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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.

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