Energy Risk - A Refined Approach For Assessing Liquidity Risk in US Energy Trading Operations
Tobias Hsieh and Arthur F Simonson , New York (http://www.riskcenter.com), Feb. 28, 2003

Assessing the credit risk of energy trading operations entails analyzing three key risks: market risk, credit risk, and operational risk.

Standard & Poor's uses a capital adequacy and liquidity model as the basis for determining credit quality for energy trading operations. Recently, however, Standard & Poor's has begun to refine its analysis of the adequacy of liquidity for trading operations. When assessing the credit quality of an energy trading operation, the overarching credit concern is the company's ability to attract and maintain adequate liquidity to fund potential losses and collateral calls that may occur. The adequacy of liquidity has become paramount when evaluating energy trading operations and has been a primary factor in many downgrades of energy merchants.

What Is Liquidity Risk? Measuring Liquidity Adequacy

To understand liquidity risk, it is useful to relate it to both market risk and credit risk. An entity's adequacy of liquidity will be measured, in part, by its exposure to market and credit risks. Market risk is the adverse effect market price movements have on a given portfolio. Although daily price movements affect the value of all trading positions in a portfolio, only unhedged positions affect a portfolio's overall value (upward and/or downward).

Credit risk is the trading operation's exposure to its trading partners' credit quality. A trading partner is concerned with its counterparties' ability to make contractual payments or deliver a specified energy commodity. For instance, a trading operation may purchase a forward position from counterparty A to hedge an open position, but if counterparty A defaults, the previously hedged position may run afoul.

Such a credit breach, if not rehedged, would then expose the portfolio to potentially undesirable marketprice movements. Moreover, if the position were purchased for speculative purposes, the speculative bet would be unraveled.

To temper market risk and credit risk, a trading operation needs adequate liquidity to fund collateral calls that may occur due to a downgrade and/or a significant price movement in the out-of-the-money trading positions. When Standard & Poor's refers to liquidity risk, it is referring to the risk that a trading operation's need for cash collateral may exceed its total liquidity resources. Strong risk –management practices dictate that companies with energy trading operations need to evaluate their specific liquidity requirements and ensure that adequate levels of cash and established credit lines are firmly in place.

For example, a portion of a company's overall credit line should be set aside for a potential collateral call and should not be intended for any other use. The evaluation of liquidity needs should also be done frequently to reflect trading portfolio changes.

These liquidity resources normally are cash and credit lines. To meet liquidity demands, companies typically draw on either cash on hand, established bank lines either at the trading operation or at a parent, or through affiliate intercompany loans. Like other businesses, a trading operation has a variety of needs for liquidity, such as the need to finance the imbalance between receivables (working capital) and payables or to provide appropriate inventory levels or to fund capital expenditures. Unlike most businesses, however, a trading operation can be subject to an enormous collateral call by its trading partners or incur large trading losses that could quickly exhaust liquidity.

In Standard & Poor's opinion, there are two factors that drive demand for liquidity associated with collateral calls. First is the size of a trading operation's energy commodity position; the contract tenor, as well as the specific price volatility of the commodity. Second is the company's own credit rating and its ability to maintain a solid rating.

To measure a trading operation's exposure to market price movements, and the resulting collateral calls that may occur from out-of-the-money positions, Standard & Poor's reviews the price and volume components of the entity's positions. The price component relates to the price volatility and how far the reference price has moved from the price at the time of the initial trade. The further away the market price has moved, the more out-of-the-market the position becomes and the more collateral that needs to be posted. The volume component relates to the portfolio's size. The more positions there are, even if the positions are hedged, the larger the collateral call. A long-dated position also generates more concern because the amount of the collateral needs to correspond to the contract's duration. Also, the collateral is trapped until the corresponding contractual obligation expires.

The second component is a trading operation's exposure to a downgrade or "trigger" event. When a counterparty is concerned about a trading partner's credit risk, it demands additional collateral from that trading partner to mitigate the credit risk exposure. If the credit quality has deteriorated significantly (i.e., falls below investment grade), the amount of collateral demanded by the trading partner is generally equal to the value of all the out -of-market positions that the deteriorating entity has with that trading partner.

Standard & Poor's evaluates an entity's exposure to collateral calls that could occur if the trading operation is lowered to a speculative rating under a stressed-price scenario and makes a determination regarding whether the entity has sufficient liquidity. The liquidity requirement to fund a potential trading loss will be addressed in a future article.

The effect of a potential collateral call and the company's ability to meet this call in a timely manner will factor into the company's rating. A trading operation's rating will be affected by the amount of dedicated liquidity (liquidity that is earmarked to cover estimated liquidity risk) it has secured in relation to the amount it would need under different price scenarios and amounts that would be needed if there is a downgrade event. Standard & Poor's is proposing to require investment-grade companies to maintain enough dedicated liquidity to cover a collateral call under a stressed-price scenario.

The size of a potential collateral call will be estimated by the sum of all the negative positions an entity would have using a stressed-price scenario. Positive positions would not result in a collateral call because a trading operation only has to post collateral to the counterparties that it owes money.

Even though the value of long- and short-term price risk management liabilities as reported on the balance sheet should reflect the sum of all the negative exposure by position, this value may overstate the potential size of the collateral call because it ignores bilateral nettings benefits. Therefore, whenever bilateral netting is available and effective, the calculation can be done by totaling the negative exposures by counterparty (as opposed to by position). For example, if a trading operation owes a net of $100 each to counterparty A, B, and C, but is owed $100 each by counterparty D, E, and F, generally it would have to post a total of $300 if its rating drops below investment grade. It would not have to post any collateral to counterparty D, E, and F because those entities owe money to the trading operation.

Importantly, collateral is not transferable. Even if D, E, and F had to post $300 of collateral to the entity, the entity could not use these postings to honor its collateral call to A. B, and C.

To maintain consistency, Standard & Poor's will provide stressed-price scenarios that should be overlaid against the entity's portfolio to calculate the required liquidity. Price scenarios are chosen over a value-at -risk (VAR) estimate, the traditional measure of the effect of market -price movements, because a trading operation's liquidity risk associated with a collateral call may have little or no relationship to its VAR. A perfectly hedged portfolio will have a VAR estimate of $0, but the potential for a collateral call can still be enormous because it may have to post collateral for half of its positions.