Energy markets need more than second-hand credit models

It is sometimes said that nobody ever defaults on an energy deal - they just declare force majeure and go to court to fight it out. Such sentiment is often heard on trading floors, and while it is an exaggeration, it has more than a grain of truth. The physical and institutional aspects of energy related transactions add a layer of complexity to the management of credit risk, often rendering models transplanted from financial markets ineffective.

The central notion of credit value-at-risk is a bankruptcy event or an erosion of credit quality captured by the ratings of firms such as New York-based Moody's Investors Service or Standard & Poor's. But energy markets are different, and a failure to perform may take place in the case of a very strong and financially stable counterparty – people just don't like to lose money and look for convenient excuses to get out of expensive contracts.

A standard operating procedure in the commodity market is to complain about the quality of the commodity under contract. This strategy had many well-known practitioners, including British economist John Maynard Keynes. Keynes was not only a great thinker in fields such as economics, mathematics, journalism and literature, but also a fearless speculator who made a fortune, although he flew too close to the flame on several occasions.

According to Robert Skidelsky: "Once, in 1936, [Keynes] had to take delivery of a month's supply of wheat from Argentina on a falling market. He planned to store it in the crypt of King's College Chapel, but found this was too small. Eventually, he worked out a scheme to object to its quality knowing that cleaning would take a month. Fortunately, by then the price had recovered and he was safe. There were loud cries that ‘infernal speculators' had cornered the market." (1)

It is likely complaints about quality and the severity of quality inspections will be proportionate to the losses on a transaction. Of course, paying attention to product specification is fully justified. No airline will want its planes to fall of the sky because its jet fuel is contaminated in a tanker used on a previous trip to carry a product that does not mix well with kerosene (2). This is why, on a well-oiled trading floor, a trader sits next to an operations manager and a credit risk analyst. The unit for measuring credit risk is – as one trader once told me – one cargo.

The physical component of energy-related transactions introduces another complication - a mutual dependence between counterparties that precludes the decisive legal action seen in many markets when credit events happen. A creditworthy counterparty may have a vested interest in the survival of a partner flirting with bankruptcy and come to its rescue or renegotiate the contracts. This reflects the fact that replacing an important supplier or customer can sometimes be a costly decision.

[Conventional credit models] are calibrated to historical data, whereas the most spectacular credit events happen due to seismic shifts in the institutional framework and technology of energy markets

Historically, long-term transactions in the energy business were based on risk-sharing arrangements and the division of gains that accrue to one party as a result of extreme market movements. Another remedy is the use of contractual provisions for the early termination or renegotiation of a contract. A failure to include such clauses in a legal document is a career-ending event, as any lawyer can confirm.

Conventional credit models can fail for another reason: they are calibrated to historical data, whereas the most spectacular credit events happen due to seismic shifts in the institutional framework and technology of energy markets. For companies with outdated business models and a limited ability to readjust, such shifts can be fatal. In the collapses of Energy Future Holdings in 2014, Pacific Gas & Electric (PG&E) in 2001, and the UK arm of Dallas-based TXU in 2002, a common denominator was the companies' failure to recognise the implications of earth-shattering developments in market structure and their vulnerability to unfolding trends.

For example, Energy Future Holdings was brought down by the shale revolution and the shrinking profitability of coal-fired power plants. PG&E failed to recognise the flaws in the design of California's fledgling power market and the potential for market manipulation on a massive scale. Likewise, TXU's UK business missed the impact of the country's new electricity trading arrangements, which replaced the Electricity Pool of England and Wales in 2001.

The irony is that the consequences of these developments were widely anticipated and there was no need for sophisticated modelling to recognise their impact. The writing was on the wall. A cup of coffee and a few hours of quiet reflection would have sufficed. This leads to another question: why do organisations fail to absorb and process information in a timely fashion and continue on a path to destruction? But that is a separate issue – and perhaps, a topic for another column.

Footnotes:

(1). Robert Skidelsky, 'Keynes: The Return of the Master', Public Affairs (2010).

(2). Jet fuel contamination happens when it is exposed to water, particulates, microbial growth and other petroleum products (such as fatty acid methyl ester). Contamination may lead to the fuel starvation of the engine.