Financial Risk Management in the Energy and Oil Sectors

Introduction

The energy industry is a sector that provides directly or indirectly services and products to the world and people. The industry itself is a key player who dominates the upstream energy sector to a considerable degree. The industry itself is a key player who dominates the upstream energy sector to a considerable degree. The energy companies play an important role in this modern day because society has developed a dependency to gas and oil services. We can see that this sector is a key in this 21st century because that gives us a lot of services and products that we need for our life.

Energy sector companies are at an operational disadvantage when we compare them to firm in other industry. The volatility of the market and the prices of commodities like oil and gas are greater than the volatility of other markets. Financial institutions and organisations of other industries are susceptible to financial risk factors like currency fluctuations, interest rates, borrowing rates… volatility related to this kind of markets is overshadowed by the commodity market. In the perspective of energy companies also if we add the complexity of their operations we can see that they are active in both markets.

The volatility of the commodity markets and the effect that it has on oil, gas, supply and demand, exposes energy firms to commodity risks, which in turn bring about price risks. These risks change when there is a threat of market risk and that also present a significant challenge to the energy companies in terms of profitability, income, investment, operating cost, stakeholder return… energy companies operate in a number of countries and markets that bring firm to trade in a number of currencies.

This increase the risks faced by companies. Fluctuation in currency rates expose firm to currency risks that are an additional part of market risk. The situation is more complicated by global factors like recession and economic crises. The recent global crisis that affects the world between 2007 and 2009 increase the vulnerability of firms to credit risks and other market risks. The question we can ask is what can we do to limit or reduce this kind of operational hazards?

The answer to this question presents itself in the form of financial risk management, with the purpose to provide to organisations the mechanism that can help them to manage credit risks or other market risks. The role of financial risk management is to determine when and in what way we have to use hedging and other financial instruments (Crouhy 2006). Research conducted by Froot et al (1994) suggest that the employment of risk management can be helpful to organisations in a number of ways, from reductions in operating costs to the increase of shareholder value.

However, Froot et al (1994) research is based to industries and organisations outside the energy sectors and does not take in account operating conditions like those present within the industry. Companies in this industry (energy sector) can take in account financial risk management to allow or reduce liquidity issues and also capital issues. That can be an important advantage due to fact of their nature of operations. That can be an urges benefit for companies or organisations if they are implement in financial risks or transactions.

This dissertation will examine the issues of financial risk management in energy sector, also how they impact in the performance of companies in that sector. The next section will clarify the exact intentions and objectives that we gone follow in this paper. Also we have to provide a set of dissertation research question that we have to answer in this dissertation.

1.1 Aims and objectives

The aim of the dissertation is to examine financial risk management in the energy and oil sector and evaluate this impact on organisations performance. In order to develop the understanding of financial risk management in that sector, we will examine the major companies in energy sector in the UK: BP, Shell, Total and Exxon. First we have to identify what exactly financial risk management is and the role he plays in an organisation. Also the tools use by financial risk management will be examine and evaluate to determine if an organisation can benefit of the use of financial risk management. The primary research question of the dissertation is: can a company operating in the energy sector improve his performance with the application of financial risk management?

With this research question, the following objectives have been identified:

• Analysis of financial risk management.
• Identification of credit and market risk and his impact on organisation in energy sector.
• Identification of performance indicators in oil and energy sector.

The first objective provides the base for the research and establishes theoretical foundations for the topic. He also investigates what is financial risk management and how it helps organisation to deal with risks. The second objective will firstly differentiate risks in the energy sector with other industries, and after will identify and discuss the different type of financial risks and his impact or effect on companies operating in energy and oil sector. The aim of the research is to determine if financial risk management has any impact on organisational performance and if yes what is the extent?

1.2 Justification for research

We conduct this research because it applies an important component of corporate finance in the sector of oil and energy. It will identify if there is a correlation between successful financial risk management and the performance of companies in that sector. The research will also determine if there is a causal link and make some recommendations to how companies can benefit of financial risk management. Risk management in any form is a costly business; the research will be benefit to the academic plan and also to the industrial plan because it will provide evidence of link between performance of an organisation and financial risk management.

Moreover, it seeks to cast light upon how financial risk management is used in this particular sector and also identify possible performance gain as a result of financial risk management. Financial risk management in the energy sector has to be explored because it will contribute to our knowledge and help for further future research.

1.3 Dissertation structure

Chapter two: literature review.

This chapter will be dividing in two parts. The first part will investigate financial risk and financial risk management. The second part will be the application of financial risk management in the energy sector.

Chapter three: research method.

This chapter will provides the research process that we will used to achieve the objectives and research question of this dissertation. It will explore the different methods that we can approach and also give justification about the method and the data we have choose.

Chapter five: Case study.

The dissertation case study will examine financial risk factors and his impact on organisations in the energy sector. We will focus on the recent global crisis of 2007 to 2009 also see what happen in the year after the crisis. We will analysed the financial performance of organisations over this period in order to determine financial risk implemented in the balance sheet and key performance rations.

Chapter six: discussions.

This chapter will provide clarity to the research by discussing the issues raised in the previous chapter in relation also to the literature review conducted in the chapter two. The chapter will draw conclusions to the issue that we have investigate and also review the dissertation objectives and try to give a answer to research question.

Chapter seven: conclusion.

The final chapter will review all we have done in the dissertation. It will discuss how we have met the objectives and also the limitation of the study that we have conduct.

Chapter summary

Financial risk management has established itself as an integral part of a firms attempt to create share shareholder value and in the same time to minimise risks that firms can face. Operating in energy sector presents a number of challenges, especially in the current socio-economic climate in which the environment, especially energy have to continue to grow in importance and social awareness. The politicisation of energy has provided the energy industry with an additional complication any mechanism, which can potentially increase performance in the face of such difficulties, is inevitably worth exploring.

An analysis of financial service management should provide an indication as to whether the discipline has the potential to serve this purpose and the benefits it might bring in the energy sector. The next chapter will examine the issue of financial risk management in detail, and also focus in the use of financial risk management in the energy sector. The literature review will provide a greater understanding of the topic and also provide the foundations that we will use in the different chapter of the dissertation. In one word, the literature review will be the foundation of the entire dissertation.

Chapter 2: Literature Review

2 Chapter overview

The first chapter provided information of the purpose of study, the aims and objectives. It provided an outline to the research that the chapter intends to examine in more details. The following chapter will present the literature review for the remainder of the dissertation, also provide explanations as much as we can for the reader so he can understand what exactly is financial risk management, how it works and the risk faced by organisation in general and in energy organisation. The second part of the chapter will look to the application of financial risk management in energy and oil sector. The information and issues presented in this chapter will be used in the case study and the discussion chapter.

2.1 introduction to financial risk management

In the nature of risk and his omnipresence across every field of effort and mitigation, management and supervising risk, involved with matters of financial nature requires a discipline dedicated towards this end. Horcher identifies 3 types of risk:

1. Risks that an organisation can face with a result to environmental changes. Theses changes target factors such as changes to interest rates, market and change rates.
2. Risks born outside an organisation’s engagement and interaction with other organisations. These engagements involve things like horizontally and vertically transactions with sellers, customers and other parties.
3. Risks arising from an organisation and target specifically people processes and internal systems of the organisation (Horcher 2005).

2.2 Outline of Financial Risk Management

Financial risk management is looking to give an answer and understand as how the risks cited above can affect organisations. If we take financial risk management as a discipline, it is concerned with managing exposure to risk cited above in general (Hermsen 2010), and also help organisations with market’s sensibility risks and credit risks (Fairchild 2002). That will be discussing further in the literature review. Horcher (2005) defines financial risk management as “a process to deal with the uncertainties resulting from financial markets” (Horcher 2005). She gives additional information by adding “it involves assessing financial risk facing an organisation and developing management strategies consistent with the internal priorities and policies of the organisation” (Horcher 2005).

An alternative outline to financial risk management, where people can gravitate, is provided by Crouhy et al (2006), who discuss the topic during their attempts to give an understanding of financial risk management to a layperson. The authors simply define and state that risk management is “the continual process of risk reduction” and of which financial risk management is “really about how firms actively select the type and level of risk that it appropriate for them to assure” (Crouhy et al 2006). As we can see, the attempt to define the topic appear with different factors, the author would suggest that the difference is superficial and simply differ as to the level of detail at which the definition is provided.

Crouhy et al (2006) give a definition of financial risk management that appears to be a reliable platform to develop an understanding of the topic, also that have been refer by other authors such as Alexander (2009), Doff (2006, 2008), Hermsen (2010)… financial risk management does not exclude the need to engage in risky activities and therefore risk management and risks that have been take are not mutually exclusive (Carey and Hyrcay 2001). Relatively, as Crouhy et al (2006) mention, the accentuation is about deciding which risks to assure, by which is meant against which types of risk will assurance be given.

In this context, the term assurance means the capability of providing an assessment of these risks and also providing information that organisation can count to make decisions that preoccupy them (Wang et al 2010). Therefore, the purpose of the activity is about providing information, based upon analysis and estimates (Carey 2001), as to the level of reward in relation to risks that are endemic to any business operation (Fairchild 2002).

In light of the above, there is a consensus in the literature in the fact that the process of financial risk management is uninterrupted activity (Carey 2001, Fairchild 2002, Li 2003, Horcher), involving a number of levels that need to be completed. Figure 1 gives an indication to the literature’s view of financial risk management process. In that process, the first level is to identify the risks that an organisation is potentially facing. The next level is to determine the tolerance of the organisation to these risks and also formulated a risk strategy.

Identify and Prioritise Key financial risks

Determine an appropriate level of risk tolerance

Implement risk Management strategy in accordance with policy

Measure, report, monitor and refine as needed

Figure 1: The risk management process (adapted from Horcher 2005)

Identify risk exposure

Evaluate performance

Measure and Estimate risk exposure

Find instruments And facilities to Shift or trade risk

Assess effects Of exposures

Assess costs And benefits Of instruments

Forms a risk Mitigation strategy:

Avoid

Transfer

Mitigate

Keep

Figure 2: The risk management process (adapted from Crouhy et al 2006)Crouhy et al (2006) have presented another image of risk management process. In that, the measurement of risk is follow by the identification of instruments of trading risk. The process proposed by Crouhy et al (2006), involves two concurrent streams of activities. Both models refer to a sequential process, where an organisation is engaged in a number of interrelated activities that are monitored and evaluated in this process. The author would suggest that the two stages are in fact interactive, where the evaluation help to redefine and adjust the strategy to face and take into account the changing nature of business.

If we consider the two process involved by the respective authors, a question can ask to know if any of that can actually be the most representative of reality in the energy sector in general? The author hopes to respond to this question in the next chapter that will focus on the specific practices of organisations engaged in financial risk management and provide a mechanism to determine which or these two model is useful.

2.3 Financial Risk Management: types of risk

2.3.1 Liquidity Risk

Liquidity risk is associated with trading assets on a market, or in fact the inability to trade particular assets. This particular type of risk is provided by Christoffersen (2003) in his description “Liquidity risk is defined as the particular risk from conducting transactions in markets with low liquidity as evidenced in low trading volume and large bid-ask spreads” (Christoffersen 2003:5).

Operating in this kind of market that has such risks has a number of implications upon an organisation’s asset and the prices trader in the industry (Jorion 1997). Christoffersen provides other clarification to risks, he says that “Under such conditions, the attempt to sell assets may push prices lower, and assets may have to be sold at prices below their fundamental values or within a time frame longer than expected” (Christoffersen 2003:5). Liquidity risk according to Jorion (2007) can be divided into two categories: ‘asset risk’ and ‘funding liquidity risk’. The author try to provide a definition of liquidity risk by focusing on aspects of ‘asset risks’ but does not give sufficient clarity about ‘ funding liquidity risk’. While, Christoffersen and Schuerman (2003) describe that as ‘scant’ (Christoffersen and Schuerman 2003).

The global economic crisis of 2007-2009 have drawn an important attention to the concept of funding liquidity risks as put forward by Drehmann and Nikolaou (2009) “They bore all the hallmarks of a funding liquidity crisis as interbank markets collapsed and central banks around the globe had to intervene in money markets at unprecedented levels” (Drehmann and Nikolaou 2009). Their affirmation is in reference to the liquidity or lack of held by bank during this period of crisis in which the majority of bank around the world failed their obligations concerning capital demands were the result was the failure of management of funding liquidity risks.

Governments and central banks around the world had to intervene into their respective economies and contribute to “money markets at unprecedented levels” (Drehmann and Nikolaou 2009). Brunnermeier (2009) made an assertion where he not only recognises the failure in liquidity risk management during the crisis; he also claims that liquidity risk played an important role in the economic downturn:

“The recent financial crisis was unprecedented in scale and speed of propagation. A well-recognised reason is that the original shock (started in US real estate funding structures heavily distorted by regulatory arbitrage) was severely compounded by the extreme funding fragility built up by. Bank risk absorbing capacity had been reduced not just by lower capital buffers, but by extremely short term funding” (Brunnermeier 2009).

If an organisation were unable to meet the demand of funding, they would be required to liquidate some assets to the meaning of generating satisfactory amounts of capital. This risk can be put into asset risk and extenuating circumstance would result in an organisation having to be forced to liquidate assets and sell at “fire- sale prices” (Crouhy et al 2001). This kind of scenario can result in the snowballing of risks where one risk compounds the other; like asset risks combining with the funding risks (Goodheart 2009). 

• Liquidity Risk
• Funding Liquidity Risk
• Asset Liquidity Risk

2.3.2 Market Risk

Market risk definition is providing by Dowd (2002). In that definition, he says it is “the risk of loss (or gain) arising from unexpected changes in market prices (e.g., such as security prices) or market rates (e.g., such as interest or exchange rates) (Dowd 2002:1). Market risk involves factors that cannot be controlled, predicted or forecasted to a lesser extent, as they are ‘unexpected’ (Dowd 2002, Crouhy et al 2006). Christoffersen (2003) provides better details about the factors; he says: as “Market risk is defined as the risk to a financial portfolio from movements in market prices such as equity prices, foreign exchange rates, interest rates and commodity prices” (Christoffersen 2003). Market risk is important because it can be used as a performance indicator to assess certain benchmarks (Crouhy et al 2006). Crouhy et al amplified this importance in their assertion. They say: “market risk is important to the extent that it creates a risk of tracking error” (Crouhy et al 2006). The error is known as the ‘basis risk’ and it is defined as “the unexpected changes in the price relationship between a financial variable and its intended hedge” (Jorion 2007).

Market risk, like liquidity risk can be divided into four categories: interest rate risk, equity price risk, foreign exchange risk and commodity price risk (Crouhy et al 2006). Each risk is associated with the unpredictable forces in the market as previously mentioned by the authors Christoffersen (2003), Dowd (2002) and Crouhy et al (2006). Interest rate risk relates to the market value of a security or investment being affected by changes in interest rate. Long-term securities like bond for example would be deemed as “interest rate-sensitive assets”, exposing its owners to greater amount of risk (Jorion 2007).

According to Crouhy et al (2006), equity risk is “the risk associated with volatility in stock prices…The general market risk refers to the sensitivity of an instrument or portfolio value to a change in the level of broad stock market indices” (Crouhy et al 2006). Danielsonn (2006) is in agreement with this definition and also provides further clarification in his assertion and states organisation can be affected by this risk from two points:

The first is a poorly judged investment selection that cannot be eliminated from portfolio diversification (Danielsonn 2006, Crouhy et al 2006).

The second is merger and acquisitions in which corporations inherits equity stocks or portfolios.

Foreign exchange risks are linked with cross border investments and international business operations and are characterised by the volatility and movement of currency and the fluctuation of international interest rates (Jorion 2007). The effects of foreign exchange can be that it “may generate huge operating losses and, through the uncertainty it causes, inhibit investment” (Crouhy et al 2006).

Commodity price risk is referring to the unpredictable future market values of commodities such as gas, electricity, gold, oil and grains (Berko 2009). Organisations that are susceptible to commodity price risk are those that are involved in producing or purchasing commodities. The risk occurs “when there is potential for changes in the price of a commodity that must be purchased or sold. Commodity exposure can also arise from non-commodity business if inputs or products and services have a commodity component” (Berko 2009). Commodities risk has an impact on consumers and end- users such as manufacturers, governments, processors and wholesalers (Berko 2009). Berko (2009) provides a summary of commodity price risk. He states that: “If commodity prices rise, the cost of commodity purchases increases, reducing profit from transactions” (Berko 2009).

2.3.3 Credit Risk

Credit risk is based on the relationship between one organisation and another. A change in the quality of credit between the two parties will negatively impact on the value of a security or the portfolio (Crouhy et al 2006). Credit risk exposes organisations to the possibility of default whereby a counter party is no longer in position for any reasons to fulfil his contractual obligations (Christoffersen 2003). Crouhy et al (2006) provide a definition of credit risk stating that: “Credit risk is the risk that a change in the credit quality of a counterparty will affect the value of a bank’s or other financial institution’s position” (Crouhy et al 2006). There are different types of credit risk such as country, sovereign and political risks and all that are characterised by cross border business and transactions (Jorion 2007). Credit risk also encompasses settlement risk whereby one party defaults after that the other has fulfilled his full obligations (Fight 2004).

These risks (liquidity, market and credit) have been described separately and they are connected to a certain extent and it is important to understand how these risks are broken down. Figure 4 does exactly that by illustrating how financial risk in his entire is broken down into his different constituent risks and so on.

Financial Risk

Market Risk

Liquidity Risk

Credit Risk

Interest rate risk

Currency risk

Commodity risk

Funding liquidity risk

Asset risk

Transaction risk

Settlement risk

Equity risk

Figure 4: Categories and sub-categories of risk. A diagrammatical representation

2.4 Financial Risk Management: BP, Shell, Exxon and Total

The first part of this chapter provided the base to understanding financial risk management and its application. This part will focus and look on how financial risk management is applied by non-financial companies, specifically in energy sector. Also it will examine the technique used by BP, Shell, Total and Exxon Mobil to mitigate and hedge against financial risks.

The management of financial risk in the energy sector and specially with the “ big four firms of BP, Exxon, Total and Shell follows similar formula of other non-financial institutions. The difference between financial risk management within financial institutions like banks and non-financial organisations is summarised by Crouhy et al (2006) in that: “the striking difference in risk management between banks and non-bank corporations is that banks are regulated and are required by their regulators to manage their credit, market and operational risks, and to hold sufficient capital against their risk positions” (Crouhy et al 2006).

The firms in the energy sector hedge in order to minimise the cost of financial distress and also in the same time to reduce the cost of capital. Furthermore, in doing so, energy sector firms aim to improve their capacity to finance growth, which without the security provided by hedging and management of financial risks may be limited due to dynamic nature of cash flows. This kind of measure are not just confined to energy sector, as the work of Froot et al (1994) and Santomezo (1995) has clearly shown, however it is the unique characteristics of the energy market and the volatile and dynamic nature which make that kind of measures all the more necessary.

This latter issue influences energy sector firms strategy towards management of financial risks, in that whilst organisations in other industries with more stable operating environments prefer to hedge in relation to the balance sheet, energy companies like Exxon and Shell specifically choose to pursue hedging activities related directly to their operations. An indication as to how these organisations implement financial risk management is provided by BP whereby their “system of risk management is designed to identify risks to the group and its operations and act to respond to them” (British Petroleum 2010). BP’s strategy insofar as hedging is concerned very much to pursue the operational approach whereby attention is centred upon factors like market and currencies fluctuations. The organisation itself divides such risk into different categories that it calls strategic, control and operational risks (Figure 5).

The strategic category of risks constitutes factors related to oil and gas, as supply and demand concerned, the company states that: “(BP) recognises the impact of oil price volatility and so ensures that it undertakes robust testing of its projects and investments against a range of oil price scenarios” (British Petroleum 2010). Other strategic risk issues affecting the organisation include the integrity and quality of the organisation’s investment portfolio and also relate to energy firm’s exposure to credit and market risk.

As the market risk is concerned, like his its competitors, BP is particularly aware of the implication of buoyancy of the market, he states that: “oil price volatility, resulting from both the economy’s low tolerance to high oil prices and the drive to constrain oil demand to prevent climate change and enhance energy security, threatens the profitability of the organisation as a whole” (British Petroleum 2010). Control consist of regulatory and liability issues centred upon oil trading regulations and volatility of the market, whilst operational factors comprise of issues surrounding drilling and production. This latter issue is susceptible to liquidity risk, the implication of which can severely impact upon the organisation’s ability to locate and harvest new sources.

Operational Risks

Strategic Risks

Control Risks

Financial Risks

Investment efficiency

Liquidity and Financial exposure

Price and market

Liability Control

Drilling and production

Quality portfolios

Credit & Market risk

Oil & gas, Supply & demand

Market volatility

Oil trading regulations

Liquidity risk

Figure 5: Structure of financial risk management at British Petroleum (adapted from BP 2010)

Shell adopts a similar outlook towards financial risk management to that of BP, but it does not explicitly categorise or delineate its risks like BP does. Shell as the other main player in the energy industry, share a business model as well as collectively operating with the same general macroeconomic environment and are also subject to the same types of risks or threats. This is recognises by Shell in that the organisation actively informs shareholders that “financial and commodity market conditions influence Shell’s operating results and financial condition as our business model involves trading, treasury, interest rate and foreign exchange risks” (Shell 2009).

Shell is also very much aware of the risks presented by the market and alternating commodity prices as “Shell’s operating results and financial condition are exposed to fluctuating prices of crude oil, natural gas, oil products and chemicals. Shell has substantial pension commitments, whose funding is subject to capital market risks” (Shell 2009).

The manner is which such risks are mitigated at Shell consist of developing of a wide-ranging investment portfolio which is “conservatively screened” in order to determine its value. The key principle as managing and mitigating against financial risk is to target investments that have potential profitability or the value of which lies beyond the well being of oil and gas prices. Investment that are profitable as long as when oil and gas prices are high only serve the heighten market risk rather than serve as a mechanism through which to address the risk presented to energy sector organisations. For Shell and other firms the most sought after investments are those which whose value in a close independent of oil and gas price as possible, given that “the important factor is not today’s oil and gas price but the price(s) during the lifecycle of an investment” (Shell 2009). The lifecycle can in fact stretch over a number of years, during which time oil prices may peak and trough a number of times, and therefore the process itself involves determining the expectation of the market.

This kind of investments serve it aid and buffer energy sector organisations from financial distress and also helping to stabilise the volatility in the value of these companies. Smithson (1998) suggest that one of the benefits of financial risk management to non-finance related corporations is its potential for increasing firm value and also reducing the possibility of financial distress. The value of energy sector firms is susceptible to fluctuations in foreign exchange, interest rates and also commodity prices such as oil and gas. The mechanism to address risks in the industry and specifically market risks are the predominant form of financial risk is by means of derivative markets and active trading.

Chapter summary

In this chapter, we have tried to explore the issues of financial risk management to set the context for the rest of this dissertation. We have approached the subject from different positions, looking to equip the reader with the necessary understanding for the research topic. We have identified the current thinking to what financial risk management constitutes and also the specific risks it aims to address. The second part has attempted to examine the application of financial risk management in energy and oil sector. It has narrowed in focus and attempted to cast a net upon the topic under investigation in a manner that develops the understanding of the reader. The latter has provided a useful means of identifying financial risk and its application in the prescribed sector and it does not provide sufficient information about the impact of the financial crisis to the actual financial statements of companies in question. To this extend, the next chapter will provide detail as to manner in which the author will collect data and how he will engage in the subsequent research.