The looming global economic downturn and high levels of corporate debt mean that the energy industry will have to cope with widespread downgrades and an increased likelihood of defaults. In order to get through the crisis, energy trading companies should strengthen their credit risk management and be prepared for the worst-case scenarios.
As governments and individuals across the world are trying to cope with the threats posed by the Covid-19 pandemic, the global economy is heading towards a downturn that will test the resilience of entire industries.
The implications of an economic slump will be amplified by record levels of corporate debt that have piled up over the last decade. Companies borrowed heavily cheap money to support their expansion in a growth cycle and boosted their stock prices through dividend increases and buybacks. In the low-yield government bonds environment, investors saw lending to riskier companies as an opportunity to increase returns. As of December 2019, global corporate debt amounted to an all-time high of $75 trillion, of which $13.5 trillion was in corporate bonds - twice the amount of total corporate debt at the end of 2008 in real terms (Source: OECD).
Energy companies are at the forefront of this trend. Utilities globally have almost $700 billion, while the Oil and Gas sector almost half a trillion of corporate debt maturing by end of 2024 (Source: S&P Global Ratings). Combined, they account for the largest global debt exposure across all industries. On top of this, energy companies are the largest issuers of junk bonds and account for 11% of the US high-yield market. Morgan Stanley estimates that 67% of investment grade debt issued by energy companies is rated BBB.
In times of high market price volatility, oil price shocks, and expected contractions in supply and demand, there is an increased likelihood of widespread downgrades and defaults on the market. Energy trading firms are thus particularly exposed to the current developments and should be taking the following immediate actions to identify weak points in their credit risk management framework and mitigate the trading counterparty related risks:
1. Identify risk
Given the fast-moving market conditions, it is challenging to simultaneously update and revise fundamental risk parameters for all counterparties. A structured and systematic approach is required to prioritize which counterparties should be (re-)assessed first, possibly on a daily or bi-weekly basis. Furthermore, credit risk departments should review their ability to identify particularly risky exposure concentrations (eg, sectors, countries, commodities) and hidden potential risk carriers. A recommended approach should include a review of:
Data gaps, based for instance on date of last review/checks or last date of external rating used in internal scoring models
Positions with high sensitivity to market risk
Scenario analysis and implication of counterparties downgrades (eg, through legal connections).
2. Mitigate risk
Once the potential risk carriers have been identified, it is necessary to define and implement actions to reduce concentrations and exposure of high-risk counterparties (eg, offsetting trades, tailoring broker instructions, opening sleeves). Potential steps include the definition and implementation of more conservative trading rules and controls, aiming primarily for high-risk mitigation effects with low business restriction impact (eg, reduction of limits, introduction of additional approvals, 4-eyes checks).
3. Prepare for the worst
The key to survive a crisis is to be well informed and operationally prepared to take timely actions in a rapidly changing landscape. Firms should build a crisis management team with representatives from Risk Management, Trading, Legal, Compliance, Finance, Treasury, and Accounting. This committee should analyse the relevant information on daily basis, have an action plan for different scenarios, and have the necessary authorisations to carry out their decisions. In order to enable the effective operation of such a team, it is necessary to:
Define the information which is essential for decision making, and set up appropriate reporting frequencies or event triggers
Establish a daily, where possible intraday, holistic view on the firm‘s liquidity, net cash outflows and liquidity demand with different time horizons
Define and test the action plan and governance in case of a counterparty default, agree on the set of scenario tactics (eg, actions that will be taken in case A or in case B, who is in charged, who needs to be informed)
At Baringa, we have experts to discuss any of the above with you and help CROs respond to the challenges of the crisis. All our consultants are set up to work remotely, and our collaboration tools allow us to partner with our clients and help them through these challenging times. Please reach out to Henning Bottger or Andrey Shutov to arrange a call.