The oil and gas industry is arguably the industry with the highest risk factor given its complex nature. Companies have to deal with the fluctuating oil prices and its recent plunge due to the US government’s trade war has been a major blow for companies. However, risks in the oil and gas sector are not just confined to price volatility but cover political risks and security risks as well. Starting from the geological survey down to the lifting and production level, this capital intensive industry is faced with uncertainties at different levels. Given the aforementioned reasons, coupled with several other complexities, companies in the US oil and gas industry must implement risk management strategies to ensure financial sustainability and protect investors within the sector. The article identifies key strategies that can be adopted to mitigate the risk of price volatility and improve the risk management process.
Despite numerous risks in the oil and gas industry, investors can still make substantial profits by developing effective risk management strategies. Request a free proposal to gain key insights.Request Free Proposal
Key Risk Management Strategies for Mitigating the Risk of Price Volatility
Risk management strategies #1: Create forward contracts
A forward contract is a customized contract that specifies prices for both parties to buy or sell an asset on a future date. It can be effectively used for hedging or speculation. In relation to the US oil and gas industry, a forward contract is a basically a private agreement signed between a buyer and a seller, obligating the buyer and the seller to purchase and sell oil at a set price which is equal to the forward price set at the start of the contract. In this, each party bears the risk of default on future commitments.
Risk management strategies #2: Develop future contracts
A forward contract that incorporates the rules of exchange is termed as a future contract. It is traded in exchanges, where a clearing house represents the buyer and seller. The key purpose of the primary house is to mitigate the risk of default and ensure the quality and quantity of the products delivered. The New York Mercantile Exchange (NYMEX) and the Intercontinental Exchange (ICE) Futures are a few of the major future exchanges. Future contracts are given much priority in the US oil and gas industry as clearing house takes the risk away from the parties, thereby improving the risk management process.
Incapability to develop future contracts can increase the exposure to volatile oil and gas prices. Stay a step ahead by requesting free platform access from our procurement experts.
Risk management strategies #3: Introduce the concept of swap
The concept of swap can be easily applied in the oil and gas industry as a hedging instrument for risk mitigation. It is the exchange of financial assets between concerned parties at a predetermined rate, as per the terms laid out in the contract. It is usually arranged through financial institutions or through banks. Similar to forward and future contracts, oil swaps are one of the key risk management strategies companies adopt to mitigate the risk of price volatility. It transfers the risk of price volatility from oil producer to the lender. Swaps guarantee a firm price for a calculated volume of crude oil for oil producers. In case of a plunge in crude oil price below the fixed price, the financial intermediary is obligated to pay the fixed price that was agreed upon in the contract.