Profile: Brett Humphreys

In the last interview in the Profile series celebrating Energy Risk’s 15th anniversary, Brett Humphreys talks to Rachel Morison about how risk management has evolved

This year to celebrate our 15th anniversary Energy Risk has been talking to veterans who have shaped today’s energy markets. As the final in this series of profile interviews, Brett Humphreys talks to Rachel Morison about how risk management has changed.

What has been the most important thing to happen to the energy markets in the last 15 years?

The development of markets that allow people to manage their risk. Since 1994 we’ve had liberalisation of the energy markets and an overall increase in trading, liquidity, hedging and risk management products.

How has risk management changed?

I would say it has grown up. 15 years ago, the role of risk management was still undefined.  We have gone from people not really knowing what it is, to value-at-risk (VaR) being discussed in annual reports and in the national press. Unfortunately, while VaR is more frequently discussed, it is still not well understood.  Part of the problem has been that risk management has a specialist lingo – for example, we talk about VaR, correlations, historical simulation, Monte Carlo, copulae and extreme value theory. Risk reports are more like a weather vane to show whether or not risk has increased today from yesterday. It cannot provide absolute measures like a thermometer.

How has the role of risk manager changed and developed?

The role of risk manager had just been introduced 15 years ago and from there, the role has progressed through a life cycle. When it first came into existence, risk managers were expected to simply measure risk, usually by estimating a VaR. We then progressed to a mitigation function where the aim was to reduce risk. The role has finally emerged into a mature stage where risk management has a central function in a company. The risk manager is no longer playing the role of the speed cop saying here is your limit, he/she is helping the firm select the risk that the company wants to take and getting management to recognise that there is no such thing as riskless profit out there.

What are the challenges facing risk managers today?

Risk managers are like generals in that we tend to fight the last war. We come up with tools that in hindsight would have been great to have before the last crisis. One of the biggest challenges is looking ahead to what could potentially cause losses for a company. The challenge is to always think outside the box and try to think about what could come next. 

Another challenge is selecting our area of focus.  Risk groups tend to report VaR at a 95% level. However, this represents fairly normal market conditions.  We have to decide, if we are managing risk at that level or if we are trying to protect the company from an extreme event.

What is the biggest lesson the market should have learned?

Systemic risk is always bigger than we expect it to be and has more devastating consequences. We frequently make assumptions based upon a lack of correlation, for example that counterparties are independent in default or that prices are independent. When these assumptions are wrong our models can mislead or provide a false sense of security.  Therefore, what we need to do is to consider the implicit assumptions in our models, what the systemic effect could be if everything went bad at once and, finally, what might potentially cause that.

Has the lesson been learned?

There is always more to do and always more refinement needed around the edges.

It is a bit like looking at the old maps that say ‘here there be dragons.’ People don’t want to go and look at these more difficult issues because we already have models that allow us to look very neatly at what is happening in the observable world. Effective risk managers look into these other areas, the dark corners of the map to try and figure out what is going on.

What was the biggest turning point in your career?

It was getting laid off from my job at a bank in 1999. In 1998, I had joined an ex-colleague of mine, David Shimko, and we were working on creating a synthetic clearing house for electricity and gas trading to tackle the credit risk in that market. When the company was acquired, they eliminated our group and David and I decided to start up a consulting company called Risk Capital Management Partners.  Without the impetus of being let go, I don’t know if I would have started the company.

What do you regard as your biggest mistake and how did you learn from it?

My biggest mistakes were related to Risk Capital’s corporate transactions. In retrospect, our initial sale agreement made it difficult to bring additional senior partners into the company.  When we repurchased the company, we borrowed too much money and we settled on the price too quickly.  I would say I now know to be especially diligent in equity transactions.

Who has been most inspirational to you in your career?

David Shimko has been a mentor and I worked with him for nearly fifteen years. I have always respected Vince Kaminski, Les Clewlow and Chris Strickland at Lacima, Valery Kholodny, and Alexander Eydeland who I now work with at Morgan Stanley.  These are all people I have enjoyed working with and hold in the highest regard.

Can the market ever prepare for Black swan events?

You can be aware that a black swan event could happen but the question is whether you can do anything about it. I think the definition of ‘prepare’ becomes important. I think we can be aware of them and we can even potentially predict the possibilities but coming up with a viable risk mitigation strategy can be extremely difficult. If there is a one in a billion chance of something happening that could cause a billion dollar loss and potentially kill the entire company, is it worth paying $10 to stop that event? Is it worth paying $1,000?  How does the answer change if I can identify a million of these type of events?  While I can mitigate the risk, if it is at an expected loss then this becomes a very difficult cost benefit analysis.  

What have you been most proud of in the papers you have written for Energy Risk over the years?

The article I enjoyed writing the most was titled ‘How to spot a VaR Cheat’ in May 2003.  My original title for the article was ‘A trader’s guide to cheating VaR.’ It was fun because I was exposing all the weaknesses and assumptions in the VaR calculations as a “guide” for traders to game the system.  Of course, good risk managers knew all these things but it did feel a little bit like a magician showing how the tricks were done.