energy trading risk management - Oil & Gas Financial Journal

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ENERGY TRADING
RISK MANAGEMENT
A Supplement to
November 2011
®

Buy vs. build: On reinventing
the ETRM wheel
Larry Hickey, FRM, Sapient, London
Take a close look at your paycheck. Note that you’re not
actually paid by the company you work for. You’re probably
paid by a payroll processing company, perhaps ADP
which pays 1/6th of all working Americans. Your company has
outsourced the payroll function.
Payroll is critically important and involves highly sensitive
data. But management recognized that your company has no
comparative advantage in the provision of payroll services. So
the function was outsourced to a payroll company which can
provide the service securely, reliably, and cheaply.
“Securely” and “reliably” because payroll companies have
developed specialized expertise in this area. They have a
comparative advantage in the provision of payroll services.
“Cheaply” due to economies of scale. The incremental cost of
servicing another company is far less than it would cost your
company to do it itself. Adam Smith would be proud.
If your company’s do-it-yourself ethos extends to issuing paychecks,
you can probably stop reading at this point. And good
luck with your ETRM build!
The same considerations come into play when a company
decides whether to buy a commercially available ETRM solution
or attempt to build one from scratch.
First and foremost, the company must make a sober determination
if the ETRM system is a competitive differentiator. Is the
way you handle your portfolio over its lifecycle so different from
the competition that it is part of your firm’s competitive advantage?
This is a high hurdle for a number of reasons.
What we do here is completely different. Really? By virtue of
all trades having counterparties, there is at least one other entity
wrestling with the same issues. How are they solving them?
Industry leading solutions provide full lifecycle support so the
portfolio can be managed and optimized at the highest level
www.ogfj.com ◆ November 2011 ◆ Energy Trading & Risk Management25

of aggregation. A single system handles multiple commodities,
integrates physical and financial transactions, and takes positions
from forwards through physical delivery. Certain analyses
such as credit and VaR only have meaning at the highest level
of aggregation. Reiner Musier, chief marketing officer at Allegro
Development, describes this “single version of the truth” as a
key motivation for new customers coming from spreadsheets or
in-house systems they have outgrown.
“Customers recognize that a patchwork quilt of point solutions
is simply not scalable,” says Musier. “They can do better.”
Ditto at OpenLink where Wolfgang Ferse, executive vice
president for commodity and energy solutions, reports about
10 instances over the past three years of oil companies that
have outgrown in-house systems and are looking for a scalable,
end-to-end system. So with end-to-end ETRM systems widely
available, the need to roll up data from disparate point solutions
is a weak argument for internal development.
Furthermore, leading solutions are modular and support plugins.
Let’s say your firm has a proprietary credit methodology that
you believe is key to your profitability. But your deal capture,
confirmations, risk analysis, position reporting, and invoicing are
standard. You can quickly implement those specific modules to
support your standard processes and then plug in your custom
credit methodology.
The same goes for option valuation. Customers frequently
implement proprietary option models or smile logic. So, even
the need for proprietary pricing models is not a valid argument
for internal development.
Against all odds, let’s assume your portfolio handling is a
competitive differentiator. The next question to ask is whether
systems development is your core competency. An internal build
will require not only the time of development resources. If the
project is to be successful, it will also require extensive input
from the front, middle and back offices. Do you really have the
skills and bandwidth necessary to develop an ETRM system
from scratch? Is systems development the best use of those
resources?
Michael Schwartz, Triple Point Technology’s chief marketing
officer, notes, “There is a particular danger if an internal
development initiative isn’t business driven. Even if an organization
has available IT staff, it doesn’t mean they have the skills or
experience to build a highly functional commodity management
system…in fact, they almost never do.”
It’s easy to underestimate the effort required to develop a
capable system. Consider a case from over a decade ago in Germany
where a coalition of large energy companies joined forces
to develop an ETRM system. The idea was for the IT departments
to work with a development group to produce a system
that would compete with established vendors. But they grossly
underestimated the cost of doing so. About four years and 100
Mio DM later, the project was quietly abandoned.
Wolfgang Ferse notes that OpenLink’s flagship product Endur
is the culmination of “over 3,000 man-years of development and
testing, with hundreds more going in every year.” That’s hard to
replicate.
The relative stability of the ETRM business is another signal
that significant barriers to entry exist. OpenLink, Triple Point,
SunGard, SolArc, and Allegro are the top five names in the
space. The youngest company is 18 years old. Much larger
names have tried and failed to enter the space.
If companies that do internal builds do in fact have a comparative
advantage in software development, one would think
internally developed systems would be offered for sale alongside
other commercial packages. But they aren’t.
Just recently a major European energy company undertook a
two-year analysis project to determine the feasibility of replacing
a gaggle of third-party applications with internal development.
In the end, the board decided that internal development was too
risky and that software development was not the company’s core
competency. So they decided to license an enterprise solution to
replace the legacy systems.
In addition to developing, testing and deploying your new
system, you will also need to fully document and conduct training
on it.
The facts on the ground
Allegro recently did a survey of energy companies regarding
ETRM systems. The company received more than 250 responses,
three-fourths of which were from trading, risk, or finance departments.
They found a roughly even three-way split between a
commercial system, spreadsheets, and an in-house developed
system to run their trading and risk management business.
In 2010 Energy Risk reported on a poll with 190 valid
responses where 54.7% described their software as mostly offthe-shelf
with some in-house add-ons. 17.6% reported having
mostly in-house build systems with some off-the-shelf. At the
extremes, 17.1% reported using off-the-shelf software only and
10.6% said their software was in-house company-developed
software only.
Both surveys have in-house development at roughly 30%.
Is there any trend toward internal development?
“No. There are always some companies analyzing or starting
in-house initiatives. But the trend is in the other direction,” says
Wolfgang Ferse. “Not only have commercial applications gained
wide acceptance in the market, now we’re seeing a push towards
outsourcing the hardware the applications run on as well.”
So this discussion is framed in a meaningful way, let’s stipulate
that ETRM implementations are complex undertakings that often
involve a variety of systems. A 2003 survey found that 33% of the
time a module of another system is used next to their main system.
If the system of record at the center is a commercial system,
that counts as a buy. If it’s an in-house system, that counts as a
build.
Let’s say there is a valid theoretical basis for an internal build
and you actually succeed in developing the software. Will you be
able to maintain it?
Markets change. New regulatory requirements emerge. A key
advantage of commercial packages is that the vendor is respon-
26
Energy Trading & Risk Management ◆ November 2011 ◆ www.ogfj.com

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sible for keeping abreast of changing regulatory and compliance
requirements. This makes sense – one vendor instead of every
energy company.
This service comes at the cost of maintenance payments,
which are also used to fund enhancements to the system. By
this means, the insights and requirements of the client base are
reflected in the system.
Michael Schwartz notes that “Triple Point’s multi-commodity
solution, CXL, is an evolving best practices platform. Clients with
deep market expertise request enhancements and modifications.
Triple Point responds and, in so doing, the product is continually
improved to better fit the markets we serve. Although every
client doesn’t request every improvement, everyone gets them.
So our clients mutually benefit from each others’ enhancement
ideas. The more clients, the more great ideas that wind up in the
product.”
OpenLink’s Endur fields enhancement requests from 15 of the
top 25 energy and commodity trading firms by market capitalization.
So, whereas internal development can only reflect the perceived
needs of a small group, commercial applications leverage
a much wider knowledge base.
In addition to maintaining and enhancing the product,
vendors also have to provide migration tools to move to new
releases and from de-supported to supported technologies.
Finally, let’s state the obvious. Commercial software can be
implemented quickly. It is thoroughly tested and is cheaper. The
economies of scale are undeniable.
Reiner Musier notes that “With Allegro’s component based
software and agile deployment methods, energy companies can
complete focused projects and start realizing value in as little as
four months.”
In the “choose your poison” category, there is the issue of
becoming dependent on the system provider. If you buy, you will
be dependent on the vendor. That didn’t work out so well for
customers on Contango when Vedaris failed in 2004. But failure
among ETRM vendors is a rare occurrence. If you build, you will
become hostage to…err, dependent on internal IT resources.
There are negatives associated with off-the-shelf ETRM systems.
Let’s address them.
First of all, even if they’re cheaper than internal development
over the lifecycle, licensing, and maintenance is expensive. Second,
the software may require extensive customization to fully
capture your business practices. This can blur the line between
buying and building. You may investigate the business processes
that drove the software to its current state and adapt accordingly
or you may decide to choose a highly configurable application to
support your processes as is. You will find that trying to shoehorn
the last 5% of your requirements into the system can be prohibitively
expensive. Finally, there is a wide perception that system
tweaks are turned around faster on in-house systems. There are

some perks to having the development shop on site.
It is perhaps for this last reason that users reported higher
satisfaction with in-house systems in a 2003 satisfaction survey.
In-house systems scored a 7.6 rating against a 5.7 for off-theshelf
systems. The authors were unable to choose between two
competing explanations.
In-house systems are on average better than off-the-shelf
systems because they better fulfill the needs of the user or users
of in-house systems are ignorant of the alternative. Put simply, inhouse
systems are on average not better or worse than systems
of external suppliers, but the close involvement in its development
gives users a good feeling about it.
Seven years later, a 2010 survey confronted the issue head
on. Respondents, who were mostly happy with their systems,
were asked – if budget was not an issue – whether they would
upgrade their existing system, buy a new system or build a new
one. 54% choose upgrade. 33% would buy a new system, and
less than 13% would build a new system. That’s 87% buy, 13%
build.
And that’s with the build enabling assumption that “budget
was not an issue.” It turns out budget is an issue on this planet.
Is it reasonable to assume that your IT shop is going to successfully
deliver a capable system on budget, on deadline, and
without you becoming a hostage to the developer? For the sake
of argument and in the face of all experience, let’s assume the
answer is “Yes.” Once developed, can the system evolve to meet
new trading and regulatory requirements? Will it reflect anything
more than the insights and requirements of a small group?
On balance, the evidence in favor of buying is overwhelming.
The comparative advantage and economies of scale enjoyed by
vendors trounce claims of uniqueness. The facts, it would seem,
have a pro-buy bias.
Let’s address the elephant in the elevator. I have spent the
past 13 years implementing commercial ETRM systems. So I
can hardly feign objectivity on this issue. While this is true, I am
highly confident that the facts bear me out. Like black swans and
Bigfoot, I have heard of successful, large-scale, internal builds. I
just haven’t seen one.
On the other hand, details on failed efforts are readily available.
The stakes can be high. With rumors that a billion-dollar
implementation exists, it pays to get this decision right. How
much sympathy will there be for the next management that lets
hope triumph over experience?
About the author
Larry Hickey is a director with Sapient Global Markets
and frequent contributor to these pages. He
has spent the past 13 years implementing industry
leading ETRM solutions, with a focus on the physical
delivery of commodities.
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Dodd-Frank compliance forces changes
in CTRM vendor-provided capabilities
Paul Campbell, Tom Lochbichler, and Simit Dhawan, Deloitte & Touche LLP, Houston
The Dodd-Frank Wall Street Reform and Consumer Protection
Act has stated goals of lowering risk, promoting transparency,
and protecting the American public. Nonetheless,
the impact of Dodd-Frank may not be fully understood for years.
Certainly, the regulatory impact is likely to be different for the financial
service industry (FSI) compared to the energy industry.
While almost the full scope of Titles I – XVI of Dodd-Frank, as
understood today, are applicable to large financial institutions,
much of the focus has been on sections of Title VII pertaining to
use of swaps and regulation by the Commodity Futures Trading
Commission (CFTC) that will have the greatest impact on energy
companies. There is concern as to what the future holds for energy
and commodity companies dependent upon solutions provided
by commodity transacting and risk management (CTRM) vendors
– these are the systems that will contain the required data for Dodd-
Frank compliance.
As an industry, CTRM vendors have traditionally trailed those
focused on FSI due to the larger, more progressive market that is
also much more heavily regulated. It is this regulation and definition
of compliance requirements that can be translated into functional
requirements for industry participants. CTRM vendors have the
added challenge of providing functionality to manage physical commodities
and logistics, the complexities of which are unique.
Deloitte has developed an informed view on the path forward
based on the benefit of a CTRM practice established more than 15
years ago and a broad view of the energy industry that emerges
from serving more than 90% of the market. This informed perspective
also comes from our understanding of the impact of regulatory
change from our Tax and Enterprise Resource Planning (ERP)
practices.
We see a likely evolution in CTRM vendor-provided capabilities
for Dodd-Frank compliance, which may follow the four stages and
30
Energy Trading & Risk Management ◆ November 2011 ◆ www.ogfj.com

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timings outlined below. This view on CTRM vendor evolution is
based on similar regulatory regime changes related to Sarbanes-
Oxley (SOX), derivative accounting (FAS 133/ASC 815), and even
more recent issues related to gas price reporting and “Shipper
Must Have Title” .
System capabilities for Dodd-Frank compliance over the next
five years will likely progress from Ad-Hoc, to Fragmented, and
then Comprehensive and Integrated. As the rules related to swap
transacting, including issues like position limits, end-use exception,
etc., have not yet been finalized by the CFTC, energy companies’
response will similarly progress from stages that can be characterized
as “Wait and See,” to “Maintain Awareness,” and then to
“Proactively” addressing the combined business and technology
solutions to meet compliance.
Ad-Hoc
While a small number of energy market participants are beginning
to address their expected Dodd-Frank requirements, the majority of
companies have been slow to make investment decisions regarding
changes to their underlying CTRM systems and processes, given
the high degree of uncertainty with respect to the final rules.
Unlike the FSI industry, which has historically been more heavily
regulated and is used to proactively responding to regulatory
ambiguity, many energy companies have difficulty making investments
or major decisions to address these issues until they become
better understood. Similarly, CTRM vendors are unlikely to build
functionality that addresses Dodd-Frank in any comprehensive manner
thereby putting the burden on energy companies to develop
internal ad-hoc solutions to meet their needs.
As in the past with SOX and derivative accounting requirements,
the initial response to be in compliance with Dodd-Frank for most
companies will be to develop interim solutions using Microsoft
Excel. Similarly, the related business processes will likely be highly
manual and ad-hoc.
In this environment, the challenge to build out these ad-hoc
tools will be three-fold. First, from a data perspective, organizations
will need to capture information not currently available in existing
systems. Examples of this would include Dodd-Frank counterparty
classification, obligation security method, and counterparty end-use
exception election, as well as new internal deal classifications. There
will also be an element of data cleansing so that the reported data
is accurate. Companies that have transacting and counterparty
information in numerous systems will have an especially large challenge
with integrating and standardizing their data to meet these
initial reporting requirements.
Dodd-Frank reporting requirements will not only impact energy
companies’ trading functions but also likely the fuel procurement,
treasury and regulated hedging functions. Therefore, these ad-hoc
solutions and processes will impact a large number of personnel.
Second, the data must be combined and transformed to correspond
to Dodd-Frank reporting standards. Positions will need to
be aggregated and classified, and new reporting views need to be
developed which in many cases are currently not produced by companies
today, and lack relevant business processes and controls.
Third, mechanisms for internal as well as external distribution
need to be developed. This includes the governance, responsibility,
and accountability for approving information. This will include
approval of some reports by the board and senior executives as
defined by the CFTC. The standards that companies would likely
apply to these reports will be similar to those required for external
financial reporting.
Internally, position limits, counterparty exposure, collateral,
and trading behavior consistent with classification will need to be
actively monitored and reported on. The standards that companies
would likely apply to these reports will be similar to those required
for normal operational reporting.
Early on, for most companies that have not gone through Dodd-
Frank preparatory projects, the focus will be on rapidly responding
to the new requirements and will not be on developing sustainable
processes and compensating controls. Given the high bar of complying
with Dodd-Frank, companies cannot afford to stop there.
This will lead them into the next stage of maturity.
Fragmented
In the short to medium term, Dodd-Frank rules will continue to
be refined. Energy companies will need to work towards not only
enhancing and automating their previously constructed tools and
processes, but also towards integrating these into their commercial
and regulatory reporting organizations.
Dodd-Frank regulations will not stop at requiring merely periodic
passive reporting. They will reach deeply into the business and
will require an extremely high level of internal communication.
For example, managing a counterparty’s Dodd-Frank designation
will be an on-going process. Further, companies that are able to
proactively integrate Dodd-Frank requirements into their trading
strategies will likely have a competitive advantage.
At this stage it is unlikely that off-the-shelf solutions, from
specialized niche vendors or traditional CTRM vendors, will be available.
Therefore, energy companies will need to enhance their previously
developed ad-hoc processes and tools for sustainability while
incorporating a higher degree of automation and workflow capabilities.
These tools and processes will be more closely integrated into
the commercial organizations and, as learning is internalized, a set
of industry best practices will be developed. Excel-based tools will
give way to data repositories that are integrated and linked to existing
CTRM solutions and other business systems. New data capture
will be automated to a greater extent than before.
Finally, commercial decisions will be strongly influenced be the
Dodd-Frank reporting process. Energy companies will now be
transitioning out of passively responding to an externally imposed
reporting requirement, and into a stage where Dodd-Frank is
becoming ingrained in their business. At the conclusion of this
stage, a small number of niche vendors that have built custom solutions
for energy companies for Dodd-Frank compliance tools may
emerge.
Comprehensive
In the medium term, we expect that Dodd-Frank compliance
32
Energy Trading & Risk Management ◆ November 2011 ◆ www.ogfj.com

equirements will continue to mature and be revised to meet the
regulators’ defined objectives. The associated reporting standards
and related data requirements may continue to be impacted but to
a lesser degree. However, energy companies will have a comprehensive
view of the impact of Dodd-Frank on their organizations
and will look to migrate their previously built tools and processes
into enterprise systems.
We expect that the energy industry will favor CTRM vendors that
provide automated Dodd-Frank compliance monitoring and reporting
capabilities. Stability in Dodd-Frank rules and client demands
will likely push major CTRM vendors to make significant investments
to meet these needs. To this end, leading CTRM vendors will begin
to offer Dodd-Frank compliance modules that are built through a)
internal development efforts, b) joint development programs with
their new or existing clients, c) expert advice from external consulting
firms, and/or d) acquisitions or partnering relationships with
niche vendors.
Historically, major CTRM vendors have used these strategies to
build their capabilities to meet derivative accounting requirements.
At this stage, energy companies may need to consider Dodd-Frank
compliance capabilities of their CTRM vendors as they consider the
continued use of these platforms.
We expect leading CTRM vendors and a smaller number of
niche vendors to be leaders in offering Dodd-Frank compliance
solutions at this stage. We could also see major ERP vendors enter
the solutions market related to compliance by providing this functionality
as a part of their solution suite.
Integrated
In the long term, we expect the Dodd-Frank rules and compliance
requirements to stabilize for all impacted companies, including
energy. This stage will continue the evolutionary process of CTRM
vendors enhancing automation, workflow, and reporting capabilities
of their Dodd-Frank compliance modules/capabilities. Major ERP
vendors, like SAP and Oracle, may make Dodd-Frank compliance a
major focus of enhancing their capabilities using similar strategies
used by CTRM vendors.
Ultimately, ERP vendors may surpass CTRM vendor provided
capabilities in this area. Recent history points to this trend where
major ERP vendors have begun to offer robust governance, risk,
and compliance (GRC) tools to automate SOX compliance. CTRM
vendors have instead focused on expanding their capabilities
to manage transactional and operational activities of multiple
commodities and modes of transport. These vendors have not
significantly enhanced their platforms to meet their client’s SOX
compliance needs as these have evolved over the years. ERP vendors’
integrated approach to Dodd-Frank compliance, by incorporating
best practices from FSI and energy companies, could provide
integrated and robust industry standard solutions.
Conclusion
Energy companies should not rely on their CTRM vendors to
provide Dodd-Frank compliance capabilities in the short to
medium term, nor should they wait for niche vendors to emerge
in this timeframe. Given the uncertainty in Dodd-Frank compliance
requirements, expected evolution of these rules, and the investment
required by vendors to build out these capabilities, we expect
that energy companies will have to bear the burden of building out
these solutions and related business processes internally. Nonetheless,
CTRM and ERP vendor solutions will emerge in the medium to
long term.
In conclusion, while some energy companies are waiting to see
what the Dodd-Frank rules are before taking action, others are
progressively moving towards maintaining awareness and understanding
their potential impact. A smaller subset of companies are
proactively addressing those impacts now.
At a minimum, all energy companies should ensure that their
technology and business leadership teams are aware of the potential
impact on their systems and processes. They should actively
consider Dodd-Frank compliance requirements as they plan to
upgrade their existing systems or initiate implementation of new
CTRM applications in the next 24 months. Additionally, they should
put placeholders in their 2012 budgets to account for potential
technology and process impacts due to these regulatory changes.
Our previous experience of guiding energy companies through
sweeping regulatory changes, especially trading, informs us that
their total impact may be hard to discern but it is coming and, from
a compliance standpoint, cannot be avoided.
About the authors
Paul Campbell is a leader of the Deloitte &
Touche LLP’s Commodity Transacting and Risk
Management practice and is also responsible
for all Dodd-Frank services for energy companies.
He brings both a business and technology
background to solving risk management issues.
Prior to joining Deloitte in 1999, he worked for
a regulatory agency and several energy trading
companies.
Tom Lochbichler is the leader of Deloitte’s Trading
Technology practice, and has over 17 years of
diverse experience delivering solutions across the
Oil & Gas and Power & Utilities spaces. He has
led numerous trading technology and regulatory
projects at oil majors, including the design of a
trade monitoring and surveillance platform, an
assessment of a global regulatory compliance
reporting platform, as well as a pilot of a communications
surveillance application.
Simit Dhawan is a senior manager with Deloitte
and Touche LLP’s Energy and Resources practice.
He is primarily focused on assisting his clients in
designing and implementing transformational
business and information technology solutions
to manage and monitor risk around their trading
and relational operational activities.
www.ogfj.com ◆ November 2011 ◆ Energy Trading & Risk Management33