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									white paper: analyzing counterparty
credit risk
                                                                                  A White Paper sponsored by Allegro Development Corp.



Credit risk management for energy companies
Roiled credit markets, fluctuating energy prices and Dodd-Frank move credit to the front seat.

      he Dodd-Frank Wall Street Reform and

T     Consumer Protection Act—enacted in
      the midst of a slow recovery in the
United States from the “Great Recession”—is
the most comprehensive financial reform
act passed by a U.S. Congress since the
1930s. The act includes provisions that im-
pact energy companies that typically hedge
their exposure to volatile oil and gas prices
and other business risks.
    Much remains uncertain, however,
regarding the legislation’s detailed execution.
An extraordinary amount of rule-making by
the Commodity Futures Trading Commission
(CFTC), Securities and Exchange Commission
(SEC) and others is needed first.
    More specifically, the Act’s Title VII estab-
lishes a regulatory structure for derivatives,
including commodity hedges. To continue
over-the-counter, direct hedging with coun-
terparties, energy companies—as well as                 Given the uncertainty of the situation,      customer or counterparty—is a more major
others—will need to demonstrate they are            but cognizant of the general drift, experts      concern than ever.
“commercial end users.” This will almost            say energy companies would be well served           Fortunately, solutions exist today to help
surely be determined based on multiple fac-         to strengthen credit risk management pol-        energy companies effectively tackle the new
tors, but it has not yet been specified what        icy as part of their hedging and risk-man-       challenges in credit risk.
those will be, or what weight each will have.       agement strategy.
Nor are reporting requirements for energy               Going forward, an energy company             Changed credit markets
companies with commercial-end-user sta-             should be able to present a thorough, near       Energy companies operate in an environ-
tus clear yet.                                      real-time analysis of its and its counterpar-    ment of uncertainty when it comes to the
    Nevertheless, energy companies should           ties’ credit-worthiness. The ability to do so    emerging regulatory structure, energy mar-
prepare to spend time being measured by             may make a difference in terms of regula-        ket prices and the state of credit markets.
the CFTC to determine whether they can              tory regime, margin requirements and total           Dr. Praveen Kumar, chair, department of
enter over-the-counter hedges. Use of risk          risk profile attainable.                         finance, the C.T. Bauer College of Business
analyses to determine commercial-end-user               Other factors weigh in as well, including    at the University of Houston, believes petro-
status is already under discussion, amongst         credit markets that remain troubled and the      leum price volatility will continue. This un-
other parameters. It is likely that an energy       prospect of renewed energy price volatility.     certainty of course colors how well
company will need to demonstrate a credit           As in any time of uncertainty, sound evalu-      managers can evaluate credit risk.
profile, including for its counterparties, con-     ation of credit risk—the potential loss caused       Kumar told Hart’s E&P magazine that
sistent with its stated strategy.                   by nonpayment or nonperformance of a             one big reason for continuing volatility is

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that national oil companies, whose govern-           and severing relationships with all but              Paul Evans, former treasurer of North-
ments use oil revenues as a political tool,          their best or largest customers.                 western Energy Corp., a regulated utility
are likely to overreact on the supply side to      Given continuing uncertainty in oil and            holding company based in Sioux Falls, S.D.,
any rise in demand, sending rising prices       gas markets, energy companies must deter-             agrees. During his seven-year tenure, he in-
spiraling back down again. To succeed in        mine whether counterparties have survived             stituted daily monitoring of credit risk at
such an environment, Kumar said compa-          the turmoil—or remain in danger. They must            Northwestern, which was trying to improve
nies must factor what he calls “embedded        ask what assumptions have these parties               its own credit rating. But he also
optionality” into their planning and risk-      made, in terms of projected interest rates            demanded daily information on its coun-
management processes.                           and future petroleum prices, as the basis for         terparties and business partners. He didn’t
    Moreover, credit markets haven’t yet re-    their trades? What hedging strategies have            believe in relying solely on third-party
covered from the 2008 economic crisis.          been invoked? What is their credit profile?           credit rating agencies such as Standard &
While oil and gas industry credit markets are                                                         Poor’s Ratings Services, Moody’s Investors
said to be reasonably accessible, other         Credit risk and reward                                Service, or Fitch Ratings.
areas of the economy remain frozen. Even        Until recently, most companies considered                 “There is a close relationship between
then, in a recent posting, Michael Corley of    credit risk to be a poor cousin compared to           credit risk and the liquidity of a company,
Mercatus Energy Advisors, Houston, notes,       the need for realistic market-risk evaluation.        which affects your financing capability,
“We’ve received numerous inquiries from         Yet sound credit risk management is an im-            and—as a counterparty—affects how you do
oil and gas producers that are being forced     portant component of industry best practices.         business,” Evans says.
to find new hedging counterparties…most             “With larger amounts of capital at risk, and          Published credit ratings are a traditional
often due to credit-related issues.”            with extreme volatility in commodity markets,         source for information about a company’s
    He notes the following reasons for the      traditional methods for evaluating risk have be-      credit worthiness. However, the much-pub-
change:                                         come ineffective,” says Allegro’s Michael Hin-        licized conflicts and inadequacies that lie
  • Fewer E&P credit facilities, reducing       ton, Chief Customer Officer. “In the past it was      behind the ratings provided by the agencies
     credit available for hedging,              considered sufficient to look at the credit rat-      have sown doubts about their efficacy.
  • Banks and energy companies cutting          ings of counterparties once a month or even               Even then, many small- and mid-sized
     back trading desks,                        once a quarter. Today, even looking at credit         companies don’t have published credit rat-
  • Counterparties, both banks and energy       data in ‘near real time’ is inadequate. You have      ings. To evaluate these companies, some
     companies, reassessing risk tolerance,     to consider the indicators of future risk as well.”   depend on scoring models that combine

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historical financial statements and data          sheets, internally developed, or custom soft-       things are all too readily apparent. The
about similar companies to piece together a       ware applications. Given today’s environ-           credit risk function must become a full-
profile. The inadequacy of this approach is       ment, legacy enterprise applications don’t          fledged member of any program and tool
obvious, as it fails to take into account spe-    have the functionality or integration with          set for energy trading and risk management.
cial circumstances related to a company or        other risk functions needed for holistic            Credit information must be complete, accu-
industry sector.                                  credit management.                                  rate and timely—and easily accessible to
   “Energy traders too often work based on           For one, it’s difficult to aggregate stand-      decision makers. And it is possible today to
the best information available at the time,”      alone spreadsheets to bring to light total          manage credit risk holistic to other forms of
Hinton says. “It amounts to saying, ‘you          exposure, as well as where credit risk is con-      risk, and to integrate directly with needed
have this much credit at that point in time,’     centrated, how it is likely to change over          information and analytic tools. Workflows
but the counterparty credit profile may have      time and its relation to cash flow. Without         mirror business processes, and promote
deteriorated since that point in time. There      automated roles-based workflow across dis-          management by exception through use of
is also the issue of integration with the         parate systems it is difficult to achieve stan-     alerts and other means.
physical supply chain.”                           dard     business      processes.      Without          The problem may be most acute, con-
   For some energy companies, hundreds            connectivity to the physical supply chain           cludes Hinton, “for small and mid-sized com-
or thousands of transactions per day may          and logistics networks, important events            panies that don’t have the resources of a BP
be the rule. Yet surveys indicate most man-       that impact credit risk can go undetected.          or ExxonMobil. They don’t have the tools to
age the increasing volumes using spread-             The limitations of today’s way of doing          deal with credit risk comprehensively.” n



A strategic enterprise solution
Real-time information, integration, workflow and analytics act as pillars in the new environment.

         il and gas producers as well as energy   in relation to the potential cost of credit and     information that is shared and acted upon

O        companies of all types face increasing
         challenges in credit risk management
due to the post-crisis regulatory regime being
                                                  finite liquidity availability. Credit limits must
                                                  be established not just for individual coun-
                                                  terparties but also for concentration in
                                                                                                      in a consistent manner across the entire en-
                                                                                                      terprise—including accounting; commercial
                                                                                                      trading, marketing and hedging; scheduling
put in place, continuing credit market uncer-     industry segments, commodities, geogra-             and logistics; and treasury.”
tainty, commodity price volatility, and gaps in   phies and credit-rating categories. Existing            Energy companies have spent hundreds of
information related to credit risk, especially    ways to evaluate and manage credit risk be-         millions of dollars on enterprise systems and
that for counterparties.                          tween counterparties typically are lacking in       risk-management systems. However, until
    As part of overall risk management, the       these areas. Most companies can’t, in a             recently, credit risk management has been
credit risk function has relevance from the       timely manner, measure current and future           treated like a poor stepchild. “Credit risk groups
front office, where traders and marketers         exposure, or build robust credit risk models        have been faced with an extremely time-con-
buy and sell, through the back office, where      to rate counterparty credit scores.                 suming, manual effort whenever they sought to
counterparty information is collected, ana-           Executives want to understand the finan-        consolidate information,” Meche says.
lyzed and integrated in overall trading and       cial risk inherent to their aggregate position
risk management. Credit and liquidity must        with regard to commodity price, bank liq-           Systems response
be managed as key components in a strat-          uidity, and other parameters. In other words,       Energy trading and risk management (ETRM)
egy for value creation and risk management.       they must have insight into potential prob-         solutions emerged as a result of the recog-
    Besides evaluating counterparty risk, the     lems lurking beneath the surface of their           nized need for a more holistic approach to risk
credit risk group negotiates key contractual      own credit and risk profile.                        management, and the inadequacy of enter-
credit terms, establishes limits, measures            In a paper from Empirical Risk Consult-         prise resources planning systems to do the job.
portfolio exposures and default risk, esti-       ing, Eddie R. Meche, president, points out:             Most recently, credit risk management is
mates potential exposures and manages             “The pricing of credit risk and liquidity costs     being incorporated into ETRM as a key in-
collateral received and distributed. An addi-     into a business plan and charging such costs        gredient. In one important example, Allegro
tional role is mitigating risk by identifying     to business units should be attempted, but          Development Corp., a global leader in ETRM
potential netting and setoff rights to reduce     is not enough. Since liquidity is a finite          solutions, has introduced Credit 8.1 as a fully
exposures, and potential collateral obliga-       resource, it should be budgeted and allo-           integrated part of their ETRM system. The
tions, to be executed by others.                  cated across the organization based on the          system supports evaluation of every aspect
    Credit risk management must be part of        consolidated risk-reward framework.”                of counterparty credit risk and liquidity to de-
an overall business plan because compa-               An integrated approach to effective credit      rive a profile of current and future exposure.
nies evaluate volatility in trading or hedging    risk management, Meche says, “Depends on                Perspectives from the real-world experi-



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ence of several Allegro clients, representing     present, to support a forecast of counterpar-         the Allegro Credit component, credit limits
different transaction models found in the         ties’ potential future credit situation, including:   and positions with trading counterparties are
energy industry, influenced development of          • Market and credit event liquidity ade-            checked and verified as part of trade entry.
Credit 8.1. As part of an integrated ETRM so-           quacy stress testing,                           Current credit positions and as many as six
lution, consolidated counterparty hierarchy         • Credit-value-at-risk analysis,                    time periods into the future can be viewed.
details and a system of record are estab-           • Potential future-exposure analysis,                   Allegro’s credit risk solution provides
lished for effective credit risk management.        • Walk-forward analysis.                            comprehensive tools and delivers the trans-
    First, it automates acquisition of current,       Timely and accurate collateral data al-           parency needed in a marketplace where
comprehensive data through interfaces with        lows a comprehensive view of counterparty             price volatility and credit questions rule the
external rating agencies. Transparency into       liquidity, including collateral status, obliga-       day. Users analyze and forecast counterparty
counterparty credit status includes scoring       tions and disputes—as well as functionality           credit profiles. They capture real-time credit
and rating details, limited breaches and          for default risk and recovery.                        information available from multiple sources;
warnings and measurement of mark-to-                                                                    analyze counterparty liquidity, collateral, de-
market and unsecured exposure.                    Workflow and supply chain                             fault potential and the possibility of recovery.
    Risk managers can monitor daily collat-       To Michael Hinton, of Allegro, integration of             Further, integration of Credit 8.1 into the
eral, margin and liquidity requirements, and      credit risk within an enterprise system is the        rest of the Allegro 8 platform gives traders
construct credit risk scoring models by inte-     secret sauce. This integration allows managers        current and accurate counterparty credit data,
grating current rating-agency data with pro-      to define a workflow that links credit risk man-      supporting more profitable trading. Integra-
prietary information. With access to this         agement directly to other business processes          tion with trade-capture and contract-man-
timely and accurate credit data, managers         such as logistics. If a counterparty approaches       agement functions reveals credit exposure
can gain better transparency into a counter-      or exceeds a credit limit, the system can auto-       associated with those physical and derivative
partys credit status and make real-time de-       matically prompt users to take action on that         positions. This is what’s needed in markets
cisions based on that data.                       information to mitigate additional exposure.          defined by price volatility, increased credit
    It is important to evaluate effects of            “You’re embedding that physical supply            markets and increasing regulatory burden.
counterparty agreements with and without          chain and its current status in your system,”             Amidst such uncertainty, industry partici-
netting. Energy companies today combine           says Hinton. “That’s powerful when it                 pants say market-risk controls alone are no
potential future exposure measures with           comes to deciding whether, for example, to            longer the sole measure of good credit risk
recovery rates and default probabilities to       release a shipment. In such a case, a ship-           management. The need to view portfolio
calculate credit-value-at-risk measurement.       ment might be held until additional collat-           exposure on a real-time basis takes a com-
    According to David Johnson, a managing        eral or other means have been deployed to             pany beyond evaluating credit risk by means
director at Protiviti, “Energy traders often      reduce overall exposure.”                             of spreadsheets and home-grown software
have forward transactions that extend two             Allegro’s configurable workflow and mes-          applications. Today’s advanced solutions,
to three years into the future. These trans-      saging include customized approval mecha-             such as those provided by Allegro Develop-
actions are highly vulnerable to fluctuating      nisms set up within the system that can               ment, provide a holistic view of credit and
energy prices and often require significant       automatically notify management, col-                 other forms of risk, and are integrated directly
levels of collateral or margins.”                 leagues or external parties of actions re-            with the essential trading, logistics and ana-
    There is thus a need to extend beyond the     quired to complete deals. Combined with               lytic tools that energy companies need. n



  Allegro credit risk management functionality
  Integrated rating agency data to monitor daily collateral, margin and liquidity requirements.

        redit Connect 8.1, as a component of the Allegro 8 platform,          a competitive advantage in mitigating credit risk and making

  C     provides real-time access to credit and financial data, in-
        cluding credit ratings, company financials, credit metrics,
  market implied ratings, credit default swap (CDS) pricing, and other
                                                                              critical portfolio decisions.”
                                                                                  Allegro’s Credit Connect 8.1 automates import of credit rating
                                                                              data, fundamental data, and business entity information from
  key credit data for portfolio analysis.                                     Interactive Data Corp. Risk managers can easily monitor up-to-
      “With today’s tight credit markets, commodity price volatil-            date collateral, margin and liquidity requirements, access
  ity and heightened counterparty risk, companies need real-                  Moody’s, S&P and Fitch ratings data and construct credit risk
  time credit risk management across all commodities and                      scoring models.
  business transactions,” says Allegro’s Michael Hinton. “Allegro                 Credit Connect works with Allegro’s Credit 8.1, integrated
  automates the retrieval of current rating agency data, reduces              with more than 30 business components in Allegro 8 for trading,
  time needed to analyze credit-adjusted financials, and identi-              risk management, operations, logistics, optimization, systems
  fies outliers on specific performance metrics. Customers gain               integration, and accounting. n



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                                          About Allegro Development
  Allegro is a global leader in energy trading and risk management solutions for power and gas utilities, refiners, produc-
ers, traders and commodity consumers. With more than 26 years of deep industry expertise, Allegro’s enterprise platform
drives profitability and efficiency across front, middle and back offices, while managing the complex logistics associated
with physical commodities. Allegro provides customers with flexible solutions to manage risk across gas, power, coal,
crude, petroleum, agricultural, emissions and other commodity markets, allowing decision makers to hedge and execute
with confidence. Allegro has recently been recognized as the Energy Risk Software House of the Year and received The En-
ergy Business Awards Gold Award for Excellence. Headquartered in Dallas, Texas, Allegro has offices in Calgary, Houston,
London, Singapore and Zurich, along with a global network of partners.
              To learn more about Allegro’s credit risk management functionality, visit
           http://www.allegrodev.com/risk-management/counterparty-credit-risk




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