tolerance for risk in mind and analysis that quantifies the likelihood of certain price outcomes, we can see price risk that lies in front of us and we’ll know when and how aggressively to respond to it, exactly the way a driver knows when and how hard to hit the brakes.

We do risk management this way every day on the way to work. We just need to continue to do it once we get there.

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