Risk Management Can Be Competitive Advantage in Coming Years

William T. Wilson

nergy-market volatility drives managers to E distraction as they try to forecast financial results, make investment decisions, and allo- cate resources. Volatility increases the cost of capital and affects capital investment efficiency. What is more, it is only going to get worse.

Volatility drives managers to distraction as they try to forecast financial results,

make investment decisions, and allocate resources.

Volatility affects energy markets the way topography affects a car’s fuel efficiency. As you motor down a long, straight superhighway, fuel efficiency stays at a consistently high level. However, throw in a few hills and curves and watch the miles per gallon bounce u p and down like a golf ball in a concrete culvert. Companies have been riding through economic hills and valleys for the past 15 years. Many have learned how to live with this undulating reality. Fundamentals will win. However, man- agers who learn to understand and mitigate the risks of volatility can overcome one of the most important challenges facing them now and in the future. These managers will be positioned to reap significant opportunities by turning the potential value of risk into real competitive advantage. In this article, I will discuss the sources and risks of volatility, and some of the ways that Unocal Global Trade manages risk to generate value in volatile markets.

William T. Wilson is president of Unocal Global Trade, in Houston.

Price Swings Price swings are the most obvious manifes-

tations of market volatility. Using the oil mar- kets as an example, during the past 20 months West Texas Intermediate (WTI) dropped from $27 a barrel of oil equivalent to $13. In any single month, there may be a two-dollar move in the peak price, changing the absolute price by 10 percent. Even more volatile are the natural gas markets, where, for example, prices for a million Btu’s during the two-month period from September 1998 to October 1998 moved 21 percent, from $1.67 to $2.03.

Supply and Demand Supply and demand are the fundamental

drivers of volatility. We do not have to look any farther than recent events in the Asia Pacific region to see that demand can be highly vari- able. Eighteen months ago, analysts expected economic growth there this year to drive up global energy consumption by 1.5 million barrels of oil a day or more. However, economic troubles in the region have produced an actual decline in consumption of about 500,000 barrels a day, precipitating a fall of almost one- third in world oil prices. In the Western Hemi- sphere, the world’s largest energy-consuming region, marginal demand increases are expected. Variability in natural gas demand will be par- ticularly significant, especially in seasonal demand. For example, total natural gas con- sumption in North America climbed to nearly 26 trillion cubic feet in 1997, in contrast to the previous decade, when demand for natural gas actually fell.

Unfortunately, the supply of oil and gas is very inelastic in the short term. It takes a long time for exploration and production companies

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to respond to demand in- creases by putting more rigs in the field to find and produce new supplies of oil and gas. It takes even longer for the middle of the industry to respond with new gas plants and pipelines, especially since gas deregulation took all the slack out of the sys- tem. Thus, with the ex- t reme osci l la t ions of demand, the short-term in- elasticity of supply, and no room to maneuver in the middle, the markets and prices are inherently volatile.

Fund Speculation Of course, these sup-

ply and demand funda- mentals are not the only causes of market volatil- ity. Speculation on the New York Mercantile Exchange (NYMEX) by a group of highly capitalized investment funds with significant amounts of cash searching for mar- ket opportunities, some less-than-affectionately referred to as “the Huns,” can have a significant impact on market volatility (see Exhibit 1). For example, in early August 1997 natural gas prices were about $2.00 (just left of center on the graph). At that time, the industry considered the natural gas price outlook to be neutral. N o significant shifts in supply, demand, or seasonal impact were foreseen that would significantly impact prices. A mild winter was forecast and day rates for drilling rigs were at an all-time high. There were some nuclear outages and local coal supply problems. However, the fun- damentals generally suggested price neutrality.

Regardless of such situations, the specula- tors do not look at these elements in the same way the industry does. Speculators focus on a number of technical variables in deciding whether their activity can affect the market. In this case, where the industry saw a static natural gas market, the funds saw a chance to make money by getting into the market and pushing prices up. The graph indicates that there was a very strong correlation between fund activity and the market price. Beginning in August 1997, the price of natural gas was driven from about $2.20 to $3.50. Those of us in the industry looked at the fundamentals and concluded that there was no way this made sense. We believed

fundamentals would win in the end. We were proven right once again in November and December 1997, when the funds got out of the market and the price plunged to the earlier levels of August 1997. In fact, at that point even the funds were short, pushing the market down even more.

. - . very strong correlation between fund activity and the

market price.

It is a relatively recent development that the fund managers have targeted the NYMEX natu- ral gas market. The most important criterion to the funds is liquidity. Fund managers want to get in and out of the market fast. The apparent threshold in the gas market is open interest of 200,000 contracts, which was first approached in late 1996 when the funds entered the market in a significant way. When the funds are in the market at that level, they do not make the market. This is because it is still large enough to be liquid but small enough to react to their pricing pressures. This is exactly where fund managers want to be. They can take the tremen- dous amount of capital that they control and use it to push the market around a little bit. Moreover, the funds have huge amounts of money to reinvest. Typically, if a fund cannot make $20 million or $30 million on a single trade, the fund is not interested. Thus, regardless of the

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fundamentals, these people can be a real force, and they can cause a lot of havoc.

The stakes are high for everyone in a volatile environment, but particularly for com- panies such as Unocal that are more heavily weighted to the upstream side of the industry rather than the downstream. Goldman Sachs reviewed the correlation between changes in crude oil prices and changes in per-share earn- ings for a range of oil and gas companies. Their analysis, “Unocal: Price Risk Exposure,” shows that as an almost pure Exploration & Production (E&P) company, Unocal is significantly more sensitive to price movements than other more integrated companies. However, even for the integrated companies, a $1 a barrel change in crude oil prices can impact earnings per share between 6 percent and 17 percent.

Mitigating the Impact of Volatility How does a company not only cope with

the impact of volatility, but also profit from it? There are several methods, including three on which we will focus: vertical integration, hedg- ing, and margin maximization.

Vertical integration is the method the oil and gas industry traditionally has used for coping with volatility. However, it is not quite as efficient as it once was. In the past, when there was less price transparency, it was easier for one part of the value chain to help another. Now, with markets and competition developing along every interface in the value chain, each piece of the value chain stands on its own, making its own decisions and its own value contribution to the corporation.

Another method is hedging. This some- what controversial tool uses the futures markets to lock in prices for months, and sometimes years, into the future in order to remove the risk of increases or decreases in prices. At best, hedging is a mixed bag missing the potential for profit in favorable price moves and removing a large degree of flexibility from the manager’s discretion.

A third method, and the one on which we focus, is called “margin maximization.” Unocal Global Trade has identified five elements that are involved in a concerted strategy of margin maximization.

Selling Smart This means getting the highest return for

our products by selling selectively; finding the highest value markets and selling there. For example, Unocal used to sell all of its natural gas at the wellhead. That changed when we decided to compete further downstream and

found potential margins exceeding costs.

Compete Selectively We are very selective about where we

choose to compete. We understand that we cannot compete everywhere. It is also impor- tant to us that we understand our competitive advantage before we enter a market. For ex- ample, we do not have significant electricity assets right now. That makes it difficult for us to compete effectively. When we can establish a competitive advantage, and we are hoping to do so in the future, we will compete in this market. Meanwhile, we are leaving it to other players.

Measure the True Market Many producer-marketers deceive themselves

about how well they are doing with their mar- keting. Essentially, this stems from a simplistic measurement of performance against market indi- ces. The key question for managers is whether in- house marketers are providing the maximum possible value for upstream assets and whether they are beating the true market. This is measured by adding the index price, plus the producer’s premium, plus overhead.

Many in-house marketers benchmark sales against an index, a geographic composite of prices for all production delivered into a pipe- line pooling point. An example of this is IFERC, a standard for the industry that tries to measure the price at the beginning of the month, for the first day of flow. It is not the most rigorous measure, but it is the best measure in the industry right now. We also have the firm-gas premium, also known as the producer premium or supply-security premium. These are different names for a producer’s competitive advantage. The firm-gas premium pays for a producer’s ability to guarantee that the promised volume will flow 30 days without interruption for a fixed price for that month. Premiums decrease over time, but the market still pays a premium because it wants to ensure the gas shows up. Producers have a competitive advantage in their ability to guarantee a noninterruptible flow of gas, and can get the same premium without a marketing staff.

.) . . bringing in top managers and traders with the skill and

the savvy to beat the producer premium and compete

successf u Ily.

Before Unocal changed to a profit center, the marketing group sold gas at the producer

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premium, which is essentially the firm-gas premium. When we made the shift to a profit center, we reorganized in- house trading by bringing in top managers and traders with the skill and the savvy to beat the producer premium and compete successfully (Exhibit 2).

Know Your Margin and Cost Drivers

It is not enough for in- house marketers to be satis- fied with making just the IFERC index and a supply- security premium. It also is not enough to reduce aver- age fixed or overhead cost per unit by simply increas- ing volumes. Companies that only measure against these benchmarks actually could be losing money when marketing and opportunity costs are factored into the equation. For example, if an internal transfer price from exploration and production to mar- keting might be 2 cents a million Btu’s below the IFERC Index, and the company sells at the index plus a penny for a margin of 3 cents. However, if the company’s operating costs are 4 cents, each unit of gas is sold at a loss. Exhibit 3 shows the margins achieved at Unocal since we began using the profit center approach to focus on margins and costs.

Understanding the Market Structure As markets mature and gain efficiencies,

margins tend to decrease. For example, the North American crude-oil market is highly ma- ture, transparent, efficient, and crowded with participants. Thus, astute competition will trim the margins that can be achieved in these markets. In older markets, market direction offers the main trading opportunity, while im- mature, deregulating markets offer a number of arbitrage and service opportunities. One of the mistakes made by companies during the past few years is to make competitive commitments in the wrong markets, i.e., competing on service in mature markets.

At Unocal, we compete in service and arbi- trage in deregulating, immature markets while we compete using trading in more mature markets such as North American crude oil. Thus, market structure dictates the competitive

strategy. This strategy also provides the flexibil- ity to go where the market structure dictates.

Ma rg in Maxi m izat ion Works The fact that margin maximization works

has been borne out by Unocal’s success. We are the largest independent oil and gas producer in the United States, achieving near-record pro- duction levels in 1996 and increasing capital spending in the Lower Forty-Eight by 50 per- cent. However, we recognized that production growth is only part of the value equation and that margin growth is also important.

During the past four years, Unocal signifi- cantly expanded both volumes and margins (again, see Exhibit 3). Since 1994, crude oil and natural gas trading margins have doubled. Unocal Global Trade markets about 1.6 billion cubic feet of gas in North America and 200,000 barrels a day of crude oil and gas liquids worldwide. In 1994, the trading function gener- ated $6 million of pretax earnings. In 1997, three years after we zeroed in on maximizing margins, the trading function produced $27 million in earnings. In the first nine months of 1998, we have generated $21.5 million. Thus, I believe it is safe to say we have established that maximizing margins works.

Summary Markets are increasingly risky and will

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remain so. They are inherently dynamic and can be affected significantly by pressures from pow- erful outside forces. On one extreme are the price takers, people who take the most price risk, and on the other extreme are the service merchants. While many of our competitors are becoming more like the price takers, Unocal is moving more toward the risk management so- phistication of the service merchants.

O n one extreme are the price takers, people who take the most price risk, and on the other extreme

are the service merchants.

Companies have to attract capital in order to grow and prosper, and the capital markets are requiring companies to show continuously im- proving performance. There are risks in the world, but with the risks come opportunities. Whether it is corporate financial risk or strategic risk, compa- nies must be able to use the tools of risk manage- ment to help them seize the opportunities.

While many people view risk management as a tool to be used in mitigating the downside risk, we believe it can help companies spot and exploit opportunities. By understanding market structure and the competitive dynamics of im-

mature and mature markets around the world, companies can assess their ability to compete in those markets and see the opportunities that are there for them.

For companies under earnings pressure, trading and marketing are becoming more and more important. It is vital that the upstream sector does well and prospers, because it drives the overall prosperity of a company. However, companies that perceive their in-house market- ing as a cost rather than profit center leave money on the table. Managers who have not looked hard at their marketing operations need to understand whether they are maximizing the value of their upstream assets.

Every one of these assets is in a different market, facing different market structures. To maximize these assets, we believe we have to be smart about seeing the risk, mitigating the price and market risk where they exist, under- standing the opportunity within those markets, and seizing those opportunities.

By selling smart, competing selectively, measuring the true market, using risk manage- ment judiciously, and focusing on margin maxi- mization, we at Unocal Global Trade believe a company not only can survive in a world of increasing uncertainty, but also can grow and prosper in the global marketplace. W

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