Financials & Physicals Converge as Integration Comes of Age

Posted on September 14, 2005
Posted By: Jonathan English
 
Professionals in energy trading, transport and risk management seek the holy grail: more accurate forward perspectives and a better understanding of risk — in turn enabling more confident decisions and strategic agility. New software technologies and streamlined, integrated business processes are propelling energy companies toward that goal.

Nowhere is the trend toward a better understanding of risk more evident than in the accelerating move to integrate physical product management and derivatives trading.

Physical traders and risk management teams, and their respective business processes and software, evolved separately and in many cases remain separate today. However, in forward thinking organizations, teams increasingly collaborate on physicals and financials and are therefore competing more effectively in complex and volatile markets — for example by making more effective use of live market-data feeds, advanced decision analytics and simulation capabilities.

To make these changes happen, savvy companies are deploying a new generation of integrated software solutions and, partly as a result, adopting more holistic and efficient business processes that bring together physicals and financials. Further, this integration extends well beyond the bounds of traditional energy trading, transport and risk management, embracing field production and other functionality.

Companies are reporting a remarkable range of advantages from physical/financial integration. For example, traders and risk managers are assessing risk and predicting prices with greater accuracy, and determining optimal patterns of execution across multiple commodities.

They are also gaining huge efficiencies — streamlining operations, ensuring regulatory compliance, speeding up execution of trades and reducing errors and associated costs. Further, new, more flexible integration model is making it easier to keep software current with rapid changes in the markets.

And the competitive gap is widening. For instance, some producers using traditional, separate auditing and accounting systems often wrangle in court with interest owners over netbacks and other complex accounting issues, some of which stem from subtle, cumulative accounting errors. These errors are now largely avoidable with integrated solutions.

Gaining Advantage: Combining Physicals & Financials

As the move to integrate information and processes gathers speed, leading organizations are resolving technical issues that stood in the way, creating more effective solutions. Because energy companies are now deciding how best to integrate physicals and financials, it is crucial to understand the enabling technologies, what they offer and how they differ.

Among the most important technologies are component architectures and XML Web services. Component architectures enable ‘best fit’ solutions tailored to a company’s unique requirements and are able to undergo rapid modification to keep pace with fast changing strategies and market trends. XML Web services are a global Internet standard enabling far reaching communication and collaboration capabilities.

Meanwhile, determining optimal patterns of exercise in the face of complex options and futures has become a daunting challenge. Physical transaction data has to be transferred to a separate database and reorganized to perform analyses such as mark-to-market, Value at Risk (VaR), earnings at risk and correlations. For the growing minority of companies that trade across multiple commodities, this situation becomes nearly unmanageable, further driving up risk.

Advanced solutions combine physicals and financials into a single database within a fully integrated collaboration environment. Features include real-time market data, advanced decision analytics with 3D graphics and a variety of collaboration tools — plus enterprise security, audit controls, regulatory compliance and user-defined reporting. Given these resources, traders and risk managers gain more accurate understandings of risk and market dynamics. They can also execute on these insights more quickly and with dramatic efficiency. Trading organizations become ‘forward focused’ rather than relying mostly on historical data as in the past.

Integration within and beyond ETRM generates other positive impacts across the enterprise — improving operations and reducing costs, for instance, in contract compliance, credit risk management, error reduction and process efficiency and speed.

These improvements and cost savings alone can more than pay back the total cost of owning a fully integrated, next-generation solution for trading, risk and physicals management.

Impact: Managing Credit Risk

Companies reduce credit risk by integrating counterparty credit information from the physical and financial sides. For instance, a mid-size producer may have seemingly unrelated credit exposures with a counterparty for physical trading, derivatives and, if it’s a financial institution, possibly foreign exchange. These exposures may be managed by three departments within the producing enterprise. But the company’s true, ongoing credit risk isn’t known unless all this information is aggregated through an integrated environment. Otherwise, the aggregate risk with a single counterparty could rise well beyond the company’s policy limits without anyone realizing it — a potential minefield.

Impact: Competing at High Speed

The new, integrated solutions deliver huge efficiencies that accelerate business processes while reducing costs. In traditional trading environments, scheduling has to be manually pushed through a system or process. But in an integrated environment each physical trade automatically appears on a scheduler’s screen. The scheduler can simply drag-and-drop that order onto a listed location to complete the task. The system automatically generates any fees associated with the product movement. Impacts of the trade cascade throughout the enterprise, adjusting positions, volumes, financial balances and risk exposures. All required notifications and documents automatically accompany the order. Processes happen at the speed of a mouse click. Traders, schedulers and other participants can attach manual correspondence, instructions and notes. These become permanently associated with the transaction, forming a comprehensive record that authorized users can access with a click.

Impact: Error Reduction & Ensuring Contract Compliance

All process steps automatically become auditable. Any action, document or note can easily be tracked with the transaction, or traced back through it. Errors are reduced. Should an error occur, accounting personnel can pinpoint and reconcile it. Incorrect prices, volumes or other details can be quickly caught and corrected. Corrections instantly propagate back through the enterprise as the integrated system readjusts every affected entry, sum, charge, valuation and projection. Prior period adjustments (PPAs) are no longer a nightmare. As a result, accounting can close each month on time without excessive labor and stress. Integrated information also helps ensure that flows of cash precisely conform to the contractual obligations that accompany physical transactions — so the company doesn’t pay too much or receive too little, and is less likely to end up in court.

Technologies Converge on Integrated Solutions

To develop the next generation of solutions that enable physical and financial integration, vendors of software for trading, risk and physicals management are bringing together a variety of technologies. Chief among these are component architectures and XML Web services.

  • Component architectures consist of numerous independent software components. One solution set, for example, offers more than three dozen component applications, ranging across physical and financial operations throughout the energy industry. Each component can work as a stand-alone application, yet seamlessly integrates with any number of other components in any combination — providing mix and match flexibility that’s not possible with conventional suite-type software. The result: scalable, flexible, ‘best fit’ ETRM solutions tailored to the unique requirements of any energy company.
  • XML Web services provide a global standard and infrastructure for integrating application software and business processes on a pure Internet platform. Adding these Web services sporadically on top of old solutions has proven only partially effective. Thus building solutions from the ground up on a pure Internet platform has been the latest and most important focus — enabling pervasive plug-and-play capabilities, enterprise-wide and market-wide collaboration, faster deployment and numerous other benefits. Microsoft Corporation, through its .NET Web Services, has become a leading proponent of XML technology.

While these technologies each offer advantages, the combination does even more. It creates a holistic information environment that amplifies and extends all these advantages. Synergy happens because XML Web services provide part of the ‘glue’ that integrates component architectures, while these new architectures efficiently leverage Web services’ potential to enhance integration and enrich collaboration between physical and financial teams.

Further, Web services technology lets ETRM software providers readily integrate live data feeds into any application, a crucial step in giving traders and hedgers up to the minute decision support. Real time market data, delivered as it’s happening, becomes even more effective when processed through decision analytics that draw upon both physical and financial transactions — another defining characteristic of next-generation solutions for trading, risk and physical management.

Summary/Conclusion

Component architectures, XML Web services and related innovations together comprise the collaboration lynchpin integrating physical and financial aspects of energy trading, transport and risk management. Teams using the new solutions within and beyond this field are achieving measurably improved optimization and risk mitigation. Upstream, mid- and downstream trading and business activity are becoming more integrated. And optimal patterns of exercise can be readily determined even across multi-commodity transactions. As a result, companies are becoming more competitive in every respect: strategic, operational and financial.

To enable these capabilities, next-generation solutions are addressing value, risk, processes, strategy and compliance across traditional industry boundaries. For example, options and futures decision support is becoming fully integrated with location-specific physical inventories, delivery commitments and ever changing disposition strategies. These solutions are also protecting traders and their companies by providing enterprise-level information and process management. Capabilities include enterprise security, automated processes for regulatory compliance and end-to-end tracking and audit. Further, because information processes and ‘people processes’ are entwined, process integration is driving ‘people integration’ — for example, promoting unprecedented collaboration between physical product managers and derivatives traders. As a result, technology is driving a new, more competitive era in trading, risk and physical management throughout the energy industry

This article first appeared in the March edition of Commodities Now magazine – www.commodities-now.com.

 
 
Authored By:
Jonathan English is Managing Director, EMEA at Allegro Development. He is based in London.
 

Other Posts by: Jonathan English

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