Risk Management

Risk management in the energy sector: Use of options

By definition an option is an agreement where a buyer has the right to buy or sell an asset for a given price in the future. The seller is obligated to sell or buy the asset which is stated in a contract, but the buyer is not obligated to exercise the right.

Options are traded in most market places and the buyer of options pays a premium to the other party (the seller). Valuation of options is affected by demand and supply, but other factors are also vital in pricing i.e. the price of the underlying asset and time to expiration. There are also theoretical models of option pricing, i.e. the Black-Scholes model.

By using options one can reduce (or increase) risk. Risk can be reduced by buying the right to sell the asset at a given price (if the price drops), this is called downside risk.

In the energy sector there is historically high volatility when it comes to oil price. With use of options, a seller of crude oil can lock the price at an adequate level and still sell the oil for a higher price since the options doesn't obliged to sell at a given price, i.e. if the price should rise in the future. One the other hand, a refinery can use options to lock the price of their input (crude oil), but if the price drops it still can buy the oil for a lower price.

Risk management in the energy sector: Value at risk

In the energy sector we find different sources to uncertainty. Some of these uncertainty's can be removed thru diversification, but some cannot, i.e. market risk. The price on oil is exposed to market risk and the risk cannot be removed thru diversification. It is therefore impotent for managers to know what's on stake and how they can cope with the uncertainty. VaR quantifies the risk with simple numbers; this makes VaR simple and easy to work with. To implement VaR there are a few alternative