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Risk Magazine: Putting Energy Into Credit

The December 2005 issue of Risk Magazine contains a great reference article on energy derivatives and their impact on credit risk management. In the article Putting energy into credit, author Duncan Wood explains that while high oil prices mean more banks are looking to get involved in the energy business, many energy companies below investment-grade, and hence banks are getting creative in how they structure the deals to mitigate credit risk.

As the article states, “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.”

The article continues, “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.’

The article continues with sections entitled “Portfolio Management” and “Security Sources” that include commentary about 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.’

Toomre Capital Markets recommends that the reader review the entire Risk Magazine article and welcomes your thoughts and comments. As energy commodity price levels continue to increase, how will your organization manage its energy and credit exposures?