Energy firms are ramping up their use of credit default swap pricing information to more closely monitor counterparty credit risk as slumping commodity prices pile pressure on credit profiles across the sector.
Oil majors, commodity trading houses and utilities are among the growing number of firms that have requested real-time credit derivatives pricing from data provider Markit in recent weeks as they look to more accurately assess their counterparty exposures in a sector that has been crushed by oil and metals prices hitting six-year lows on Chinese growth concerns.
“Energy firms are taking a more sophisticated approach to managing their counterparty risk,” said Gavan Nolan, director of credit research at Markit. “Some of the oil majors have been using CDS data to more effectively allocate capital to suppliers, but the trend is expanding to commodity trading houses and utilities as they tend to have lots of counterparties.”
It is an approach that is bringing corporate risk management closer in line with credit value adjustment desks at banks, which use CDS prices to measure and reserve against potential credit losses stemming from counterparty risk associated with their derivatives portfolios.
“We’ve seen massive volatility on Glencore – it has taken steps to maintain its investment grade rating but is still trading like a Single B credit”
While the development of sophisticated bank CVA desks comes in response to Basel III capital rules, CDS is becoming an increasingly important monitoring tool across the broader corporate sector.
“We’re seeing corporate treasurers across all sectors look at CDS data more and more, but market-based measures of credit risk are particularly important for energy firms as many have big trading operations,” said Nolan.
Capturing volatility
Until recently, energy firms relied largely on financial results and ratings agency reports to monitor the credit profile of their counterparties. Tumbling energy prices, however, have put the future of many lower-rated companies in the balance and forced higher-rated companies to take drastic action to safeguard their investment grade status. It has triggered some huge credit swings across the sector that can only be captured via market-based measures.
Swiss commodity trading firm Glencore has been one of the more volatile energy names in credit markets. Five-year protection jumped above 400bp earlier this month – more than doubling since early July – as lower commodity prices put the firm’s investment-grade status in jeopardy.
A US$2.5bn capital raising exercise, which forms part of a wider US$10bn package aimed at slashing the company’s US$30bn debt pile by a third, has staved off any junk downgrade for the time being, but CDS pricing at over 340bp suggests ongoing caution over the company’s future as an investment-grade index constituent.
“We’ve seen massive volatility on Glencore – it has taken steps to maintain its investment grade rating but is still trading like a Single B credit. You need to look at a market-based measure to reflect that,” said Nolan.
Catastrophic
For lower-grade counterparties, particularly North American junk-rated E&P firms that ramped up debt issuance to fund production in response to the shale boom, current commodity prices could prove catastrophic to business models. Many have seen bank credit lines slashed as Brent crude oil spot prices have halved over the last 12 months and continue to languish below US$50 per barrel.
“If prices stay at these levels for a long period of time there will be an inevitable impact on credit quality. We’re going to see a lot of pressure across the sector and we will see more defaults,” said Nolan.
As one of the most liquid CDS sectors, many energy counterparties have an active market for credit protection – Markit provides pricing on over 300 names across the energy and utility sectors.
For those counterparties not represented, however, energy firms are turning to sector curves as a proxy for implied market pricing – similar to procedures used by banks.
“CVA calculations often use sector curves as a proxy, and that is a big driver of demand for data that we’re seeing from energy firms right now,” said Nolan.
