Beware the pitfalls of right- and wrong-way risk

Credit exposure can be hazardous. Misinterpreting the risks posed can be ruinous

Right and wrong

Identifying right- and wrong-way risk is crucial in managing risk. Often risk managers within the energy sector struggle to identify which kind of risk they face and the consequences can be catastrophic.

The International Swaps and Derivatives Association defines wrong-way risk as the risk that occurs when “exposure to a counterparty is adversely correlated with the credit quality of that counterparty”. In essence, it arises when default risk and credit exposure increase together. Right-way risk is the opposite: exposure to a counterparty and credit quality are favourably correlated. Good risk management can mitigate exposures to wrong-way risk and promote transactions characterised by right-way risk, but it’s a hazardous undertaking and one should be aware of the dangers of an oversimplified approach.

According to Isda, there are two types of wrong-way risk. Banks face specific wrong-way risk when they occasionally collateralise with their own or a related party’s shares. The Enron saga provides a useful example: in 1999, the company chose to hedge risk related to certain merchant investments with an entity called LJM, which was set up and run by Enron’s chief financial officer and effectively funded through Enron shares. So if Enron’s stock price dropped, LJM would struggle. Enron’s management effectively created a pool of highly toxic risks, which became part the firm’s ultimate self-destruction.

The second kind of wrong-way risk – general – arises when a counterparty’s credit quality is correlated with a macroeconomic factor. For example, a natural gas producer enters into a swap, receiving a fixed price and paying a floating rate. If gas prices go up, the producer is incentivised to walk away from the transaction, either by defaulting or by finding a legal excuse to get out (this is what lawyers are for). At the same time, its credit quality deteriorates as it pays increasing floating prices. From the point of view of the hedge provider, this is wrong-way risk.

The hedge provider can ask the producer to post collateral, but that’s not always an option as producers are typically strapped for cash. Instead, the hedge provider can extend credit secured against the producer’s assets. A rising gas price will likely lead to an increase in the value of those assets, potentially offsetting any increase in credit exposure.

These types of credit agreements are not uncommon, but there are hidden dangers that risk managers often overlook. Firstly, the assets used as a security for the loan are encumbered, reducing the gas producer’s borrowing capacity. Should the producer encounter an emergency and need funds immediately, it may find itself unable to borrow from other lenders as assets are tied up with the initial credit agreement. The best the producer can hope for is an extension of the credit terms with the hedge provider – with whom it becomes a captive customer.

There are many examples of lenders and hedge providers assuming they face right-way risk, engaging in wishful thinking and foregoing due diligence

Secondly, one of the dangers of poorly designed hedges can be found in the timing of the cashflows. A hedger often enjoys the benefits of improved market conditions one day at a time, whereas the credit exposure related to hedges changes across their entire time horizon. A natural gas producer might hedge a significant percentage of the current year’s production (often 70–100%), a smaller percentage of year two output (50–60%) and an even smaller percentage (20–30%) of that expected for years three and four. It is a rational strategy, but an upward shift in the forward price curve will increase credit exposure along the hedge’s entire maturity structure, while the benefits of higher prices will accrue over time. A requirement to post collateral can stress cashflows, so it is understandable why companies choose to rely on a credit facility secured with the company’s assets. But remember, overall borrowing capacity is reduced and the loan can be expensive.

Lastly, dealing with any kind of risk requires a robust due diligence process and often when energy companies hedge they assume the risk has disappeared. If our gas producer has sold his entire expected production for the next few years, rising prices have no positive impact on his credit quality. They may even generate negative outcomes: with the higher gas price, producers tend to raise output, which can lead to a surge in operating costs. Sand – used in hydraulic fracturing – has seen an increase in value recently with the growth in US drilling activity, for example.

There are many examples of lenders and hedge providers assuming they face right-way risk, engaging in wishful thinking and foregoing due diligence. Ashanti Goldfields had been using financial instruments to hedge gold production but, in October 1999, a short-lived spike in prices resulted in a liquidity crisis. Facing losses of around $250 million–$280 million, the company was forced to restructure its hedge portfolio and issue additional shares.

According to Ayowa Taylor in her doctoral thesis at the London School of Economics, Ashanti expected gold to trade at between $250 and $270 per ounce, so arranged hedges to realise the price of at least $355. Downside protection was achieved by selling future production forward and buying puts that came to a total of 36% of reserves. The puts were funded through the sale of call options, on about 15.5% of the reserves. About 33.6% of the reserves were committed to lease rate swaps, under which Ashanti paid a floating lease rate in exchange for a fixed lease rate.

Gold lease rates require explanation: say, a mining company expects a thousand ounces of gold production. There is, however, a time lag between extracting metal ore from the ground and delivering refined product. But the company has expenses to pay, such as wages and other running costs, so it might borrow gold from a bullion bank, sell it for cash to pay its bills, then pay the bank back in its own now-refined gold. The difference in the value of the gold received and returned represents the lease rate. The actual details of such transactions are more complicated, but this description captures the essence of the deal.

It seems ironic that a market development a casual observer would interpret as positive for the miner – higher gold prices – carried the seeds of the miner’s destruction due to an imprudent hedging strategy

When Ashanti initially structured its hedges, the lease rate was below 1.4%. Every percentage point increase in the lease rates would reduce the target price of the hedging strategy – $355 per ounce – by $20.

In 1999, central banks were criticised for monetising their gold reserves – which was considered to be lowering the value of gold crucial to the export economies of several developing nations. So, in late September that year, 15 European central banks declared a moratorium on bullion sales and gold leasing with the intention of reducing derivatives trading. Gold prices spiked by 20% and the lease rate topped 9% by the end of the month.

As a result, Ashanti’s hedge book value fell from $290 million in June to negative $570 million by October, and banks made a collateral call of $270 million. The company did not have liquid assets anywhere near that amount. In February 2000, the company negotiated a waiver from its collateral obligations for three years in exchange for warrants on 15% of its equity.

Essentially, Ashanti made directional price bets masquerading as hedging operations. The success of the strategy was predicated on falling gold prices, which would allow the company to return gold borrowed from the bullion banks at a lesser value. It seems ironic that a market development a casual observer would interpret as positive for the miner – higher gold prices – carried the seeds of the miner’s destruction due to an imprudent hedging strategy. No risk manager should jump to conclusions without considering such hidden dangers.

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