Value at risk, commonly called VAR, is a methodology for energy companies to evaluate the level of risk associated with their portfolio of assets and contractual commitments.
Whatever techniques are used to manage risk, it is critical for management of a company to actively measure the aggregate risk level it has incurred on at least a daily, if not an hourly, basis. The risk that is measured is the risk to the company’s expected earnings stream if certain movements in market price or other detrimental events were to occur. This aggregate risk is measured by creating a "book" that shows all physical and financial positions and using this information to estimate the earnings impact of various potential price movements. Procedures must also be in place to catch accidental execution mistakes or unauthorized actions of employees who may be trading outside of the guidelines given by management and thus increasing levels of risk. We are all too familiar with the potential for huge impacts caused by failures in risk management.
A common way of measuring aggregate risk is called value at risk (VAR). In industry jargon, VAR can be described as "an estimate of a portfolio’s potential for loss due to market movements, using standard statistical techniques and an estimate of future market volatility." In layman’s terms, VAR is a calculation that attempts to assess how much total risk associated with potential losses in earnings a company has taken on over any given period of time.
Unfortunately, VAR is an imperfect means of quantifying actual risk. To calculate VAR, an assumption is made as to what level of market volatility will be experienced and then a level of statistical certainty is chosen (often 95%). Given a 95% certainty, your actual Value at Risk will theoretically exceed your calculation 18 days out of the year (5% of the time). And if one of those days is a day when natural gas or electricity prices spike well above expected levels, you can lose a lot of money quickly!
The VAR model also assumes historical correlations between various commodities that may or may not actually occur. In reality, one number cannot adequately reflect the complex risks encountered in today’s marketplace. Thus, it is always important to understand that the levels of risk in the marketplace are inherently high, and no means of analysis or use of risk management techniques can fully hedge all risks.
Despite this caveat, VAR is useful for a number of purposes:
- Quickly quantifying risk associated with a specific transaction.
- Comparing risk associated with expected return for alternative transactions.
- Quantifying risk across a portfolio of transactions (rather than looking at each transaction individually).
- Evaluating overall corporate risk profiles.
- Setting limits on allowed risk either by specific trader, specific business unit, or corporate-wide.
As the industry has become experienced with risks associated with energy markets, new more complex analysis tools that go beyond simple VAR have been developed. It is likely that in the years to come, risk management techniques will continue to evolve.