 Now that we've covered the various financial derivatives for energy commodity trading, it's time to address the risk controls that are truly necessary to hopefully avoid major trading losses. Today's market environment dictates the need for risk controls in financial energy derivative trading. They've probably never been as important as they have been now. There's a history of huge losses. You have those early case studies that hopefully you read before viewing this many lecture. There was the huge Enron debacle and some of these things are still occurring today. As recently as last month, we found out that JP Morgan, in fact, had made huge losses in credit default swaps again because of improper oversights over some of their traders. There's also extreme volatility in energy commodity prices. The fickle and teetering global economy impacts the price of crude oil every single day. The geopolitical climate with unrest in the Middle East, you have some revolution in places like Nigeria. These all impact the price of crude as well. In addition, there's a credit crunch after the huge financial collapse of 2008. There is certainly a risk of losses due to counter parties collapsing. Also increased margin requirements in lesson seven. We talked about the margin requirements associated with each energy commodity in order to trade. This speaks to huge cash flow issues if you're going to trade in those. Weather patterns, La Nina, El Nino, global warming and even unpredictable hurricane seasons. These can have an impact on energy prices, adding to the overall validity of energy financial commodity derivatives. Various financial risks that are out there. We have market risk that is price risk, operational risk can we and or our counter parties perform under the contracts. There is a liquidity risk these days. Are there going to be enough counter parties out there that are financially sound and are willing to make market for us when we want to go into the market. Also the prospect of exchange interruptions. Blackout in the major city could in fact shut down some exchanges. The New York Mercantile Exchange itself was shut down for two or three days after 9-11. And then of course part of the financial risk these days is the speed at which these transactions occur. We have electronic trading. We have virtually 24 hour a day 365 days a year trading going on globally. We have the international petroleum exchange in London, the international continental exchange in Atlanta, Georgia, the NIMEX, Globex which is owned by the Chicago Mercantile Exchange and then Clearport which is a NIMEX electronic over the counter trading platform. And you hit that buy or sell button. The transaction occurs at the speed of light and there is no taking it back. Other risks that most companies face, legal risks, we have standardized contracts to hopefully mitigate that. The ISDA, the NAISB and of course a force of major clauses essentially list a host of reasons why one of the two party counter parties to the contract may not be able to perform and can be excused. I mean such things as acts of God and strikes and failure of equipment and so on. Credit is a big risk in the post-2008 economic collapse. Everyone is concerned about the credit of their counter parties, the counter party liquidity, the number of parties that you can actually trade with and then the solvency of the counter parties with whom you enter into financial derivative contract arrangements. Risk controls. Some of the main topics. Why controls? I've already studied the case studies in the financial markets which led to the development of a system of risk controls which were later mandated in the energy industry. We'll talk about some specific risk measures. Energy commodity trading and why risk measures are necessary there, the types of controls that need to be implemented and then finally some recommendations. If you were to do a risk analysis for a company and turn around and hand them a consultancy report, these would be some of the things that you would look for and then recommend. You've already covered these three case studies in detail. Metallica's L-Shift with their $1.5 billion loss in trading for oil contracts, the Orange County Investment Pool, a loss of $1.64 billion in bond and interest trading, Bering's Bank, an estimated $1.3 to $1.5 billion loss where Nick Lieson was trading stock index futures and then Armanth in September 2006 here in the United States they lost $6 billion in trading NYMEX futures. Some common issues and I hope that you found these through each of those case studies that there was a general theme or themes running through there. You had single or multiple rogue traders. That is they traded positions that they believed were good ones to trade. They were involved in risky derivatives, not just the underlying, but things like options and straddles and collars and other exotic types of financial derivatives. There was little or no accountability, again as you recall in the case of Nick Lieson. He actually controlled the accounting, the settlement and trading functions. They also had in most cases total control of the paper trail in the Orange County Investment Pool as well as with Bering's Bank. There were hidden accounts, but the trader themselves were controlling the paper trail when others came in to audit and then a lack of understanding and recognition by the executives of financial derivative trading and the risks involved. Even today a lot of executives are not aware of the types of positions that their trading groups have put on or aware of what that exposes the company to from a financial perspective. Some of the more common risk measures that usually are implemented, marked to market, marked to market is the value of a portfolio at the close of the day based on settlement prices. So let's say for instance you have some stock in an E-Trade account, until you do something with that stock, until you sell it you're not really making any money, but every day the closing price on that stock can be marked against the price at which you purchase that stock and you will have either an unrealized gain or unrealized loss on your portfolio. That is what's known as marked to market. Value at risk is a complicated theoretical maximum loss on a total financial trading book. It's usually calculated for a given period of time, let's say a three to five day period, a certain confidence level, statistically speaking you may want a 95 to maybe as much as a 98% confidence level, a defined holding period and then expected market conditions. The expected market conditions are variations in price that could occur in the market place. It is expressed as a single value for instance a VAR on a book could be something like $10 million loss at 98% confidence level with a holding period of three days. The prices within the system, the value at risk is calculated using software systems that have huge algorithms. It will be based on historical energy commodity futures prices as well as it will generate its own through a Monte Carlo simulation module that will generate thousands of iterations of different types of prices as it's a random number generator. So the marked to market calculation takes place and then the rest of the algorithms calculate the VAR. A couple of more risk measures, profit loss, that's the daily profit or loss on the marked to market changes. So it's the daily change in the unrealized gain or loss after the portfolio is marked to market. The volumetric position is the total of all derivative contracts in the book including the options delta effect. I touched briefly on the idea of delta in the lecture on options. Delta represents the potential contract exposure that the writer of the option has. If the buyer of the option should choose to exercise those options, then the seller of the options either going to have to go out and sell contracts or buy contracts to cover that position. And as time moves forward, their exposure to that changes daily. That's the delta effect. So when we're talking about the volumetric position of a financial trading book, we're talking about all contracts, the actual underlying financial derivative contracts, as well as the implied number of contracts that the book is exposed to for options sales. In April of 1990, the introduction of the NYMEX natural gas futures contract added to the contract totals for crude oil that were already trading. It did provide price transparency and market liquidity. It allowed commercial participants to hedge their price risk. It also provided a whole new host of financial derivative trading for speculative traders. So now you had a new proliferation of financial derivatives. You had options, puts calls, various exotic options. We talked about the types of swaps. You have the Henry Hub lookalike. You have basis swaps and you have swing swaps. So the number of financial derivatives exploded with the advent of the natural gas contract on the New York Mercantile Exchange. The Securities and Exchange Commission and the Commodity Futures Trading Commission mandated that publicly traded energy companies had implemented risk controls for fiscal year 2001. And one of the thoughts there was that they needed to calculate the mark-to-market on their book and reported it as earnings. Obviously to the federal government that meant higher corporate taxes, but what they didn't realize was that if mark-to-market was going to be viewed as earnings, then companies could find ways to create and falsify their mark-to-market. This basically gave Enron a license to steal. They created various fictitious off-balance sheet companies where mark-to-market earnings were generated. And the more earnings that they showed, then the higher the share price and so on. So traders would now have a large stake in the mark-to-market value of their book. So they themselves would begin to set the forward curves. That is, they would begin to go ahead and set the future prices themselves. So this resulted in the manipulation of the mark-to-market. They also set cash market indexes, which was, you know, blatant market manipulation in the publications that we talked about in cash pricing. And they would roll their positions, their financial positions, forward and backwards to increase their mark-to-market value when it was convenient for them to do so. In the post-Enron area, the top five natural gas marketing companies in the United States were gone within a year. Wall Street became very leery of energy trading companies. And you'll see that after that point in time, a lot of companies became energy services companies and no longer energy trading companies. Wall Street wants the book size analyzed and mark-to-market. They don't put much value at risk, if you'll excuse the pun there. Companies started to adopt FAS-133 hedge accounting, which shrunk the spec book because hedge accounting allows you to take a financial derivative. That's truly a hedge and basically those two balance each other out in terms of your open positions. The remaining positions in your book are speculative. And then, of course, Sarbanes-Oxley was adopted, which created a massive amount of reporting for companies who were publicly traded and dealing in financial energy derivatives. So if you were to evaluate a company, these would be some of the recommendations I think that you should make. First and foremost, executive training. Executives have got to understand the nature of financial derivatives, the exposures, what's going on in their trading shop. So if need be, they can pull the reins in on their traders. A risk policy and procedures needs to be developed within that. You should state the purpose of the hedging activity. It should list the risk measures and limits on each risk measure. There needs to be formal oversight in the form of a risk control desk. The positions and responsibilities of the risk control desk personnel need to be delineated. There needs to be some type of risk oversight committee comprised of executives, generally the top executives in the company. There needs to be a trading policy with violation penalties for individual traders. Specific procedures need to be outlined as well. It's highly recommended that they would adopt FAS-133 hedge accounting, which would shrink their speculative positions. Both internal and external auditors need to be educated. They need to understand financial energy derivative trading and its risks so they can make proper audits. And then of course the federal government mandates that Sarbanes-Oxley requirements be adopted and the corresponding reporting be timely produced.