In today's more volatile, faster moving and more unpredictable commodity markets, sound risk management is even more important than it once was. Furthermore, I have made many arguments in past IssueAlert articles that structural change in commodity markets demand that risk managers review their risk management methods and approaches. I have argued that historical trends have broken down potentially impacting risk techniques that rely on historical data and also that certain quantitative risk analysis methods might be producing invalid results as input parameters such as volatility are exceeded for the method. I have argued that more emphasis be placed on stochastic techniques and stress testing.

Recently, I had the pleasure of discussing these and other issues with Dr. Chris Strickland of Lacima Group. Chris is an industry-recognized risk management expert and author or co-author of many respected books on the topic. He is also co-founder of Lacima Group, a company that delivers expertise in applying financial engineering techniques to the energy, commodities, and financial markets through its Lacima riskAnalytics software and services.

Dr. Vasey: Please describe Lacima Group and its activities?

Dr. Strickland: Lacima Group is a specialist provider of software and services dedicated to commodity risk management, valuation and optimisation of complex derivative contracts and physical assets. We have changed a lot over the past few years—many people know us as a consulting company that had developed a suite of standalone libraries, and who had the financial engineering abilities to develop solutions to complicated valuation problems. However, we moved away from the standalone components model a few years ago and are now a specialist software provider with a wide ranging risk analysis application. We have recently developed our riskAnalytics solution to provide users with greater access to advanced energy risk methodologies for which Lacima has become a recognized world leader. Leading energy companies around the world now rely on Lacima's tools and expertise to help manage their multi-commodity risk, value and optimize their assets. Lacima Group is unrivalled in terms of the number quantitative analysts and quantitative developers that that work in the company. We have enjoyed consistent growth over the past 10 years with a client base spanning 20 countries and currently have offices in Houston, London, and Sydney.

We strive towards providing professionalism of the highest standard in our advisory services to compliment our software offering, and are delighted to have won the prestigious Energy Risk Award for Advisory Firm of the Year 2008.

Dr. Vasey: What is Lacima Group's riskAnalytics application and what does it do?

Dr. Strickland: Lacima's riskAnalytics application is focused on providing comprehensive risk metrics for companies to value multi-commodity derivative contracts, value and optimize their physical assets. The solution is customizable to address the needs of utilities and energy consumers operating across numerous geographic markets seeking sophisticated risk analysis with a single, enterprise-wide view of risk metrics, as well as the needs of companies operating on a national level, that seek less sophisticated risk analysis and reporting within a cost-effective implementation framework.

Most risk modules offered by energy trading and risk management "ETRM" systems are considered 'light' when analysed on the risk metrics reported and the valuation techniques, if present at all. Unlike nearly all ETRM systems, Lacima's riskAnalytics application has been developed by industry recognized practitioners (Members of Energy Risk's "Hall of FAME") to specifically address specific characteristics of the energy industry, principally unique behaviour of commodity prices, differences in construction of regional markets, existence of complex contracts with embedded optionality and physical asset operational constraints.

Lacima's riskAnalytics solution is able to handle earnings calculations on a portfolio of swing contracts, gas storage, power generation assets, retail load contracts, as well as hedge derivative contracts. It is able to perform analytics and create risk metrics using both single and multi-factor models and has been built to seamlessly integrate with any of the market ETRM systems. The solution can aggregate data from different systems, such as for oil, gas, and power, or for North American power and European power. Therefore, organisations can benefit from a single system to manage their entire risk analytics requirements without having to go through the costly process of replacing the underlying ETRM systems.

Dr. Vasey: Given market conditions today, what has Lacima done to enhance or improve the package recently?

Dr. Strickland: In the last 12 months, Lacima's riskAnalytics solution has been enhanced to provide risk metrics (such as Value at Risk, Earnings at Risk, and Potential Future Exposure) that handle gas storage, gas swing contracts (able to handle make-up, carry forward, indexation, and price tranches), and power generation assets, and has rolled out to major energy utilities worldwide such as Gazprom Export and Centrica in Europe, EPCOR in North America, and LYMMCo (joint venture between Tokyo Electric Power Company, AGL and others) in Australia.

Dr. Vasey: You are quick to talk about how ETRM packages are 'light' in terms of risk management. Why is your package superior?

Dr. Strickland: In practice, it is the front and back office requirements that determine to a large extent what application is chosen during the ETRM systems selection process—invariably the risk management requirements become secondary, even if not by choice. For many large organizations dealing with multiple commodities across numerous geographies, this can lead to employing multiple systems, as they each have their strengths in handling individual commodities and different regional characteristics. For example, it is not unusual to have different systems for oil, gas, and power, or for North American power and European power, due to the differences in market construction and the physical flows of the underlying markets. Organizations seeking to replace these disparate systems in order to achieve their goal of a single risk application, reporting a consistent set of risk measures across their global portfolio, are typically faced with an economic bill running into the multiples of tens of millions of dollars with implementation plans running over a number of years. Lacima's riskAnalytics solution has been designed to work with existing front and back office systems, and not to replace them, and so can be implemented in a fraction of the time and for a fraction of the cost.

In addition to all the standard hedging derivative contracts, the solution utilizes advanced analytics for the optimization and valuation of storage contracts, complex gas supply agreements, and power plants in a single consistent risk framework. Furthermore, any custom analytic needs can be handled directly by Lacima's team of experts, maintaining the consistent risk reporting framework.

Dr. Vasey: How do you think today's commodity markets have changed and why is risk management even more important now?

Dr. Strickland: There have been a lot of changes in the commodity markets over the last few years.

Organizations trading multiple commodities are now the 'norm,' rather than it being the realm of the 'sophisticated' investor and so market and credit risk metrics need to be able to handle the joint evolution of multiple commodities and multiple geographies. At the same time spread trades have become very popular (trading strategies are being employed that are essentially positions on the basis between two commodities, or between different points on the forward curve) which has led to a changing relationship between commodities. All of this has led to the complication of the relationships between commodities has made risk management even more important, and means that basing risk dependency's purely on historical relationships is risky.

In addition there has been a blurring of the distinction between 'physical' commodity and 'financial' players. We see more and more banks that are employing physical traders, resulting in the need for their systems to handle physical trades as well as financial trades, leading to reported risk metrics which need to take into account both physical assets and financial books. It is no good reporting your value 'at-risk' of just your trading book when the cashflows to the organization derive from both physical assets and financial contracts (hedges)—this again has led to a need for more integrated risk management.

Incorporating the flexibility of physical assets into valuations and risk reports, as well as the requirements from the accounting profession to report the value on such flexibility, also necessitates being able to accurately measure the embedded optionality in those assets (such as generation assets, pipelines, and storage facilities), or complicated contracts linked to physical assets. This is an area not adequately handled by typical ETRM systems, which Lacima's riskAnalytics solution is well placed to address.

About Chris Strickland

Dr. Strickland is co-founder and Director of Lacima Group, providing risk management consulting, software and training worldwide. He is an Associate Research Fellow at the School of Finance and Economics, University of Technology Sydney, University of Warwick. Dr. Strickland consults extensively with senior executives globally in the areas of energy risk management, strategic risk assessment, and implementation of risk systems. Previously he worked for RBC Gilts Ltd, and Kitcat and Aitken. & Co. in London. Dr. Strickland is the co-author, with Les Clewlow, of the books "Energy Derivatives Pricing and Risk Management" and "Implementing Derivatives Models" and co-editor of the book "Exotic Options: The State of the Art" and has a regular series of articles in Energy Risk Magazine. He has a First Class Honours degree in Pure Mathematics (Liverpool), an MSc in Mathematics (Warwick) and a PhD in Finance (Warwick). Dr. Strickland was elected to Energy Risk's Hall of Fame.