Risks Associated with Energy Portfolios

Firms that buy, sell, market, distribute, or design hedges for natural gas and oil are entities that have exposure to various risks. First, they all bear exposure to price risk. Macro-economic conditions, local disturbances, weather, supply and demand imbalances, and strikes at energy production facilities are some of the factors that influence the price of oil and gas. Second, companies that attempt to mitigate price risk by hedging (or intermediaries that take the opposite side of a hedge trade) may be exposed to basis risk. Basis risk is the risk of a movement in the price of natural gas or oil relative to the price of the hedge vehicle. Another risk which affects all hedged positions in energy products is volatility risk. The relatively high price volatility of oil and natural gas translates into greater uncertainty, and consequently greater risk. An additional risk which is quite prevalent in commodity products is the risk raised by a "stack and roll" hedging strategy. It was this type of risk which ultimately unhinged the hedging strategy of Metallgesellschaft in late 1993. The following sections provide additional insight to three of the above-mentioned risks.