Chapter (2): Risks In The Energy

Cycle

• Risk is defined as the effect of uncertainty (probability) on objectives. An effect is a

positive or negative deviation from the expected.

• Risk management is defined as the set of activities to direct and control an organization
regarding risk such as methodical identification, assessment and prioritization of risks
followed by coordinated and economical application of resources to minimize, monitor
and control the probability and/or impact of unfortunate events.
 Chapter (2): Risks In The Energy
Cycle

• Risks in energy cycle are often grouped into the five broad categories:
1. Market risk.

2. Credit or default risk.

3. Operational risk.

4. Liquidity risk.

5. Political or regulatory risk

• Within these risks, an additional number of other risk subcategories exists.

 Chapter (2): Risks In The Energy
Cycle

1. Market risk

• The potential loss due to changes in market prices. With constantly changing crude and
natural gas prices, buyers and sellers may not get the best price for their product or may
miscalculate demand or pricing, causing material adverse effects.

• Market risk directly affects profitability. If the company cannot earn a return to cover its
investment costs, it may decide either not to undertake the investment after all, or, for
whatever reasons relating to its operational activities, accept significant losses.
 Chapter (2): Risks In The Energy
Cycle

1. Market risk

• When managing market risk there are a wide variety of issues to consider. One basic
problem is that energy prices can vary significantly to seasonal changes in demand and
supply. For example, the price of heating oil is higher in winter months than during the
summer.

• Similarly, disruptions in the distribution system such as malfunctioning pipelines or

inadequate storage facilities, can have a significant impact on the price.
 Chapter (2): Risks In The Energy
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2. Credit (default) risk

• The risk that a counterparty is not able to make payments as agreed for goods or
services provided. When companies sell their products or services, often they do not
demand an advance or up-front payment. By delivering the products or services before
receiving payment, the company subjects itself to the risk of nonpayment.
Chapter (2): Risks In The Energy
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2. Credit (default) risk

 Chapter (2): Risks In The Energy
Cycle

3. Operational risk

• The risk of loss resulting from failed or inadequate internal business processes,
including systems, operational characteristics, and people.

• Operational risks also includes a wide range of risks, such as quality risks, model risks,
and legal risks.
 Chapter (2): Risks In The Energy
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3. Operational risk

• Quality risk – the product does not meet specifications outlined in the contract.
 Chapter (2): Risks In The Energy
Cycle
3. Operational risk

• Model risk – the risk that models used by the company are not correctly specified.
 Chapter (2): Risks In The Energy
Cycle

3. Operational risk

• Legal risk–the potential losses from failure to comply with the law or adverse
regulatory changes. Each transaction in the energy cycle is governed by a contract. To
make transactions between buyers and sellers faster and easier, they are based on a
master agreement, which offers a broad framework for transactions between the parties.
However, there are times when the parties may agree to terms that would violate the
terms of the master agreement. This would give rise to legal risk.
 Chapter (2): Risks In The Energy
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3. Operational risk

• Legal risk may have significant cost and time implications, particularly if the resulting
conflict leads to litigation. Litigation can take years and its costs can be considerable in
relation to the original damage.
Chapter (2): Risks In The Energy
Cycle
 Chapter (2): Risks In The Energy
Cycle

3. Operational risk

• Legal risk– when a company fails to obey with safety, environmental, occupational or
other regulations, it also exposes itself to legal risk. Industry regulators often inspect
operations to monitor the compliance with standards and regulations. When a company
is found to be in breach of regulations, the resulting fines can be substantial.
Chapter (2): Risks In The Energy
Cycle