white paper: analyzing counterparty credit risk

Transcription

1 white paper: analyzing counterparty credit risk A White Paper sponsored by Allegro Development Corp. November 2010 Credit risk management for energy companies Roiled credit markets, fluctuating energy prices and Dodd-Frank move credit to the front seat. he Dodd-Frank Wall Street Reform and Consumer Protection Act enacted in the midst of a slow recovery in the United States from the Great Recession is the most comprehensive financial reform act passed by a U.S. Congress since the 1930s. The act includes provisions that impact energy companies that typically hedge their exposure to volatile oil and gas prices and other business risks. Much remains uncertain, however, regarding the legislation s detailed execution. An extraordinary amount of rule-making by the Commodity Futures Trading Commission (CFTC), Securities and Exchange Commission (SEC) and others is needed first. More specifically, the Act s Title VII establishes a regulatory structure for derivatives, including commodity hedges. To continue over-the-counter, direct hedging with counterparties, energy companies as well as others will need to demonstrate they are commercial end users. This will almost surely be determined based on multiple factors, but it has not yet been specified what those will be, or what weight each will have. Nor are reporting requirements for energy companies with commercial-end-user status clear yet. Nevertheless, energy companies should prepare to spend time being measured by the CFTC to determine whether they can enter over-the-counter hedges. Use of risk analyses to determine commercial-end-user status is already under discussion, amongst other parameters. It is likely that an energy company will need to demonstrate a credit profile, including for its counterparties, consistent with its stated strategy. T Given the uncertainty of the situation, but cognizant of the general drift, experts say energy companies would be well served to strengthen credit risk management policy as part of their hedging and risk-management strategy. Going forward, an energy company should be able to present a thorough, near real-time analysis of its and its counterparties credit-worthiness. The ability to do so may make a difference in terms of regulatory regime, margin requirements and total risk profile attainable. Other factors weigh in as well, including credit markets that remain troubled and the prospect of renewed energy price volatility. As in any time of uncertainty, sound evaluation of credit risk the potential loss caused by nonpayment or nonperformance of a 1 customer or counterparty is a more major concern than ever. Fortunately, solutions exist today to help energy companies effectively tackle the new challenges in credit risk. Changed credit markets Energy companies operate in an environment of uncertainty when it comes to the emerging regulatory structure, energy market prices and the state of credit markets. Dr. Praveen Kumar, chair, department of finance, the C.T. Bauer College of Business at the University of Houston, believes petroleum price volatility will continue. This uncertainty of course colors how well managers can evaluate credit risk. Kumar told Hart s E&P magazine that one big reason for continuing volatility is

2 that national oil companies, whose governments use oil revenues as a political tool, are likely to overreact on the supply side to any rise in demand, sending rising prices spiraling back down again. To succeed in such an environment, Kumar said companies must factor what he calls embedded optionality into their planning and riskmanagement processes. Moreover, credit markets haven t yet recovered from the 2008 economic crisis. While oil and gas industry credit markets are said to be reasonably accessible, other areas of the economy remain frozen. Even then, in a recent posting, Michael Corley of Mercatus Energy Advisors, Houston, notes, We ve received numerous inquiries from oil and gas producers that are being forced to find new hedging counterparties most often due to credit-related issues. He notes the following reasons for the change: Fewer E&P credit facilities, reducing credit available for hedging, Banks and energy companies cutting back trading desks, Counterparties, both banks and energy companies, reassessing risk tolerance, and severing relationships with all but their best or largest customers. Given continuing uncertainty in oil and gas markets, energy companies must determine whether counterparties have survived the turmoil or remain in danger. They must ask what assumptions have these parties made, in terms of projected interest rates and future petroleum prices, as the basis for their trades? What hedging strategies have been invoked? What is their credit profile? Credit risk and reward Until recently, most companies considered credit risk to be a poor cousin compared to the need for realistic market-risk evaluation. Yet sound credit risk management is an important component of industry best practices. With larger amounts of capital at risk, and with extreme volatility in commodity markets, traditional methods for evaluating risk have become ineffective, says Allegro s Michael Hinton, Chief Customer Officer. In the past it was considered sufficient to look at the credit ratings of counterparties once a month or even once a quarter. Today, even looking at credit data in near real time is inadequate. You have to consider the indicators of future risk as well. 2 Paul Evans, former treasurer of Northwestern Energy Corp., a regulated utility holding company based in Sioux Falls, S.D., agrees. During his seven-year tenure, he instituted daily monitoring of credit risk at Northwestern, which was trying to improve its own credit rating. But he also demanded daily information on its counterparties and business partners. He didn t believe in relying solely on third-party credit rating agencies such as Standard & Poor s Ratings Services, Moody s Investors Service, or Fitch Ratings. There is a close relationship between credit risk and the liquidity of a company, which affects your financing capability, and as a counterparty affects how you do business, Evans says. Published credit ratings are a traditional source for information about a company s credit worthiness. However, the much-publicized conflicts and inadequacies that lie behind the ratings provided by the agencies have sown doubts about their efficacy. Even then, many small- and mid-sized companies don t have published credit ratings. To evaluate these companies, some depend on scoring models that combine

3 historical financial statements and data about similar companies to piece together a profile. The inadequacy of this approach is obvious, as it fails to take into account special circumstances related to a company or industry sector. Energy traders too often work based on the best information available at the time, Hinton says. It amounts to saying, you have this much credit at that point in time, but the counterparty credit profile may have deteriorated since that point in time. There is also the issue of integration with the physical supply chain. For some energy companies, hundreds or thousands of transactions per day may be the rule. Yet surveys indicate most manage the increasing volumes using spreadsheets, internally developed, or custom software applications. Given today s environment, legacy enterprise applications don t have the functionality or integration with other risk functions needed for holistic credit management. For one, it s difficult to aggregate standalone spreadsheets to bring to light total exposure, as well as where credit risk is concentrated, how it is likely to change over time and its relation to cash flow. Without automated roles-based workflow across disparate systems it is difficult to achieve standard business processes. Without connectivity to the physical supply chain and logistics networks, important events that impact credit risk can go undetected. The limitations of today s way of doing things are all too readily apparent. The credit risk function must become a fullfledged member of any program and tool set for energy trading and risk management. Credit information must be complete, accurate and timely and easily accessible to decision makers. And it is possible today to manage credit risk holistic to other forms of risk, and to integrate directly with needed information and analytic tools. Workflows mirror business processes, and promote management by exception through use of alerts and other means. The problem may be most acute, concludes Hinton, for small and mid-sized companies that don t have the resources of a BP or ExxonMobil. They don t have the tools to deal with credit risk comprehensively. A strategic enterprise solution Real-time information, integration, workflow and analytics act as pillars in the new environment. Oil and gas producers as well as energy companies of all types face increasing challenges in credit risk management due to the post-crisis regulatory regime being put in place, continuing credit market uncertainty, commodity price volatility, and gaps in information related to credit risk, especially that for counterparties. As part of overall risk management, the credit risk function has relevance from the front office, where traders and marketers buy and sell, through the back office, where counterparty information is collected, analyzed and integrated in overall trading and risk management. Credit and liquidity must be managed as key components in a strategy for value creation and risk management. Besides evaluating counterparty risk, the credit risk group negotiates key contractual credit terms, establishes limits, measures portfolio exposures and default risk, estimates potential exposures and manages collateral received and distributed. An additional role is mitigating risk by identifying potential netting and setoff rights to reduce exposures, and potential collateral obligations, to be executed by others. Credit risk management must be part of an overall business plan because companies evaluate volatility in trading or hedging in relation to the potential cost of credit and finite liquidity availability. Credit limits must be established not just for individual counterparties but also for concentration in industry segments, commodities, geographies and credit-rating categories. Existing ways to evaluate and manage credit risk between counterparties typically are lacking in these areas. Most companies can t, in a timely manner, measure current and future exposure, or build robust credit risk models to rate counterparty credit scores. Executives want to understand the financial risk inherent to their aggregate position with regard to commodity price, bank liquidity, and other parameters. In other words, they must have insight into potential problems lurking beneath the surface of their own credit and risk profile. In a paper from Empirical Risk Consulting, Eddie R. Meche, president, points out: The pricing of credit risk and liquidity costs into a business plan and charging such costs to business units should be attempted, but is not enough. Since liquidity is a finite resource, it should be budgeted and allocated across the organization based on the consolidated risk-reward framework. An integrated approach to effective credit risk management, Meche says, Depends on information that is shared and acted upon in a consistent manner across the entire enterprise including accounting; commercial trading, marketing and hedging; scheduling and logistics; and treasury. Energy companies have spent hundreds of millions of dollars on enterprise systems and risk-management systems. However, until recently, credit risk management has been treated like a poor stepchild. Credit risk groups have been faced with an extremely time-consuming, manual effort whenever they sought to consolidate information, Meche says. Systems response Energy trading and risk management (ETRM) solutions emerged as a result of the recognized need for a more holistic approach to risk management, and the inadequacy of enterprise resources planning systems to do the job. Most recently, credit risk management is being incorporated into ETRM as a key ingredient. In one important example, Allegro Development Corp., a global leader in ETRM solutions, has introduced Credit 8.1 as a fully integrated part of their ETRM system. The system supports evaluation of every aspect of counterparty credit risk and liquidity to derive a profile of current and future exposure. Perspectives from the real-world experi- 3

4 ence of several Allegro clients, representing different transaction models found in the energy industry, influenced development of Credit 8.1. As part of an integrated ETRM solution, consolidated counterparty hierarchy details and a system of record are established for effective credit risk management. First, it automates acquisition of current, comprehensive data through interfaces with external rating agencies. Transparency into counterparty credit status includes scoring and rating details, limited breaches and warnings and measurement of mark-tomarket and unsecured exposure. Risk managers can monitor daily collateral, margin and liquidity requirements, and construct credit risk scoring models by integrating current rating-agency data with proprietary information. With access to this timely and accurate credit data, managers can gain better transparency into a counterpartys credit status and make real-time decisions based on that data. It is important to evaluate effects of counterparty agreements with and without netting. Energy companies today combine potential future exposure measures with recovery rates and default probabilities to calculate credit-value-at-risk measurement. According to David Johnson, a managing director at Protiviti, Energy traders often have forward transactions that extend two to three years into the future. These transactions are highly vulnerable to fluctuating energy prices and often require significant levels of collateral or margins. There is thus a need to extend beyond the present, to support a forecast of counterparties potential future credit situation, including: Market and credit event liquidity adequacy stress testing, Credit-value-at-risk analysis, Potential future-exposure analysis, Walk-forward analysis. Timely and accurate collateral data allows a comprehensive view of counterparty liquidity, including collateral status, obligations and disputes as well as functionality for default risk and recovery. Workflow and supply chain To Michael Hinton, of Allegro, integration of credit risk within an enterprise system is the secret sauce. This integration allows managers to define a workflow that links credit risk management directly to other business processes such as logistics. If a counterparty approaches or exceeds a credit limit, the system can automatically prompt users to take action on that information to mitigate additional exposure. You re embedding that physical supply chain and its current status in your system, says Hinton. That s powerful when it comes to deciding whether, for example, to release a shipment. In such a case, a shipment might be held until additional collateral or other means have been deployed to reduce overall exposure. Allegro s configurable workflow and messaging include customized approval mechanisms set up within the system that can automatically notify management, colleagues or external parties of actions required to complete deals. Combined with Allegro credit risk management functionality Integrated rating agency data to monitor daily collateral, margin and liquidity requirements. the Allegro Credit component, credit limits and positions with trading counterparties are checked and verified as part of trade entry. Current credit positions and as many as six time periods into the future can be viewed. Allegro s credit risk solution provides comprehensive tools and delivers the transparency needed in a marketplace where price volatility and credit questions rule the day. Users analyze and forecast counterparty credit profiles. They capture real-time credit information available from multiple sources; analyze counterparty liquidity, collateral, default potential and the possibility of recovery. Further, integration of Credit 8.1 into the rest of the Allegro 8 platform gives traders current and accurate counterparty credit data, supporting more profitable trading. Integration with trade-capture and contract-management functions reveals credit exposure associated with those physical and derivative positions. This is what s needed in markets defined by price volatility, increased credit markets and increasing regulatory burden. Amidst such uncertainty, industry participants say market-risk controls alone are no longer the sole measure of good credit risk management. The need to view portfolio exposure on a real-time basis takes a company beyond evaluating credit risk by means of spreadsheets and home-grown software applications. Today s advanced solutions, such as those provided by Allegro Development, provide a holistic view of credit and other forms of risk, and are integrated directly with the essential trading, logistics and analytic tools that energy companies need. Credit Connect 8.1, as a component of the Allegro 8 platform, provides real-time access to credit and financial data, including credit ratings, company financials, credit metrics, market implied ratings, credit default swap (CDS) pricing, and other key credit data for portfolio analysis. With today s tight credit markets, commodity price volatility and heightened counterparty risk, companies need realtime credit risk management across all commodities and business transactions, says Allegro s Michael Hinton. Allegro automates the retrieval of current rating agency data, reduces time needed to analyze credit-adjusted financials, and identifies outliers on specific performance metrics. Customers gain a competitive advantage in mitigating credit risk and making critical portfolio decisions. Allegro s Credit Connect 8.1 automates import of credit rating data, fundamental data, and business entity information from Interactive Data Corp. Risk managers can easily monitor up-todate collateral, margin and liquidity requirements, access Moody s, S&P and Fitch ratings data and construct credit risk scoring models. Credit Connect works with Allegro s Credit 8.1, integrated with more than 30 business components in Allegro 8 for trading, risk management, operations, logistics, optimization, systems integration, and accounting. 4

5 About Allegro Development Allegro is a global leader in energy trading and risk management solutions for power and gas utilities, refiners, producers, traders and commodity consumers. With more than 26 years of deep industry expertise, Allegro s enterprise platform drives profitability and efficiency across front, middle and back offices, while managing the complex logistics associated with physical commodities. Allegro provides customers with flexible solutions to manage risk across gas, power, coal, crude, petroleum, agricultural, emissions and other commodity markets, allowing decision makers to hedge and execute with confidence. Allegro has recently been recognized as the Energy Risk Software House of the Year and received The Energy Business Awards Gold Award for Excellence. Headquartered in Dallas, Texas, Allegro has offices in Calgary, Houston, London, Singapore and Zurich, along with a global network of partners. To learn more about Allegro s credit risk management functionality, visit 5