Risk Management and Price Volatility

The Role of Risk management in the managing price Volatility in the Global oil and Gas Market Energy is a basic requirement for all human activity. A main characteristic of every culture and society throughout history has been the way in which it has used the energy resource at its disposal, and the per capital consumption of energy is the common measurement of its level of development. The oil and gas market are the driving force of the global economy and accounts for an ample of the world’s energy consumption. This is the process of organizing, at various levels, the commerce of bringing Oil and Gas from the wellhead to end-users.

Price volatility is the “Sustained, unpredictable price movements that frustrate the economics of high-load-factor use of natural gas in industrial, chemical, and power-generation applications (on the upside), or frustrate the organized, sustained growth of deliverability from domestic onshore unconventional resources. ”(Task Force on National Gas Stability, 2010) These Erratic and Unpredictable changes in prices and the dominant reliance of the economy on crude create concern, uncertainty and indirect cost to the economy.

This affect decision making and in other to manage the concerns, uncertainty and indirect cost that are associated with the oil and gas markets, Risk management is introduced. Risk management is the systematic ongoing process by which an organisation identifies, prioritizes and implements programmes to reduce the chance of negative outcomes on a business (Wayne Harrop’s). In this case effective risk management helps to assess the unpredictable changes in prices, its possible economic impact and Produce strategies to curtail the impact of price volatility.

The focus of this review would be to accentuate the causes of price volatility, and how effective risk management minimizes dangers of price volatility in the global oil and gas market. Origin of Price Volatility Causes of Price volatility There lots factors that are responsible for the abrupt changes in the volatility of price in the oil and gas sector. These factors posses a positive or negative impact depending on the scenario and movement of the market forces (the demand and supply) or mostly due to the market force or various scenarios.

Below are some of the factors that could affect the volatility of crude in an oil and gas market. Market forces The price of crude oil rises if the cost of producing and supplying is high, or if there is more consumers willing to buying crude at a current price (i. e. when demand is greater than supply). The price of crude will fall if the cost of production and supply of crude is low or if people are willing to buy less crude at a given price (i. e. supply is greater than demand).

The price of crude is said to be stable when the price at which the quantity demand over time by the consumer matches the quantity the producer is willing to supply. In general, the price of a commodity, such, reflects producers’ costs and Consumers’ willingness to pay The vitality and responsiveness of the supply-demand balance is the most important factor determining whether price volatility in either direction will occur. As with price drivers for other commodities so it is with oil and gas.

The interaction of demand and supply for global oil and gas has been the major economic driver of price volatility in the global Economy. As more and more demand is made of oil and gas, the price for the commodity has responded either positively or negatively. Positively here refers to increase while negatively refers to decrease in prices. OPEC The Organisation of Petroleum Exporting Countries (OPEC) emerged in 1960 due to the need to systematically respond to increases in the global oil production.

It comprises of 12 top member oil exporting nations with 81. percent of the world’s proven crude reserves, up from 79. 6 percent in 2009 (lawler, 2011). OPEC basic function is to coordinate and unify the petroleum policies of its Member Countries and ensure the stabilization of oil markets in order to secure an efficient, economic and regular supply of petroleum to consumers, a steady income to producers and a fair return on capital for those investing in the petroleum industry. OPEC’s first successful assertion of market power came in 1973-1974, where market forces were no longer the ole determinant of the world price of crude oil. (OPEC did this by agreeing among member countries to limit the supply of crude oil in order to influence crude prices.

At that time, OPEC members agreed to limit how much crude oil they would produce and to place an embargo on the sale of crude oil to the U. S. OPEC members adhered to the production limits and, when OPEC lifted the embargo six months later, crude oil prices had tripled from $4 to $12 per barrel (The dynamics of demand, supplyand competition, 2005) .

Based on its inception of improving and defending oil prices, OPEC has influenced the changes in oil prices by the methods adopted like introduction of quotas, rationing of petroleum production. The introduction of this method led to oil price increase which was favorable to member nations as the domestic oil market is dependent on regulated oil prices by OPEC as it increases their revenues and unfavorable to importing nations.

Also during The Venezuelan oil industry strike, which began last December and extended into January, withdrew a startling 2. million barrels a day from the market. This pushed prices to more than $3/b above the band. In response, OPEC rapidly organized an Extraordinary Meeting of its Conference, which raised the OPEC-10 production ceiling by 1. 5 mb/d and restored some balance to a potentially destabilizing market. Natural Disaster Imbalance between quantity supplied and quantity demanded as a result of disaster can lead toan upward pressure on prices of oil products.

Natural disaster has bee n perceived to be extremely disruptive. Countries heavily dependent on oil i. e U.S have been heavily affected by natural disatsters like political instability and hostility that loom key producing countries like Nigeria, Iraq, Iran and Venezuela. (Parmenent Subcommittee on investigations, 2006) Environmental distasters can be in the form of hurricanes katrina and rita 2005 as consumers all over the U. S and those outside the gulf of mexico region affecetd experienced a rise in the price of gasoline as supply was affected as demand was high. (Cheveron 2005 -2011) Global economic growth: Dependance on oil as a major boster of the global economic growth adversely affect price volatility.

Higher oil prices have an incompartible economic impact on oil importing developed countries because they re more energy- intensive and imported oil dependant. (Internation Energy Agency, 2004). Increase in econmic growth of nation s like U. S and china has lead to increase in price of oil. This is a result of chinas need to increase transportation fuel , relatively inefficient industrial sector and government attempt to diversify into a non- coal source of energy. (U. S. International Trade Commission, 2006) The U. S economic growth on the other hand has been as a result of increase in oil consumption gasoline is an inportant componet.

Unwillininess of consumers to reduce oil product consumption , while Rise in oil product price may decrease expenditure on ther goods and services there by reducing the rate of economic growth. For nation that rely heavilly on oil sector for econmoic growth eg nigeria, high oil prices, based on rising oil demand, create an inflow of oil derived revenue, increasing GDP growth. The nation would be in danger if economic growth of consuming nation decline reducing the demand and price of oil if the price go too high for long period of time. (Pirog, 2005) .

Higher oil prices have an incompartible economic impact on oil importing developed countries because they re more energy- intensive and imported oil dependant.. Production Volume: At present, global liquid fuel usage is pegged at about 85 million barrels per day, for the moment, the global production volume is enough to cater for the demand. However, when economic activities picks up owing to the quick recovery of the world from recession, it will be difficult to rump up production volumes to meet the increasing demand. This is due to the lead time before production can be romped up to meet demand.

This in turn will keep oil/gas prices on the increase. Trading (Speculation) Volatility creates the risk which leads to desire to hedge, in contrast gives rooms for speculator to enter the market( Horsnell paul, Mabro Robert,1993). This refers to trading in derivatives, commodities (includes Oil/gas), bonds, equities or currencies with a higher-than-average risk in return for a higher-than-average profit potential. Speculators take large risks, especially with respect to anticipating future price movements, in the hope of making quick, large gains.

The activities of the speculators in the oil and gas market contribute to the non fundamental Factor of price volatility. However, for speculators to affect oil prices, they most trade in parallel. (I. e. in the same direction) MANAGING PRICE VOLATILITY The management of risk is an important issue facing oil and gas Organizations today. Extreme fluctuations in price due to rapid expansion in emerging Asian and latin America markets together with influence of hedge funds and market speculation have lead to companies and governments started investigating ways to stabilize oil and gas markets as the entire market and industries are at risk.

In other to mitigate risk, government and companies have adopted the structural approach Laws and legislation Risk management has ensured the compliance of oil and gas firms with the various environmental regulations, standards, objectives and goals as specified under legislation or official guidelines on a project. Government and companies are fully committed to integrate Health, Safety and Environmental Management System (HSE-MS) by introducing the international standard for system models, such as the international Standard Organisation ISO 9000 for quality management, and ISO 14000 for environmental management.

The introduction of these laws and standard has lead to the drastic reduction in potential environmental impact (aquatic, terrestrial, atmospheric impacts) which leads to reduction in supply and increase in price volatility. Effective implementation of these law and legislation are enshired in the approval and permitting processes, with the Environmental Impact Assessment (EIA) etc acting as an important tool.