Reducing risk through technology

Michael Hinton explains how technology can help petchems raise their risk management game

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Reducing risk through technology Michael Hinton, chief customer officer and senior vice president of products and solutions, Allegro.
By  Michael Hinton Published  December 11, 2016

The oil price slide of the last two years has caused the price of petchem products to drop to near 2008/09 recession levels, pushed down by oil spot prices currently hovering at the $40 bbl (WTI) mark, and global crude futures closing at 11-year lows.

Of course oil markets have always been volatile, but many chemical producers were sideswiped by just how quickly and drastically the oil price dive tanked their margins. And despite the adjustments the industry has made to date, it’s too soon to relax. The evolving nature of today’s energy markets makes more volatility and new price shocks almost inevitable.

Against a chaotic business backdrop, improving the visibility of the market risks around essential feedstock becomes mission critical. To protect their margins and manage the crack spread between feedstock costs and refined product prices effectively, petrochemical companies have to raise their risk management game. The time to re-model and prepare for whatever new shocks lie below the horizon is now.

What changed?

After four years of relatively stable prices, too many companies were unprepared – caught napping by the sudden drop in crude prices that began in mid-2014 and continues to the present day.

Politics, weather and war have always been variables with the potential to destroy margins. What’s driving today’s oil price shocks however are baseline shifts in the global dynamics of energy market supply and demand.

Oil supply has grown in recent years, mainly due to new production from US shale. OPEC has kept oil production up, while rebounding exports from countries that had been held back by embargo, or experienced political upheaval – namely Iran and Iraq – have added to the glut. Slower global economic growth and increased energy efficiency, meanwhile, have conspired to push down demand.

But the changes aren’t finished. What should be worrying petchem companies now is the prospect of more supply-side shocks in the near term, making it even harder to find profit in the crack spread.

Petchems are caught in a classic double whammy. Crude prices determine production costs for finished products since the chemical building blocks for ethylene, and propylene are directly produced from oil, and oil derivatives like naphtha. But petrochemical production is also energy-intensive, with manufacturing infrastructure that needs its own hedging strategy to mitigate energy costs—all of which are affected by the price of oil.

What causes volatility?

As Iran negotiates its way back into major export markets, production is still just a trickle – but one with the potential to drive prices lower. Production from other troubled countries like Iraq and Libya can be expected to be chaotic, affected without warning by disruptions related to political and social unrest.

Meanwhile, the shale boom that’s been so transformational to the US economy and global petro politics generally, has also brought new supply chain management issues – namely high production-decline rates. It’s quite normal for peak production at shale wells to drop by up to 80 percent within a year. That means shale oil supply needs constant oversight and new production sources continually lined up.

On the upside, new shale and other light tight oil production can be launched relatively quickly – so quickly that pundits have speculated the US could replace Saudi Arabia as the world’s go-to swing producer. On the downside, shale producers have shown a preference to park their investments when oil prices are low, leading to rushed supply ramp-ups when oil prices rise.

What should petchems do?

The oil price collapse has exposed a fatal weakness in the petrochemical industry: too many companies without the capability to respond quickly when price shocks land. The stable price environment that preceded the 2014 drop lulled many chemical-company leaders into a false sense of security, and they failed to keep up investments in risk management systems.

The problem is fixable. A petrochemical producer with the right technology tools in place can expand margin in a falling-oil-price environment by identifying sourcing savings ahead of declines in product pricing. When oil prices go back up, margins can be still protected by raising prices faster than costs rise. The key is to have visibility of risks and changing market conditions, and stay steps ahead of the competition.

Commodity management to the rescue

With the right commodity management tools and attendant processes in place, the impact of oil shocks on petrochemical companies can be minimised. Effective CM should provide petrochemical companies with the ability to do the following:

Analyse portfolio exposure to measure how various oil-price scenarios will impact the value of oil and other energy trades

Monitor oil-price indicators to identify impending oil shocks

Minimise risks by modelling the cost alternatives for financial hedging, contracts, as well as the logistical risks attached to replacement feedstocks

Perform simulations on portfolio to guide trades under different oil-price scenarios; for example, what do we do if the oil price goes up 7 per cent or 11 per cent next year? By applying this and other ‘what ifs’, petchems can make educated assumptions about costs and prices based on where the market is going.

The level of uncertainty that continues to define oil markets should banish any complacency around trends that dominated during normal conditions. Despite the lessons of 2014 onward it’s still an open question which petchem companies will push ahead of the competition and which will continue to watch profitability slide.

Raising the visibility of market risks is absolutely essential if chemical producers are going to manage the crack spread and control feedstock and energy costs effectively. Only with commodity management systems and processes in place to provide critical business intelligence, transact and capture data in real time, then analyse it to make optimal decisions around trade execution, position management and physical logistics, will this happen.

Smart investments in commodity management systems will enable producers to effectively plan for, respond to, and even benefit from the oil price roller coaster. Ultimately, oil-price volatility can create both risks and opportunities. If equipped with the right tools, petchem companies can position themselves for profit.

Michael Hinton, chief customer officer and senior vice president of products and solutions, Allegro.

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