RiskCredit RiskFrack attack: energy uncertainty and the need for agile credit risk

Frack attack: energy uncertainty and the need for agile credit risk

Ian Tobin, Head of Credit Risk at Brady PLC, answers what are treasurers and credit risk officers meant to make of banning fracking, and how should they prepare?

Some might call it a pre-election stunt, but the UK government has banned fracking. Big news for the parties involved perhaps, but largely met with a shrug by the global markets.

But what if the US made a similar move? The US fracking/shale boom has fuelled a surge in US production, making the country the largest oil producer in the world and almost making it a net exporter for the first time on a monthly basis. US fracking oil is a big deal – for markets, for the country and for a host of companies around the world directly or indirectly affected by the oil price.

Yet Democratic frontrunner Elizabeth Warren has pledged to ban fracking should she come to power in the November 2020 election. Competitors Bernie Sanders, Kamala Harris and Cory Booker have made similar pledges, while Joe Biden has pushed for a ban for new permitting on public lands.

If the most drastic of these scenarios came to pass, a swathe of smaller operators could go out like a light, regulated out of business. Some argue that such a ban would never get through congress, yet an incoming president could probably ban fracking on federal lands by executive action, which accounts for 2.7 million b/d itself. Even the big players are getting nervous: Exxon and Chevron have fielded questions about the potential policy during recent earnings calls.

Familiar political risk

The rumblings bring an old problem firmly into today’s conversations and sharply into focus: political risk. Political risk is nothing new to the oil and gas industry, but even familiar risks need to be assessed and mitigated. Political risk is just the headline though, a shorthand for an event that manifests itself in various different risk categories, each with its own datasets, analysis tools and concerns.

One such risk category is credit risk: the risks a company is exposed to by virtue of its credit exposures and limits. For oil traders, a potential full – or even partial – fracking ban could prove a seismic event. Trading with a frack-heavy small operator? Overnight that counterparty becomes a very different proposition. Its credit rating may be downgraded and it suddenly becomes a very different trading partner.

Most likely, the head of risk will be anxious to cut credit limits for that counterparty to limit exposure. For a purely speculative trader, that may be a relatively easy wave to ride out. But what of a corporate trader acting on behalf of, say, a refinery? The company has likely made commitments to deliver certain amounts of refined products at future dates, Given the  scenario where the trader has just had their trading limits with a trusted counterparty slashed, this will force them to find other sources elsewhere – quite possibly at elevated prices as a swathe of production is cut from the US market.

Equally, there may well be some winners, with the constrained supply pushing up oil prices and benefitting operators weighted towards other methods of production, such as the supermajors investing heavily once again in Gulf of Mexico production. Savvy trading desks may wish to increase credit limits with such companies, both to recognise their position of strength and enable greater trading activity to cover for constraints elsewhere.

Traders increasing credit limits

The other thing about risk is that it’s always a two-sided coin. Even if nothing changes, there are risk decisions to be made. The status quo calls for analysis like any other scenario. So, if fracking continues unchallenged and is even allowed to continue its growth trajectory, it may begin to exert greater downward pressure on oil prices. This, in turn, may encourage traders to increase credit limits for trading with lean, low-cost-of-extraction operators and consider moderating exposure to those tied into more expensive methods of production.

The common denominator is a need for oil traders to get their credit risk house in order and be ready to react fast to developments. If political promises become reality, the firm’s counterparty risk landscape changes overnight. It will be no good to be left spending days figuring out what it means before recalibrating risk appetite and trading strategies. Should a full or even partial ban come to pass, companies will want to rapidly reassess their credit exposures to frack-heavy operators, possibly revising down credit limits significantly.

What if?

The best approach is a proactive one, taking a data-led approach to credit risk that sits astride the firm’s entire trading book and offers the head of risk or credit risk function to ask what if?

What if the ban does happen in the US? What if anti-fracking noises from the UK spread elsewhere in Europe? What if the ban only extends to federal lands, how does that affect things compared to a full ban?

It’s not necessary to have a crystal ball or to obsessively weigh every possible permutation and outcome, but the ability to ask what might happen in a variety of plausible scenarios is invaluable to the credit risk function. This changes the game from a reactionary scramble to a strategic function that protects the firm and, potentially, even adds value. An agile approach to credit risk will prove worthwhile whichever way the political winds blow.

Ian Tobin is Head of Credit Risk at Brady PLC

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