The evolution of Commodity Risk Management !

While maturity of Risk Management processes is good in Banking and Insurance industries which is closely followed by the Energy Trading industry, for Commodity Trading industry it is still in a relatively nascent stage. This is primarily due to delayed integration of commodity markets with the financial markets. But its history and evolution isn’t any less interesting ! In this post, we’re taking a quick look at the evolution of Commodity Risk Management over the last couple of decades and before coming back to the future !

Way back in 1980s, some leading commodity trading & processing companies started recognizing the need for a structured approach for managing risks, bringing in what is now called Risk Management Policy (RMP) – a single source of guidelines, control measures and Standard operating Procedures (SOPs). Many trading companies started with having Quantity and Value limits for assets, traders and Business Units – and while implementing RMP needed all transaction data in one place, once done, required minimal effort to implement. For a long time, the risk management problem was simple – the positions were cut whenever they touched the quantity / value / loss limits for any of the commodities / traders / business units.

As technology and model sophistication improved through 1990s till 2000s, so did costs of implementing Risk Management. Value-at-Risk (VaR) framework came to be accepted as a global standard for Risk Management, and by early 2000s was being pushed by Banking regulators world-over for their banks. Many commodity players realized that quantity and value limits weren’t forward looking – rather they were mere retrospective views of their trading history. Only after the quantity / value limit was breached, it was noticed and acted upon – leaving the portfolio vulnerable for the intermittent period. They needed a more sophisticated, more scientific measure of predicting their daily possible losses.

However, given the perennial question-mark on the effectiveness and RoI of expenditure on Risk Management, the early adopters forked into ones which invested further in Risk technology and ones that deferred that expenditure. While the former either bought a third party software solution or built their own in-house systems to use technology, the latter group moved on to building ad-hoc models in their existing spreadsheets.

But in most places, managing technological changes along with changing business process and models was tougher than originally estimated, leading to “confused solutions”. Some of the so-called solutions were too geeky to be used by business people, some were just too complicated to be managed, while others incorporated each and every user’s requirements and catered to none of them. Some of the companies that were able to manage the complexity ended up with a huge chasm between the risk team and the business users, leaving a select few which actually sailed through to see an effective implementation. Many others took as-needed approach to Risk Management, oscillating between past practices when risk management doesn’t “seem” top-priority and coming back to the future when it does (usually preceded by a rather humbling trading loss).

However, given the volatility in commodity prices over the past few years, a whole lot of companies have started their journey back to the future – blending the right amount of technological prowess with just the right mix of statistical models and business requirements. Many companies are moving from just demanding “most amount of flexibility and features” from their systems to working with their systems to improve the real effectiveness of the risk management process. Models are being simplified with caution, and complexities thrown away without guilt – and that seems the new route to future of commodity risk management.

Some of those have started seeing results with better margins, stable margins, and improved competitive edge. The additional efforts being put in to include risk limits in VaR terms rather than just quantity and values are beginning to show in the effectiveness of the entire Risk Management function.