Putting energy into credit

High oil prices mean more banks are looking to get involved in the energy business. But with many energy companies below investment-grade, banks are getting creative in how they structure the deals to mitigate credit risk. By Duncan Wood

Energy trading is big business again. After taking a nasty post-Enron hit, analysts say energy and commodity revenues at US financial services firms rebounded to $8 billion in 2004, and a host of banks have decided that they want a piece of the action. But this resurgent business is not quite the same as it used to be. Many companies that have most need for protection from volatile markets are struggling to remain creditworthy, and Enron's collapse has left bankers extra-sensitive to counterparty exposures. As a result, today's energy trading operations are being forced to spend much of their time looking for smart ways to mitigate and manage credit risk.

"I'd say we spend as much time structuring credit as we do structuring energy," says Catherine Flax, a New York-based managing director and head of power and gas origination at JP Morgan.

Bankers elsewhere tell the same story: "I'm a commodities structurer and I've spent the last three years working on credit," says Brad Blesie, a managing director in commodity structuring at Deutsche Bank in New York. "Our work right now is 70% credit and 30% commodity. It's a huge issue for everybody."

Enron's collapse was a wake-up call for traders who had previously tended to focus on pricing and execution. Once bitten, banks became twice shy. Many shuttered their operations or reined in their credit appetite. An across-the-board surge in energy prices and volatility has now lured them back – but energy trading is no place for the faint-hearted.

Many of the natural customers for energy hedges are junk-rated, according to Standard & Poor's (S&P). At the end of October, 56% of the chemicals companies rated by the agency were below investment-grade. For metals and mining companies, that figure was 46%. For transportation it was 41%. Global oil and gas companies and utilities were more creditworthy, with 31% and 17% of issuers, respectively, carrying sub-investment-grade ratings.

"Even the large companies are barely A-rated, and as they get smaller, the ratings tend to drop. There are a lot of sub-investment-grade customers in the commodities universe," says Benoit de Vitry, London-based head of commodities at Barclays Capital.

One commercial banker sums it up more bluntly: "Generating companies are often owned by project finance entities, so they've got no credit quality. Retail providers have no credit. Airlines, refineries – energy is full of people with no credit."

Getting transactions done with these counterparties isn't easy. Two of the tools most commonly used to manage credit risk – default swaps and cash collateral – are of limited use when dealing with small or low-rated companies. Few low-rated companies have spare cash to use as collateral, while buying protection in the credit default swaps market could be pricy. Instead, banks have to explore other avenues. This isn't totally unwelcome to the commercial banks, which claim they are better at managing credit risk than the market's two undisputed leaders, Goldman Sachs and Morgan Stanley. That's a claim the investment banks dispute (see box).

"If we have a client that we know well and we want to deal with them, but we can't take on the counterparty risk at that precise moment, we normally find a way to get it done," says Barclays Capital's de Vitry. "You just have to use your imagination and the tools that the market have created over the past few years."

Portfolio management

Some of the solutions being employed by banks fall into the realm of portfolio management. If a transaction would result in the bank taking on too great a concentration of risk to a single counterparty, industry, or geographic region, the bank can make room for it by reducing its aggregate exposure. That might mean selling down another trade with the same counterparty, or buying protection against companies in the same industry sector.

Many solutions have to happen at the transaction level, however, and are often motivated in part by the counterparty's desire to avoid margin payments – a situation that energy producers are frequently faced with when selling their products forward, says Jean-Marc Bonnefous, head of commodity derivatives trading at BNP Paribas in London. As prices rise, the bank's exposure increases, triggering a call for extra cash or securities. "If the transaction is backed by an open line of credit, then there's no problem because no collateral is required," he says. "But if it's capped, the producer has to find cash via some kind of credit or financing facility."

One option in these situations could be for the bank to hedge its counterparty exposure dynamically – by buying protection in the credit derivatives market as the exposure increases, for example. This could remove the need for collateral. "These types of decisions have to be made at the onset of the transaction and therefore priced in the deal," says Barclays Capital's de Vitry. Another approach could be a so-called "extinguishable derivative" where the exposure between the counterparties disappears should a specificied credit event occur, he says.

Other approaches require more subtle calculations. In the current environment of high energy prices, so-called 'right-way risk' can help banks mitigate their credit exposure, argues Deutsche's Blesie. "The big thing we do a lot of analysis on is the correlation between higher market prices for energy and improvements in the producer's credit quality," he says. This correlation is based on the observation that a producer's assets increase in value as the price of its product rises. So, even as a bank's mark-to-market exposure increases, the risk may be mitigated by a simultaneous improvement in the counterparty's ability to pay.

Of course, it's not simple to work out what degree of correlation there is between, say, the market value of natural gas and the value of gas reserves. "You can't count on 100% correlation," Blesie admits. Nevertheless, many banks are happy to take on extra counterparty exposure, so long as they believe the value of that counterparty's assets is on the up. Sometimes the bank will attempt to secure a claim on those assets as added security in the event of default, but in many cases, just knowing that the company's value is improving is enough to make the bank comfortable.

"If the asset values are increasing at the same rate that our credit exposure is increasing, we're happy to deal with them," says BNP Paribas' Bonnefous. "Most of these cases are unsecured, but if you can also get security it becomes a very efficient model."

The preferred form of security for most over-the-counter derivatives transactions is cash. But few junk-rated companies have much in the bank, and credit can be expensive, so energy traders have had to adopt a more flexible approach here too. Today, banks will accept as collateral claims on a wide variety of physical assets that would not have passed muster a couple of years ago, says JP Morgan's Flax. A standard example is the use of a second lien on a power plant, she says. "It's not exotic, but two years ago you didn't see it happening at all. It has now become more common."

More unusually, she says, there can be instances where the counterparty has an exposure to energy prices, but no energy-related assets to act as physical security – as is the case with airlines. Deals can be done in these circumstances by 'carving off' assets that are held as security for an existing loan. So, a jet fuel derivatives deal might end up being backed by ticket receivables, for example – an approach Flax describes as "a little unorthodox, but if you've got an open commodity exposure, it's arguably somewhat like a loan, so why not secure it in the same way?".

Security sources

New asset classes are also attracting attention as potential sources of security. In the energy sector, the evolution of emissions trading might provide some otherwise asset-poor companies with a way of collateralising energy transactions. Three years ago, JP Morgan's Flax structured a transaction for a US power developer in which emissions credits were used as collateral. The potential is there for derivatives deals to be collateralised in the same way, she says, but few if any transactions have been done at this point.

The reason that physical assets are not widely used as collateral is because they're often not easy to liquidate in the event of default. Accepting a claim on a valuable power plant might give a bank the impression that its counterparty risk is covered, but in the event of an actual default, turning that claim into cash requires some work. As a result, John Iglehart, a London-based managing director with Goldman Sachs and head of commodity sales, warns that banks need to adopt a hard-headed approach to collateralisation. "You can take hard assets as collateral, but if you end up owning a facility in West Africa, you don't really want to run down there and take it over," he says.

An alternative to the use of collateral is to put on a separate trade that would help offset the impact of a counterparty's bankruptcy, says JP Morgan's Flax. "If a power plant goes bankrupt, you could be required to continue providing power at high prices. You need to manage the link between your credit exposure and rising power prices and find a trade to minimise the potential impact."

In this example, she says, the off-setting trade would be a deep out-of-the-money power call. The option to buy power at a low price would increase in value as power prices rose, "so you know that if the company goes bankrupt you're able to make money", she says.

One London-based commercial banker says all the bank's energy trading desks have joint ventures with their counterparts in credit trading. He recalls a deal from last year, where the bank's counterparty exposure to a large UK corporate was closely correlated with the price of natural gas. The energy and credit desks managed to offset the risk by transacting a UK natural gas swap and a series of five-year credit default swaps. The effect, he says, was to "exactly mirror the exposure we had on the gas desk".

If banks can find ways to replicate their counterparty credit risk with a combination of vanilla trades, they can also go looking for investors that are willing to take the risk off their hands entirely, says Elad Shraga, Deutsche's head of structured credit trading for North America – and this is an approach that Deutsche has used frequently. "There are investors in this space, principally hedge funds, that will happily take the risk if the spread is attractive enough and if they're convinced that the underlying story is favourable," he says.

Other banks employ the same approach. "The trick is to create an investable instrument – a swap or bond – that matches the credit risk you've got on your books and then to move that risk on to investors," says one London-based commercial banker.

There are open questions about how the industry's credit risk management will hold up in the event of widespread distress, and while it might appear dangerous to be doing so much business at the riskier end of the ratings spectrum, JP Morgan's Flax says standards have improved. "Five years ago, no-one paid any attention to this. People figured that if it was an asset-owner it wasn't going to go bankrupt. Today, the market is much more sensitive to credit – but, increasingly, we are finding solutions." n

The dominance of Goldman Sachs and Morgan Stanley in energy trading is such that analysts at New York-based investment research firm Bernstein Research feel it can be legitimately seen as a "duopoly". According to Bernstein's estimates, the two investment banks together earned around a third of the US financial services industry's $8 billion in 2004 commodity revenues.

It's not easy to challenge an empire, but commercial banks believe the growing importance of credit plays to their strengths – the ability to measure and manage credit risk. Catherine Flax, a New York-based managing director and head of power and gas origination with JP Morgan, worked at Morgan Stanley and UBS prior to joining JP Morgan this year. "The credit and risk management expertise at JP Morgan enables us to structure solutions for clients in ways other firms can't."

Kevin Rodgers, head of commodities derivatives trading at Deutsche Bank in London, says mimicking the investment banks' strategy is a recipe for disaster. "You've got to look at your own strengths, and one of the many strengths we have is in credit trading and credit risk management. That's one way we've found to outflank the big guys."

One US-based commercial banker says: "The investment banks should have the requisite skill-sets, but I've not seen them be as effective as we are in the market. We are brought deals that they can't do."

Goldman Sachs and Morgan Stanley dispute these claims. "There's no doubt that credit is critical and the range of things we'll do has expanded over the years, but I've not seen anything from the commercial banks that we've never seen before, so I take some umbrage at claims that they are being more creative than us," says an energy trader with one of the two investment banks.

Other observers are also sceptical. Shannon Burchett, president of Dallas-based consultancy Risk Limited Corp, has previously worked in energy trading for both an investment bank (Salomon Brothers – now part of Citigroup) and a commercial bank (Chase Manhattan – now part of JP Morgan). He accepts that "managing credit risk is arguably the commercial banks' core business", but is sceptical about claims that the investment banks are unable to get transactions done because of a weakness in this area. "When there's money on the table, the investment banks can be as creative as anyone," he says.

Jeffery Hart, a senior research analyst with Sandler O'Neill in Chicago, argues that the commercial banks may be trying to make a virtue out of a necessity. "They're trying to get into a strong market and it sounds more like they're lowering their standards and moving down the chain."

The investment banker sees it the same way: "They may call it creativity, but it's really about them easing their credit terms." He's not expecting the commercial banks to stick around for long. "We're not worried. We're working in markets where you can get 30–50% volatilities. A lot of commercial banks are bringing people in from fixed-income, where they're used to volatility of 15–20%. These people come in, make a big splash, throw lots of money around and then, when the markets get ugly, they fade away again."