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NGL - Risk Management - Exposure

NGL - Risk Management Term: Exposure

Price exposure entails the possibility that there will be an unexpected mismatch between revenues and costs. For instance, a propane distributor who purchases propane in August yet does not sell it to customers until December is exposed to the risk that propane prices will be lower in December than they were in August - causing the distributor to lose money due to unexpectedly low revenue if it must match competitive pricing from other distributors. Alternately, a propane distributor who purchases propane based on Conway prices but who sells into markets that are priced on a Mont Belvieu basis is exposed to the risk that the expected pricing relationship between those two locations does not hold up, causing revenues and costs to move in opposite directions.

In an ideal world a company would like to know exactly what its revenues and costs will be over a given period of time. The difference between known revenues and known costs would allow an accurate margin forecast. In the real world, revenues and costs are comprised of both fixed and variable elements. It is important that a company determines what proportion of its revenues and costs are fixed or variable, and what effect a change in the variable elements will have on bottom-line profitability. The matrix below illustrates the effect that different relative mixes of fixed and variable costs and revenues have on margin exposure in some selected industries:

grid showing the difference and comparison between fixed/variable costs and fixed/variable revenue

Price risk management tools are designed to allow companies to actively limit their own exposure to price risk by contractually shifting that risk to others who are more comfortable with unexpected margin swings. These tools are usually financially settled, i.e. they are settled by the exchange of cash as appropriate; physical NGLs do not change hands as a result of the settlement of the price risk management contracts described in this material (with the exception of the prebuy contract).

It's important to note that a separate specialized "master agreement" is usually required to establish a general framework for parties to enter into financially-settled risk-management contracts (such as swaps, caps, collars, and floors, among others); these instruments are not covered by existing physical contracts that may be in place.

Such a master agreement will likely take the form of the ISDA (International Swaps and Derivatives Assocation) financial master agreement, with company-specific additions and amendments. The ISDA agreement is an involved document with specific language surrounding transaction evidence, collateral and margin provisions, settlement terms, and other areas; it is designed to protect both parties to financial transactions in an era of increased uncertainty. In addition, it is standard industry practice for a separate credit limit to be established regarding financially-settled activity.

Please note that BP's policy is to transact financial risk management instruments (such as swaps, caps, floors, and collars) only with those counterparties holding at least US$1 million in net worth. Prebuys are not subject to this restriction.

Other forms of exposure include weather risk, credit risk, supply risk, event risk, and several other types of risk. As with price, many different types of risks can now be limited and reassigned with risk management tools. Automobile insurance, for instance, can be thought of as simply a risk management tool for 'event risk'—the risk that an event will occur that causes damage to your auto.