Credit Risk Management in Energy Trading - Dealing With the Physical
Measuring and managing credit exposure in energy trading presents interesting and challenging additional dimensions to consider in comparison with the financial markets. The logistics and optionality attached to physical trades, in particular, have a realm of important but intricate nuances that affect the exposure profile.
Managing the exposure of a mixed energy portfolio is challenging, as is managing the associated capital allocation. Yet more efficient limit utilisation is increasingly important because of the raised oil price and high volatility level found in the gas and power markets.
Energy traders thus desire the increased flexibility provided by a portfolio-based approach to credit risk management, which permits the adoption of an appropriate risk profile, decoupled to some degree from trading objectives. But before such an approach can be implemented, it is necessary to understand the detail behind the logistics and physicality of the commodity.
Firstly, let us take a brief look at some selected characteristics, to explain some energy terms, and some differences that are relevant to credit.
A physical trade involves arranged or potential physical transfer of a commodity. This can be a basic spot or forward sale or purchase, usually at a floating price. A financial deal, whether a future or some other type of derivative, does not have an exchange of physical.
This is only traded in local markets. As it cannot be stored, and the demand for it is not always controllable, the price is highly volatile in the short term. The longer term price behaviour has interesting seasonality and mean reversion characteristics.
Gas is also only traded in local markets. Not quite as volatile as power since it can be stored but it still has a significant element of potential future exposure. A component of this is due to the long-term nature of the deals and their associated optionality.
Globally and domestically traded and usually shipped in either tankers or pipelines. Often deals are shorter term and therefore have less potential future exposure. However, the prominence of longer dated and ‘term’ deals is increasing. The trebling of the oil price over the past few years has also increased limit utilisation.
A basic physical oil trade involves:
In oil, payment is often 30 days after title transfer. Deals can involve the loading of a cargo or an ‘in tank transfer’, be put into ‘chains’, with all sorts of interesting implications. Within these parameters are also many other variations.
Let us consider the following fairly standard example:
An international trade where we agree to sell 5 million barrels of oil to counterparty X, to be collected by tanker from port P during the month of September. Title transfer will take place on loading. Payment is due 30 days later.
Note that when the title is transferred (in this case on loading, when the oil passes the ship’s flange), a bill of lading is issued. The date on which this happens is known as the BL date.
At the time of initial agreement, a deal that is due to ship in September could load on any day in the month. Nearer to September, a smaller band of time for loading, usually a three day band, is nominated. The actual date of loading depends on the availability of the ship in question. Invoicing takes place 30 days after the title transfer, i.e. 30 days after the issue of the bill of lading.
Exposure has ‘magnitude’ (i.e. at a particular level) and ‘width’, i.e. a length of time to which we are exposed to the counterparty.
The magnitude of the exposure is the entire cargo value (i.e. 5 million barrels multiplied by oil price). There is usually no netting of international oil trades, so this is the exposure (usually a deal will have a floating value until a ‘fixing’ date).
Until we deliver the oil and transfer the title, there is always the option of physically holding back the oil in the case of a credit event occurring to the counterparty. Therefore, we have no exposure until the date the bill of lading is issued (so the exposure is non-cumulative).
The first day on which we will be exposed to the counterparty is the first possible date of delivery, in this case 1 September. Assuming all goes well, the last date on which we will be exposed to the counterparty is the last possible payment date, which is 30 October (30 days after the last possible delivery date). Therefore, at the time of the deal, the exposure profile appears as indicated by the white area in Figure 1.
The profile changes on deal nomination. This happens when more information is known about ship availability, at which point the counterparties agree a time band of dates, say 14 – 16 September. Thus, our exposure now starts on the 14 September and ends 30 days after the 16 September, as indicated by the grey area in Figure 1.
When loading takes place and the bill of lading is issued, we are exposed to the counterparty until we are paid. Once we get confirmation of payment, we are no longer exposed.
If we consider a set of deals, exposures will shift around when an event occurs associated with any deal. Therefore, a portfolio of deals will have a bumpy and moving profile.
A ‘term’ deal, involving the shipment of consecutive cargoes (e.g. 5 million barrels per month for three months), has a more complex pattern. Consider a term deal with the specification above. Most months will have an exposure of double the cargo value, as the exposure profiles run into each other. February will have a short period with a triple exposure if using a 30-day payment period.
The actual exposure of a portfolio of physical oil deals varies with logistical events, as well as the market price.
We have examined one standard instance of a deal. Within oil markets there are many variations, such as:
In an addition to differences in the way that each deal is valued, physical characteristics also differ, increasing the complexity of deriving an exposure profile.
Adding gas, power and other forms of energy introduces even more variety into the mix. Again, as well as the significant differences in modelling deal value, the physical aspects must be considered.
Traditionally, most forms of mitigation are used in energy:
Different markets and commodities favour different forms of mitigation and scope. For example, margining is common in gas and power markets. Physical oil deals usually have a deal specific letter of credit attached. Netting is permitted in some jurisdictions and for some commodities. The use of CDSs and other forms of credit derivative are also becoming popular.
We have seen the effect of logistical choices on the exposure level of a physical portfolio, as well as market factors, probability of default and loss given default, etc. This adds a new dimension to the calculation of a true portfolio based risk measure, all in addition to the challenges faced with financial portfolios.
Some of the choices can be regarded as optionality, which can be optimised on a portfolio basis. Again, such optimisation is not purely a financial matter, as the physical underlying must be considered. This can even be optimised in itself. At the same time, issues on the logistical side are not within our control. The arrival of a ship or availability of a pipeline cannot always be optimised.
With all of this in mind, the move to a simulation-based approach requires consideration of all of these new factors, in addition to the usual risk components and credit events. Not only must we perform perturbations of the logical outcomes, but we must simulate adverse logistical events as well. Moreover, it is necessary to bind all of this by physical reality.
To implement such a framework requires the setup of a scenario generator that not only encompasses price and risk factors, but also the gamut of logistical choices. This must be calibrated to understand the physical realities of each underlying commodity, including its seasonality and demand characteristics.
Next, it is necessary to apply the scenario engine to the portfolio to create a full potential future exposure-style valuation. Note that the mitigations applied in each run must be tailored to the commodity.
Only once this is properly in place is it possible to move to a full CVar style calculation, factoring in credit events in the manner dictated by the methodology selected.
We have seen an example of how the physical aspects of energy trading affect the way we value current and future credit exposure. Much thought is required before we can put the quantitative and technical infrastructure in place to turn a current exposure into a simulated potential future exposure.
Examining the detailed methodologies that can turn this into reality is beyond the scope of this article. However, we have covered some fundamentals that must be considered to make the move forward a reality.