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Posts Tagged ‘risk management’

2 Mar 25 2010 @ 9:50am by Matt Smith in Biofuels, Capital Markets, Crude Oil, energy consulting, Global Energy, Natural Gas, risk management, Risk Strategy

Ten reasons why energy commodities absolutely rock

My name is Matt Smith and I am a financial market junkie. Having left London and the warm bosom of investment management some 1,312 days ago, all could have gone very wrong. However, I have fallen into the arms of another – the world of energy commodities. So henceforth, my reasons for their stardom is tenfold:

1. Markets are all interlinked. Although some energy commodities may spend some time way out in left field, led by their own own fundamentals (step up to the plate, US natural gas), energy commodities take their lead at various times from other commodities, or other asset classes. So the more you know about general markets, the more you can apply that knowledge to the movement in specific commodities.

2. The word fungible. Commodities have fungibility, which means their units can be substituted for another – they are interchangeable, like a dime. Hence why a pipeline attack in Nigeria or geopolitical tension in the Middle East  matters to the price of your gas at the local gas station. It is also a fantastic word.

3. How commodities latch onto other commodities at various times. For example, European power markets pick and choose which price driver to follow, seemingly like picking a jelly belly from a bag (exaggeration for embellishment). At various times, power is led by coal, natural gas, oil or carbon permits, or varying combinations of these four. It keeps you on your toes.

  1. 4. The global reach of commodities. Trying to get your head around a domestic commodity like US natural gas is hard enough, let alone trying to determine how rampant Chinese oil demand weighs in with weak US oil refinery margins to influence UK Brent crude pricing. It surely can never be wholly mastered, but it sure is fun trying to decipher all these contrasting factors, from Corpus Christi to China, via Chiswell Street.
  2. 5. While leading participants in other markets try to hide their misdemeanors through a charade of smoke and mirrors (step up, Lehman Brothers and your Repo 105’s), the largest and most influential participant in the crude complex (Opec) continue to defy their own mandates (official quotas), while fully aware they will be called out on such dissention on a monthly basis. Refreshing.

6. How can you tire of a commodity such as US natural gas, when despite having all the sophisticated financial modeling and valuation tools in the world, prices remain at the mercy of the gods with hurricanes, heat, storms, and snow?

7. Technological advancement. Energy markets are constantly evolving through technological breakthroughs, and this will only continue through developments in such areas as LNG, smart grids, biofuels and green energy.

8. Forward curves. Not only do you have the ability to analyze commodities on the cash market or the front month contract, but you get to analyze the movements of the whole forward curve, going out for years to come. They are like a 3-D version of equities. And the forward curve is just as important as the prompt (or more) to energy risk management.

9. How markets in completely different geographical areas influence each other. Case in point, UK and US prompt natural gas prices have recently converged, due to their increased competition for LNG supplies. Fungibility + transportation links = an ever shrinking world.

10. Commodity markets are like equity markets are like bond markets are like currency markets. No matter how much you analyze a market, you will never master it. But we keep trying our darndest. And that’s why they rock.

0 Mar 11 2010 @ 10:19am by Matt Smith in Crude Oil, energy consulting, Global Energy, Natural Gas, risk management, Risk Strategy

Seasons Change.

Changing seasons...China Vice-premier Wang Qishan and US Treasury Secretary Tim Geithner this week.

Blogging is kind of odd. When I first started this whole kit and kaboodle, I thought I would most likely have a bunch of blog posts stacked like pancakes, ready to be pulled like a rabbit from a hat at those moments when an inevitable bout of writer’s block kicked in. This is not the case. I have now reached a point (being a seasoned pro, with well over five months of blogging experience) where it is much better just to wing it.  I generally get a gut instinct what to write about the day or so before I should be posting. So, with that in mind, there I was, on the way to pick up some milk from the store last evening, racking my brain for what was the most important point about markets at this moment in time. And then it came to me. Like a flash. The amazing conclusion: not a lot.  

Hurrah, I thought – I live to fight another day! Let me explain. Not only are the seasons changing, but markets are also undergoing some sort of transition. As we move from winter into spring, markets are experiencing a tidal shift, although they may appear calm on the surface. By taking a butchers at our usual commodity suspects, this rather tenuous statement can be illustrated.   

First up, black gold, Texas tea. Crude oil is currently at the top of the trading range it has been in since early October.  It may well be set to leap into spring by breaking out to the upside and busting its $70-$85 shackles, but for now, it remains range-bound. Having spent the winter awaiting further confirmation of a global recovery, signs of a return in demand for crude and its products (even in the US now) may well usher prices to exit winter with a flourish. But at this moment in time, all looks rather tepid, temperate, and tame.

Onwards and sideways to natural gas –  the commodity closest to our heart here at Summit. Natty has had a bruising second-half of winter, as prices have fallen despite colder-than-normal temperatures. This now leaves prices stuck in a terrible limbo-like status, as exiting winter has spurred on selling due to strong storage levels still being intact. Nonetheless, the question remains as to when (and whether) industrial demand will fully return, and when (and if) an economic recovery will ratchet this demand higher. And that’s before the rumblings in the distance start about hurricane season (oops, too late). All the while, the 800-pound gorilla sits well-behaved in the corner of the room – a gorilla known simply as ‘Shale‘  – you may have heard of them. All in all, this leaves natty exiting winter, battered and tiredly trundling lower. But be aware that average prices have risen in the second quarter more often than not in the last decade; to write off the potential upside risks on the horizon could be churlish.    

Taking a look across the sea of other asset classes, we can see a similar state of flux. Gold remains around $1100, comfortably flowing forward and ebbing back, despite the well-wishing gold bugs calling for $1500 and the demise of the US dollar. US Treasuries continue to defy the wave after wave of new debt issuances by the US Government to remain yielding 3.75%-ish, well below what logic dictates. But, it may yet make sense when bond investors are faced with alternative sovereign debt options from the likes of PIIGS (= Portugal, Italy, Ireland, Greece & Spain). And then there is the equity market, which has just celebrated it’s 1 year anniversary since an Armageddonesque bottom price tick on March 9th 2009. Is it really fair to expect another 70% return over the next year?!

Anyway, the point I am trying to make is that markets are once again delicately poised, and although they may look like mill-ponds, if you take a look below the surface, just like the changing in the seasons, it feels a change in tide is underway. But ain’t it all swell.

2 Mar 4 2010 @ 9:04am by Matt Smith in Capital Markets, Crude Oil, Economy, energy consulting, risk management, Risk Strategy

Equities and Bonds = Pinky and the Brain

Last week I was up in arms about inflation (or its lack thereof), and how it could affect our dearly beloved commodities. This week (is no different from any other week in that) I’m trying to get my head around what’s happening in general markets, and am currently pondering equities and bonds. 

My interest is piqued by the aforementioned two tinkers, because if I can figure them out, I can color my paint-by-numbers portrait of the economic landscape, and join the dots on my canvas of commodities. There is method in my madness: equities have recently been a shepherd to commodities, specifically crude oil (for the last year, everywhere that equities went, crude was sure to go). As for the bond market, it is a barometer of both risk appetite and inflation expectations – both key influences on commodities.   

So here’s the scoop; while equities are looking like they are topping out (=risk aversion rising), I look to the bond market (and specifically Government debt) – which historically has an inverse relationship with equities (equities = risky, bonds = safe) – to give some indication for future growth and inflation. So hence in this current environment, equities and bonds = Pinky and the Brain.  

The Brain: Are you pondering what I’m pondering?
Pinky: I think so Brain, but burlap chafes me so.

The bond market - more intimidating than Mr T.

‘So what’s the big deal about the bond market?’ I hear you ask. (I will now try to avoid being super-dull and muzzle the market-nerd in me). Essentially the bond market is considered to be the wisest of all asset classes. The Brain, if you will. One of the most famous quotes about the bond market was made by James Carville, who famously quipped “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everyone.” This is because the bond market tends to be the voice of reason when other asset classes are losing their heads. For example, the change in 2-yr Treasury yields is a good way to gauge economic sentiment; they will rise as optimism grows (because expectations increase for a higher interest rate), or vice versa. As for 10-yr Treasury yields, they provide an indicative view on longer-term inflationary expectations. There are many factors that go into the bond market – too many to put onto the chopping board right now (quantitive easing and gaping budget gaps are current quandaries…while bond guru Bill Gross highlights further problems here) but my main take-away is that the bond market is a tool to assess the outlook for near-term growth and inflationary pressures, which we can then apply to our outlook on commodities.       

The Brain: Pinky, are you pondering what I’m pondering?
Pinky: I think so, Brain, but if they called them “sad meals” no one would buy them.

I have faith in the bond market. Like the Brain, it is deadpan, composed and smart. As for equities, all I have to say is P to the I, to the N-K-Y. They are scatter-brained, emotional, and seem to enjoy being hit over the head. And as life imitates art, the bond market is always teaching equities a lesson, time and time again.    

The Brain: Pinky, are you pondering what I’m pondering?
Pinky: I think so, Brain, but how will we get the Spice Girls into the paella?

So to draw this tail (I tried to resist) to an end, both of our heroic characters in today’s story could be bearish influences over the coming months. Equities could potentially scurry lower, while bonds yields are resisting the apparent urge to scamper higher (=prices lower) as deflationary or double-dip fears could develop. With these potential headwinds, commodities are likely to find it increasingly tough to take over the world, tonight, or any time soon.

0 Jan 21 2010 @ 10:55am by Matt Smith in Capital Markets, energy consulting, Natural Gas, risk management, Risk Strategy

What’s the worst that can happen?

bang!‘A cynic is a man who, when he smells flowers, looks round for a coffin’ – HL Mencken

There is nothing wrong with being cynical, and there is nothing wrong with preparing for the worst. And it shouldn’t be a surprise to see this written by someone in risk management; after all, we spend more time assessing downside risk than a professional bungee jumper. 

One of the key drivers of energy risk management, or of risk management of any kind for that matter, is to mitigate risk.  But how do you quantify risk? And why? Lacking a better way to quantify the unquantifiable, a rather unhiply-named gent called Eugene Fama coined the empirical measurement for risk – volatility.

Accurately and consistently quantifying risk (or volatility) in commodity markets is as easy as doing a cartwheel underwater (impossible – just try it), as the extreme movements in natural gas from $13.69 to $2.40 in little more than a year, so dramatically proves. But by equipping yourself with a Batman-like utility belt natureof tools for assessing the potential evolution and volatility of a market – from macroeconomic models and Value at Risk (VaR) to technical analysis – means you can come up with a plan with which you are comfortable. And this plan will be guided by your own tolerance – i.e.  how much risk/reward you are willing to and able to accept when taking a position (or not)  in a market.

So back to the original question: what’s the worst that can happen? The simple answer is we don’t know, because no-one is able to exactly predict the future. But if you have a robust enough risk strategy in place that prepares you adequately for the worst, it doesn’t matter as much what the worst-case scenario will ultimately be; you will be in a strong enough position to defend against whatever the market may throw at you.