 Why risk controls as I mentioned you guys have already hopefully read the case studies, and then you've got an activity on those Because of that we have to put risk measures in place energy commodity trading in all its forms basically the SEC and the CFTC came in at one point and said that Publicly traded energy companies will in fact have to institute some type of risk control program We'll talk about the types of controls and then last we're gonna talk about some recommendations if you were to sit down with a company and Make some recommendations for a risk program for them I've got a list of things that you might you know want to be able to say to them or recommend to them And we talked about these case studies already. I added a fourth one down there. You can see his latest 2006 There was another trading company Amaranth and they lost six billion dollars trading nine next futures again, none of oversight Common issues throughout all of these. I think hopefully you've picked up on that in the case studies They're really the single or multiple rogue traders and we say rogue traders We're talking about people who did things on their own. They made decisions on their own They were dealing in risky derivatives. These are not people dealing simply in The underlying derivatives in some case. We know they were doing option swaps Exotic options and some other things a little or no accountability. This is the big one, okay? There's there's really no line of accountability where there's oversight In several of these cases in fact in the three case studies that you had there was a total control over the paper trail as we saw in the Case study with the Gleason he actually controlled all of the accounting So he could controlled the execution through settlement and then had his phony account set up And this is one of the issues this next point the lack of understanding and recognition by the Executives of financial derivative trading and the risks involved To this day, I still believe there are executives over companies where Energy commodity trading exists financial derivatives are used where the executives truly Don't understand the risks that the company is taking on with the various forms of Transactions even if they're presented with a daily report from your risk control group. I don't know that they fully Understand and can interpret those reports properly So some risk measures these are standard risk measures one of the most common ones and one that Hopefully is most well-known is mark to market. That's the value of the portfolio at the close of the day Based on the settlement prices now in fact sim the simulator If you you know watched your position every day if you had open positions The simulator value those based on the prices at the end of the day And so that is the mark to market you are taking all of your open positions because you have not yet Close them and it's marking them against the settlement prices for the markets closing that day and putting a value on it Then we have value at risk. And this is a much more complicated risk measure. I don't expect you to Understand it in its entirety But it's what's known as the theoretical maximum loss on a total book for a given period of time at a given Confidence level at the fine holding period at expected market conditions now. I realize that's quite a mouthful There's a single number that comes out What happens is there is a first step in calculating value at risk the mark to market Calculation is run on the entire book. So you'll have a mark to market number and then What'll happen is that will get compared to historical prices, but then also within the value at risk system and again, this is a Calculation that's done by software. It's not a hand calculation There will be a Monte Carlo simulator and a Monte Carlo simulator is really a random number generator so in essence the Monte Carlo simulator will come up with literally thousands of potential price scenarios and Those will get compared against The actual mark to market values for particular day that the value at risk is run And so this comparative analysis Comes up with a single number and that single number represents again a theoretical Maximum one-day loss on the book as it exists now the parameters because this is a form of statistics It's a statistical analysis. The parameters are that basically the result is saying okay The maximum loss on the book as it exists today Comparing the mark to market to these prices that have been generated by Monte Carlo simulator The company could lose as much as ten million dollars the confidence the statistical confidence in this case on this var Calculation is 98% and Then there also has to be what's known as the holding period in other words The var calculation is done at the end of the day on the book as it currently exists with the mark to market as it was calculated for that day However in the var calculation There has to be an assumption of how many days you could hold those positions open so you'll have The the single dollar value which represents the maximum loss a level of confidence in 98 percent You know usually would be the one to use because then you've only got 2% outliers on the other end But you might have you know one day two day three day four day five day holding period That's up to the company to determine But the holding period that's chosen also represents there should represent a the Reality when it would come to liquidating the position So in other words it would be unrealistic to have a single holding day Period because you can't liquidate your entire book within one day To do that would then adversely impact the prices in the marketplace on that day Which in turn would adversely impact the mark to market at the end of that day Other risk measures profit and loss now once you've calculated the mark to market Okay, remember you're going to have unrealized gains or losses and so at the end of that day the profit or loss total It's going to be the mark to market value and what you normally do is it becomes a cumulative number each day as you go through the month So the mark to market gain or loss on day one is added to the mark to market day loss on Mark to market daily loss on day two and so on so you have this running total and then you also need to Figure out the volumetric position. You want to know from a contractual standpoint. What is your exposure? So this is the total of all the derivative contracts that you have out there that are straight-up contracts Maybe they're futures. Maybe they're swaps, but then also, you know, we touch briefly on the options delta effect In other words, you know Getting back to the options if an option writer Okay, let's say writes a put or writes a call They immediately have some exposure which is quantified in the number of contracts that they might have to buy themselves or sell Okay, in order to fulfill the obligations under the options contracts if executed So this has to be quantified. There's a certain number of contracts that are represented when the Delta calculation on the options is run So for the true volumetric position of a particular book It's all the open derivative contract volumes. In other words again things like swaps forwards futures and then What the options delta calculation ends up being in terms of contracts? You have to add all of those together. Now, you know the volumetric position for the book itself In terms of energy commodity trading, obviously, we know in April 1990 natural gas contract was launched in 1983 the crude oil contract was launched We know to the provider price transparency and market liquidity You are now able to hedge your price risk, but it also added some more instruments for speculative trading It led to the proliferation of various financial derivatives as we know options such as puts and calls more exotic options And then swaps will Henry look alike swing swaps and basis swaps Now the Securities Exchange Commission and the commodities futures trading Commission and mandated that publicly traded energy companies Have to implement a risk control program Effective with their fiscal year for 2001. Okay, so what happened here is? They had to report their market market value under their earnings So in essence at the end of every day, they had to go in and calculate the mark the market value of their open positions Well, the federal government then said that represents revenue You've either got on raw unrealized gains or unrealized losses and you have to report those in earnings Okay Well for and Ron that basically gave them the license to steal Why because what Enron did was set up various shell companies paper companies and then they would calculate the market to market earnings every day on those little companies and Basically those would show gains and the more earnings that the all these companies were making In in terms of in total showed up by Enron's books. And so this was leading to a higher share price So the state now also the other problem happened was the traders now have a large stake in mark the market They want to manipulate the prices set these forward curves forward prices that we know are in the marketplace Well, they were setting them for Certain price categories that for which they were reporting to the publications and others So you can see they were starting to try to influence the cash marketplace the cash publications Which you know as direct market manipulations then another thing they would do is roll positions forward and backwards to gain mark the market value So they had positions that could be Liquidated and they could draw cash in and then turn around and put those same positions back on they would do this again We're talking about fluffing books up so that the books really didn't Were not true reflection of actual earnings or cash positions of the companies In a post-Enron world In essence a little more than a year after Enron collapsed what had been the top five energy trading companies in the United States were gone Wall Street, you know became very leery of energy trading companies. You'll find more companies today that are named energy service companies And Wall Street analysts when they want to look at a company now They're gonna look at the book size and it was total volumetric Open positions and then the mark to market related to that. They don't really put much confidence in Value at risk. They're not as interested in that because again, as I mentioned earlier, it's sort of theoretical There are you know also more and more companies Adopted fast 133 hedge accounting and what this did was allow them to shrink their speculative book I know the words positions are not open if you can tie them to a physical transaction And then of course there was the adoption of Sarbanes oxley Sarbanes oxley is an extremely invasive and intensive Procedures and recording of pretty much every, you know, every single transaction even down to the keystrokes in some cases Now here's where I mentioned Recommendations if a company doesn't have a risk policy in place and they have to implement one to me first and foremost the executive training They need to understand What energy commodity derivatives are and the various types and the types of risk exposures that are out there trading them They have to establish risk risk policies and procedures and within the policies and procedures It has to be number one a statement of the purpose of the hedging activity You know, what is it that you have that exposes you to? price and market risk Therefore, you know, you state why you're going to hedge Also, then you start to establish risk measures and limits. What's the daily maximum mark to market? You know loss that you're going to allow the trading company to have what's the maximum var You need oversight there needs to be a risk control desk And you need have set positions within that desk and the responsibilities for each one of them There needs to be a risk oversight committee. This is usually comprised of an executive panel Trading policies have to have violation penalties in them In other words, you know, there has to be a situation where if a trader violates it There is a penalty that they're very much aware of it's going to happen which can include termination specific procedures things like deal sheets Daily checkouts and those types of things and as I mentioned, you know, adopt phas 133 heads accounting Educate both internal and external auditors. It's kind of an odd thing But from time to time you find auditors You don't really understand financial derivatives either and yet they come in to audit the books of companies that have financial derivatives On their books and then of course Sarbanes oxley you have no choice but to implement Sarbanes oxley Even as as I mentioned as complicated procedurally as it is