Mike Norman: Hello everybody, and welcome to HardAssetsInvestor.com. I'm Mike Norman, your host. Today we are going to be talking to a professional risk manager. I have as my guest today Glenn Labhart; he is the chairman of the Global Association of Risk Professionals, Energy Risk Professionals. Nice to have you here.
Glenn Labhart, chairman, GARP (Labhart): Thank you, Mike; appreciate that.
Norman: We get a lot of people on this show who are investors, and use the markets from the standpoint of investment or speculation. You've been sort of on the other side of the spectrum. You've worked in the energy industry formerly at Dynegy (NYSE:DYN). And your activity, your profession, is involved with hedging and managing risk in the energy market.
So the first thing I want to ask you is, markets have evolved to the point now that we see them; they've grown exponentially. As a risk manager, have the markets become, in your opinion, riskier, more volatile than when you started back in the business?
Labhart: They have to some extent. But I think they've just changed through time. I think that the reason they've probably changed is because the markets have become a little more electronic. You've seen a little more of an emphasis on electronic trading. But at the end of the day, you're still just managing the underlying risk of the asset. You're looking at the energy asset. You're introducing probably to some extent the speculative element that goes with that in the market.
But from my background, I've always been involved in the physical side of the trading. And so to me it's just always been a function of really looking at the asset and how one hedges the asset in order to manage two cash flows.
Norman: So what elements of risk actually come into play from your perspective in managing the full ... from production to distribution?
Labhart: What we typically look at in energy, what I always advise people on and look at, is there's the production side, there is the storage and transportation side, the refining processing. And then you have more or less the retail side. You're looking at all energy commodities from production, all the way to distribution. You're looking at it as electricity in someone's home, or gasoline in someone's automobile.
And so you have to focus on the specifics of each one of those categories, or value-adds if you will, as we call them in the energy business. Now, within each category, you have different categories of risk. We refer to them typically as the group of 30 risks, which has been coined by the banks. But just to name a few, we look at market risk, we look at credit risk, operational risk, legal risk. What sort of uncertainties could go wrong in each one of those elements within the underlying asset? And how do you employ the proper hedge strategy in order to achieve the maximum value from the asset?
Norman: Let's deal with the market risk right now. Give us an idea, some of the instruments, some of the tools you use to manage that risk. I assume it's futures, options, maybe some over-the-counter derivative products. And also, what about time frames? That's a risk as well.
Labhart: Absolutely. That's probably one of the biggest risks. Each one of the ones you mentioned is exactly what is being used. You're typically looking at the underlying asset, and the cash flows, and what instrument makes the best sense, given the credit associated with that. But the time risk is probably the bigger element, because synonymous to what you'd see in a financial market of the yield curve, commodity markets or energy markets typically we look for backwardation or contango — where we're seeing the market is worth more in the front portion of the curve, versus the back portion of the curve.
Norman: This is interesting. I have you here; you're a professional. And there's probably a lot of people out there who are unfamiliar with what you do. If you could just give us briefly how you respond to a market in contango, what you do, and what you do in backwardation.
Labhart: We'll start with backwardation, which means means that the spot month that is actually trading — the physical month — is worth more than the forward months or the futures months.
In a futures market, or any kind of market that you're in contango, the risk you're going to look for is to make sure that if you're, in the case of production, or in the supply side where you need to buy, you've got an asset that's got a purchase of fuel, you need to be careful that you're taking on a proper hedge strategy so that the next day you don't wake up and not have a force majeure clause. You've got to have more specifically a focus in the spot month of your trading. That's where it all ends up ...
Norman: That's in the contango?
Labhart: That's in the backwardation. In the contango, the market's worth more in the future, which typically ... in a lot of your markets, there's always going to be traditionally reflecting storage economics.
Norman: Is that the normal state of the oil market? Is it normally in a contango or backwardation?
Labhart: It's normally in contango, and has been that way for some time. And the reason is because, I think, you've introduced a lot of new players into the market. The banks have come in. A lot of hedge funds have come in.
Norman: The ETFs, these funds.
Labhart: The ETFs, yes. Because they're financing inventory. And what I always say is inventory is in strong hands. And I think that what you have is an emphasis on that inventory play. You are going to see certain elements of backwardation. One thing that's important about backwardation is you don't necessarily see it in a futures market. You've got to stay focused on the spot market.
So one of the elements of risk that I always tell clients is ... you mentioned the word time. You could say, for instance, a futures market has 24 months. But you've got to be focused more on the spot physical month. And it has its own elements and its own dynamics. So it's very important to do that.
Norman: Are you working in sort of a reactive way, or a proactive way? In other words, are you making a forecast? Or are you looking at the market, and taking the signals from the market — backwardation or contango — and then doing what you need to do?
Labhart: What you're typically doing in most shops in risk management for energy, you're looking at several metrics that you would employ every day. For example, much like a person who has a stock portfolio, they want to know every day whether the money they put in is worth more or less.
In energy you're looking at the very same concept. You're looking at the valuation of how much that portfolio is working or building each and every day. You tend to use different metrics. We call those value at risk. We do some stress testing. We challenge the variables of the pricings in order to tell us how much cash flow at risk we're going to have on the whole portfolio. It's very much a probabilistic technique. There's a lot of varying techniques. But it's real important in risk to be able to get your arms around what I call different metrics. Sometimes we call it a dashboard. It's like driving your car" You're always going to know what your speed is, but you've got to look at the other indicators to tell you whether your car is working or not. Risk is the same way.
Norman: Now, you have the underlying — as the producer or the merchandiser - let's say you put on a hedge; it's somewhat guesswork involved, right, to see what levels you want to place that hedge? What do you do in a situation where the hedge is not working, at least in the short term? Do you continue to place the hedge higher up, or do you sit, do you bail out of the hedge? What do you do in that situation?
Labhart: That's a good question. I think it's a function when people usually bail out, because their credit risk comes involved. They can't afford to play. You're getting eaten up with your cash. Your what we refer to as potential exposure has gone beyond the scope of what your funds will allow. And you need to get out.
I typically advise clients to set their targets so that they they have targets for cash, and knowing when to get out. And also how to kind of balance the risk between credit and market risk. So you don't necessarily have to bail out all the time. You might also want to be in the right instrument based on what your balance sheet can afford.
Norman: Has the financial crisis made it tougher? I mean, you can't get the financing from the banks and the financial institutions perhaps as you were able to get it before.
Labhart: That's correct. You've seen margins increase on the exchange, certainly with oil going to $100 a barrel. You've increased your margins. The outstanding legislation of Dodd-Frank has probably reined in a lot of the trading.
Norman: You think so?
Labhart: I think it has. I think that it's forced a lot of the liquidity out of the market because people are — specifically on the banks that are participating — having to take a different view of what they can and cannot do, because it's still somewhat unknown. It hasn't fully been vetted yet in the market.
You've had hedge funds probably still playing with it on the market, still trading. But you've also had a lot of people who were traditional hedgers uncertain as to what requirements are going to be placed. So the Dodd-Frank bill I think that will come out in July is going to tell the tale more of what's going to occur in the market for people to hedge the assets, and be able to continue the risk management programs.
Norman: What about the Wall Street players? They've really become a very big factor in the commodity markets. You've been involved in the energy side for a long time. But now, for example, you see firms like Morgan Stanley. I heard Morgan Stanley is the largest owner of physical heating oil in the Northeast. But they're doing it as a financial player. I mean, they're not driving trucks around delivering oil to people. How has that impacted the markets, in your opinion?
Labhart: I think that the banks participating, they provide a great service. And I hope that at certain times ...
Norman: You do?
Labhart: Yes, I do. Because I think that the banks are going more toward a play where they're lending money on the market. They're allowing people to do more of what I would call commodity finance, but at the same time providing hedge services. And I think that you could compare it to like what J.P. Morgan (NYSE:JPM) has done. They're looking at it and not trading as much of a speculative type of development in the market. What they're doing is they're lending money, managing a larger arbitrage. But they can take the risk of the investment on their balance sheet for someone. So therefore, assets are being financed. People can hedge. And it's a good function.
So I hope that with the legislation, some of this will smooth itself out, because we need to move velocity of money.
Norman: That's a different perspective. Let me just get real quick your outlook on oil prices for the next year or two years.
Labhart: I think oil is going to remain volatile, but I think it's going up.
Norman: Back to $150; beyond?
Labhart: I don't know specifically $150, but it's got a shot at it.
Norman: It's got a shot at it. All right, there you go; Glenn Labhart. Thank you very much. That's it for now folks. Tune back in; we'll have some more great interviews right here on HardAssetsInvestor.com. I'm Mike Norman. See you next time.