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Could your risk management system withstand the perfect storm?

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In many boardrooms of energy companies the question is asked whether their risk management system is robust enough to help their company through similar turbulent times as the financial companies are facing today? Now the lessons of the credit crisis become clear this is the time for you to thoroughly examine your risk management framework.

The outcome of this might be a change in the way you execute your risk management methodologies and processes. Such a change would make you and your company less vulnerable to an exposure to material unknown risks.

Risk models are useful, but so is common sense

One thing that has become clear is that the executives of many renowned banks relied way too much on the quants and their risk models. Where common sense would have told them not to get involved in the complex structured instruments like the subprime products in the first place.

I have noticed that also within many energy companies risk models are seen as the Holy Grail for valuing the risks of exotic products. This is not to say that risk models are useless, but that the outcome of a model is as good as the assumptions it is based on.

Therefore the final decision to buy or sell structured or exotic products should be based on human judgement. If the senior management cannot fully understand all the risks of a product, they should decide that trading in such a product is out of the question. On the Internet I read a very good analogy to this: "Risk models are like a GPS device used in a car; it's helpful as a guide, but the driver still needs to look out the window".

Enterprise Risk Management (ERM) Framework

Another lesson that could be learned is that the different risks, such as price, credit and operational risk have a close relationship and should not be dealt with in isolation. Energy Companies should consider how to approach the implementation of an integrated company-wide system to tackle all of these risks. This could be achieved by introducing an Enterprise Risk Management (ERM) Framework. ERM will allow for a more timely analysis of risks and a deeper understanding of how your company is impacted by the dynamic risk environment of the global commodities industry.

I have supported several energy companies with the implementation or assessment of their ERM Framework. Through this work I know that it is certainly not an easy task to perform but that the rewards are high: a healthy and sound company with a robust and efficient risk management system.

This is my first blog, please let me know what you think!

- Kasper Walet -

 

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