Managing geopolitical risk in energy markets

The increasing influence of geopolitical risk on energy markets is forcing risk managers to reassess their risk management strategies around such event-type risk, finds Gillian Carr

A much-noted characteristic of energy markets last year was that prices were influenced more by geopolitics and macroeconomics than pure supply and demand fundamentals. This has left risk managers needing to reassess how best to measure and manage geopolitical risk.

The increasing influence of geopolitics is a trend many people see continuing for the foreseeable future for several reasons. First, the scale of unrest in some of the biggest energy-producing countries is at historically high levels. Recent events have included the Arab spring, the North African revolution and Iraq, and the stand-off between Iran and the West over its nuclear programme. Second, a greater percentage of oil than ever before is now produced by countries outside the Organisation of Economic Cooperation and Development (OECD), much of it in countries with higher political risk. Third, the financialisation of the market is believed by many market experts to contribute to the trend of prices reacting more to headlines than supply and demand. All these reasons make it more necessary than ever for risk managers to put plans in place for measuring, managing and even mitigating geopolitical risk. Many are now working out new strategies for measuring and modelling the impact of geopolitical risk.

“It’s safe to say there’s a pretty good movement towards improving the measurement and assessment of operational risks, including geopolitical risk,” says Jeffrey Butrico, head of corporate risk and insurance management at Austrian oil and gas company OMV.

Jayesh Parmar, partner at UK-based energy consultancy Baringa Partners, agrees. He has noticed a movement towards trying to make assessing geopolitical risk more objective and quantifiable. “A trend is beginning in which geopolitical risk is being modelled on a less subjective, more objective and transparent basis,” he says.

Of course, geopolitics has long exerted an influence on oil and gas prices due to the fact that physical production is often located in politically unstable countries. But the scale of the instability in recent years has been the key factor in pushing it to the forefront of risks companies need to address.

“It’s been gradually rising, particularly over the past two or three years,” notes Parmar. “It’s not been a sudden, absolute one-off change but the events of just 2010 to 2011 – developments in Iran, Iraq, the Arab spring, Libya and instability in Pakistan – are increasingly driving geopolitical risk up the agenda. It’s always existed but the level of turmoil and the interconnectedness of world markets have made it increasingly important,” he adds.

UK-based risk consultancy group Control Risks, which monitors and produces country-specific political risk ratings, has seen the risk rise in a number of oil-producing countries since 2009 (see table 1, below).

Another driving factor has been that within the oil and gas industry there is general concern about reserve replacement ratio (RRR), as fewer conventional plays are discovered each year. To keep up their RRR, many energy companies are now considering areas that were previously dismissed.

“On the one hand, you have opportunities in countries with low political risk, such as Canada’s oil sands or US shale gas, but where there are great technical challenges, so you replace political risk with other concerns,” says Butrico. “For more conventional types of oil and gas, companies are all going into places that are far more difficult, politically speaking, than they would have gone to before. It’s an industry-wide trend that everybody recognises.”

Butrico points out that there’s a double whammy: companies are having to go into politically risky countries that they wouldn’t have gone into before at a time when these countries are becoming more risky. “The risk profile in North Africa and the Middle East has undeniably gone up substantially in the past year,” he says.

Another reason for the increased influence of geopolitical and macroeconomic risk on energy prices is the financialisation of commodity markets. The large sums of money that has entered commodity indexes in the past decade has changed the nature of commodity markets. Market behaviour has been modified by the increased number of financial players that tend to trade on wider global events, some market experts believe.

The supposition that commodity prices have become less correlated to supply and demand is borne out by a reduced correlation of the oil price with oil inventory levels since 2005, according to a report by Commerzbank. “This lower role for inventories data is also probably due to the fact that financial investors now play a much more important role in the crude oil market than previously,” it says.

An indication of investors’ greater relevance is the huge increase in the number of open oil futures contracts, which on the New York Mercantile Exchange alone averaged 2.6 million a day in 2010, twice as high as five years earlier. Investors are justifiably worried about supply issues, the report goes on to say, which means that when a supplier such as Libya or Iran is in doubt, the rational response is to prepare for shortages. “Against the backdrop of contagion risks in neighbouring regions, tighter supply cannot be ruled out for the future and is accordingly being priced in. This geopolitical risk premium cannot be precisely quantified,” says the report.

It’s also worth noting that political risk isn’t always confined to countries renowned for political instability. For example, the political will of the US in terms of allowing the production of shale gas will have a huge bearing on the gas industry in the future, with natural gas prices likely to soar if the US changes its stance on shale production.

All this has put an increased focus on improving the management of geopolitical risk. In the past, it has tended to be an inexact science, with it being difficult to predict or measure the consequences of a low-probability geopolitical event occurring on a wide enough scale to affect a market.

There are two major ways in which companies can address geopolitical risk. First, by diversifying their physical portfolio so they aren’t overexposed to any particularly risky country or area. Second, by improving the way they model and measure risk, integrating it into wider financial risk management in order to get a better geopolitical risk profile.

As geopolitical risk has risen in the past few years, so has the participation of the risk manager in the discussion around entering countries in the first place. “In my experience, to enter into a country depends more on strategic decisions at higher levels and the risk manager has little input in the decision. However, this is changing because the impact of good geopolitical risk analysis by risk managers has become evident in the past few years,” says Jaime Roman, vice-president for risk management and market analysis at Spanish utility Endesa.

The first approach often occurs as part of a company’s investment decisions. Hans-Kristian Bryn, a strategic risk partner at business advisory firm Deloitte’s London office, describes geopolitical risk as “event-type risk that people are seeking to incorporate in particular into their investment decisions. Like many event-type risks, geopolitical risk has challenges in term of the data that you can observe. So really what you’re trying to do is to build event models or event descriptions that allow you to stress test your decisions.”

Traditional risk management techniques that address geopolitical risk for corporates that have physical assets typically involve diversifying one’s portfolio so that assets are not concentrated solely in one area. “Risk can be mitigated by avoiding concentrations,” says Butrico. “Don’t have too much concentration of your portfolio in one country or even in one region, so if that region blows up, you can survive that because you’re in another region. And maybe both are equally risky – but if one goes up, the other one you hope doesn’t go up.”

Using local partners or joint ventures can also lessen your risk, adds Butrico. “Having a good local partner could help insulate you but also it would help you in terms of having the knowledge of when the situation is bad.”

As energy companies often have investments that are long term and physical, they should look at a long time horizon when considering whether to go into a country or not, says Richard Harper, director at UK-based gas logistics and risk management company and consultancy Tethra Energy. “As an example, if you look back at Russia over the past 20 years, there have been good times to invest and there have been bad times to invest. You’ve had people pile in because the returns looked good, and then find that anyone making too much money has some of their business appropriated.”

As there have been a number of high-profile cases of this in the energy industry, Harper believes that more companies need to spend more time examining long-term outlooks and not just present situations. “You can’t just look at a snapshot. You have to think about whether a country will be stable for the next 10 years and whether the current framework will continue. If your answer to that is no, then you shouldn’t be doing it just because it’s good at the moment.”

However, there is only so much that can be accomplished with the mitigation route. “At group level, analyses of each country are performed periodically and the country risk is evaluated. From there, we may decide to reduce our activities in these countries,” says Endesa’s Roman.

But this is not always possible, he says, particularly when there have already been long-term contracts set for the region where instability is occurring. “For example, if we are talking about North Africa, we are often talking about long-term contracts, so it is difficult to move your position from one day to another. Mitigation techniques are not at hand in the short term because it is cumbersome to modify these contracts.”

As geopolitical issues are increasingly influencing market and price risk, so companies that do not have a physical presence in these regions can still feel the fallout. As global oil prices remain vulnerable to supply disruption, news coming out of areas such as Nigeria or Iran can be a determining factor in oil price shocks.

“Markets aren’t great at dealing with these geopolitical risks, partly because they are quite hard to quantify,” says Parmar. “The risk associated with very low-probability, hard to define, but potentially huge-impact events, is hard for markets to really price adequately.”

Hedging programmes are another way of limiting risk if physical exposure is inevitable. “In the past decade, people have tried a lot of things. Whether it’s an airline or an industrial or a utility, they’re doing all they can to reduce exposure from an efficiency and an operational standpoint, but generally there’s not a lot of flexibility for many of our clients in reducing their exposure,” says Shannon Burchett, chief executive of Dallas, Texas-based consulting company Risk Limited.

“If there is concern that oil goes to $200 a barrel, they’re not in a position at this point to reduce their usage. They’ve already done that from an operational standpoint, so the next stage tends to be a strategy in terms of hedging against price spikes. In the end, that goes back to scenario planning and stress testing for a particular portfolio.”

Parmar says he sees his clients starting to use two approaches in managing geopolitical risk. “They’re trying to assign probabilities based on the very broad likelihood of these events and then they’re coupling that with scenario-based assessment.”

A scenario-based assessment is increasingly used when there is a direct involvement or a direct relationship with a particular geopolitical risk, says Parmar. For example, if a country is on a route of a major gas pipeline and there is geopolitical risk to the gas flowing through there, then gas companies in that country typically have both the probabilistic element assessed as well as the scenario-based assessment of the potential impact of disruption and any corrective actions that they might need to undertake.

“In the type of leading practice that companies are developing now, you have a top-level definition of the risk from a particular scenario. You adopt some broad quantification-type metrics associated with that and those are typically broadbrushed because you don’t have the same level of historical volatility that you can go back and correlate with, and that’s the real difference and the challenge,” says Parmar. “So it has to be treated as a one-in-a-hundred type event, looking at what the implications of it happening would be and measuring the impact – losses, loss of earnings, and so on. That way you do get within your risk capital allocation a reasonably considered assessment of the implication of that risk.”

Other consultants see similar practices being adopted. “The best practices are to explicitly model the impact on cashflow and deliverability of geopolitical scenarios, or a geopolitical event risk-type description, depending on what you’re doing,” says Bryn.

But there’s always going to be a fundamentally qualitative aspect to this risk, says Jonathan Wood, global issues analyst at UK-based risk consultancy Control Risks.

“You get situations where, however much polling you’ve done and however much sentiment analysis you’ve done, elections and political transitions, just to name one small area, can still surprise you in terms of who actually comes out on top and, perhaps more importantly for some countries, how the people who don’t win react to that situation. And occasionally that can be foreseen in advance based on the history and tradition of those types of things but occasionally it can’t. And I think there’s probably more emphasis on this now, especially in the wake of the past 12–18 months of social protest around the world.”

Having a model could also lead to developing a system that would indicate when geopolitical risk is reaching a critical level. “It’s not the majority but certainly some companies are trying to come up with some sort of quantification measures that you could perhaps apply; some sort of key risk indicator to indicate that your risk is going up and give you some sort of early warning,” says Butrico.

Also, keeping an eye on economies, especially in the Middle East and North Africa, should be a priority in this scenario modelling, he says. “I think they’re a leading indicator of political unrest. Economic deterioration is a leading indicator
for problems in a country.”

Constantly monitoring and revising assumptions about the operating environment is essential and a practice that more companies are now aware of, given the recent past, says Wood. “As we’ve seen in the past year, certain paradigms about political stability can be fairly rapidly upset and I think, increasingly, we would argue that the speed of political change has in some circumstances increased. Sometimes this means companies that are not paying active attention can be caught unawares by rapid political change. So constantly monitoring and constantly revising one’s understanding of the political contexts is important.”

The approach any company takes with regard to geopolitical risk is also dependent on what market they are in, and how they are being affected by the event. “If you’re in a very liquid commodity and there would have to be a very severe shock before it would affect availability, then you’re probably more concerned with the price movements. If you’re in something where there’s very high concentration in a regional production and so therefore chances of supply shortages are much higher, then you need to deploy a very different mitigation strategy, and think very differently how you manage that risk,” says Bryn.

Overall, while geopolitical risk has not been at the forefront of many risk managers’ minds, it is slowly becoming a larger priority as the risks become greater from it. “Most companies are pretty good at measuring and managing financial risk, credit risk, etc, as we have a bunch of relatively transparent prices that allow us to follow that pretty well,” says Butrico. “Therefore, non-financial risks are really getting a lot more attention these days and there’s been an increase in resources dedicated to enterprise risk management, as opposed to just pure financial risk management.”