Exclusive Interview With Michael Carter, Director of Credit Risk at EDF Trading North America
by marcus evans 08 Sep 15:27
- How will the Commodities Futures Trading Commission (CFTC) regulatory reforms affect risk management practices in the energy trading industry?
To a large extent it is still unknown as there are still so many details that have to be worked out. I think the CFTC has released a list of 30 areas that they intend to address over the coming year. We don’t know enough details just yet to know how it will affect different companies. For instance they may elect to permit end-user exceptions to differentiate the people who are solely in the business of trading energy derivatives for speculative purposes, versus those who are doing it to hedge a physical position they already have. We just don’t have enough details for people to begin to make grand assumptions about how they’re going to conduct their future business. There is a huge amount of unknown detail hanging out there. This is an 800lb gorilla in the room for a lot of energy companies.
- What is the importance of knowing the fundamentals and going “back to basics” with risk management practices?
There’s a significant convergence within the energy space between the efforts of physical energy companies and financial participants. For instance, you have energy companies who are trading with the banks. Historically they have had different ways of managing their risk. Physical energy companies have typically been more involved in managing their physical business and less involved in managing their financial risk. There was not even a natural gas futures contract until the early 90s. There are many companies in the physical energy space who still aren’t even margining while banks already have all of this in place. As they are forced to trade more and more with one another, I don’t think you can continue to have this great disparity in how risks are managed between those two massive efforts. There may be a bank, for instance, that will want to trade under an ISDA contract and they’re talking to an oil company that has never had a daily margining requirement and now they’re being forced to. It’s definitely changing the rules of the game and requiring not only the physical companies to learn how to do things like Wall Street does, but it’s requiring Wall Street people to understand some of the nuances of the physical commodity space.
- Can controlling risks in energy trading provide greater market assurance for companies like oil and gas producers, electric providers and gas utilities?
Yes but I think it’s important to remember that those who come to this game looking to manage a latent risk are often simply exchanging one risk for another. Sometimes it’s a more dangerous one. A producer of a product comes to the market with what they need to sell and if they enter into a margining arrangement, they could lock in a profitable deal but be margined into default if prices move and they can’t come up with collateral. That’s sometimes a more dangerous risk to face because it’s unforgiving and it’s over in a few days. A lot of companies can operate in the red for a while, but ones who can’t meet a margin call literally have only days to fix the problem. If you go in and try to cover a market risk that you face and you sign a contract to agree to provide collateral when prices change, you are exchanging one form of risk for another. That’s a common issue for companies in this market.
- How can risk management give confidence to the insurance companies, banks, and manufacturers that work with energy companies?
One of the issues we have to deal with is the importance in having confidence in your counterparty’s ability to perform. If you have good controls and you believe your counterparty does too, it eases everyone’s concern and lets each party focus on the transaction rather than heightening the tensions and increasing the potential for negative actions. If I’m trading with a counterparty who I believe is weak I’m going to be concerned and I’m going to halt trading at the first sign of trouble rather than giving them the benefit of the doubt – as I may if I thought it was a strong and well controlled company. Entities in the market have a great deal of subjective flexibility when they interact with individual counterparties and sometimes entire classes of counterparties. Simply having a degree of anxiety over your counterparty or particular industry sector can make people take defensive actions more quickly.
- What are the key challenges facing the industry right now?
Uncertainty. What’s the pace of the economic recovery likely to look like? That affects the demand for the product. How is the coal industry going to be affected if there is a change in regulation and public opinion regarding emissions? How is the huge amount of gas that has been discovered in North America going to affect the geopolitical energy balance? Is that going to cause some shifting away from other energy sources? It is very difficult for executives in the energy space to make long term plans.
Another is the unequal application of business practices. That has the opportunity to introduce arbitrage into the trading process. The biggest challenge right now is getting everyone on the same page. Back in the 90s energy companies started trying to adopt Wall Street-style risk management practices. That’s where the Enrons and the Dynegys of the world started to really introduce something in the energy patch that basically had been in the financial kingdom. That effort is still underway and is more advanced in commodities like gas and power than it is in oil and coal, for instance, although they are moving in that direction, too. It is being made more difficult because even more “sophisticated” techniques such as Credit Value Adjustments (CVA) are becoming more common, making the process a moving target.
There are still a dramatic number of physical energy players out there who do not fully embrace the more robust risk management techniques yet. If they’re going to continue to evolve in their business practices, they’re going to have to step up the level of their capabilities and improve the training of their personnel and upgrade their systems and policies.
The marcus evans 3rd Annual Risk Management in Energy Trading Conference will take place on 21-22 October, 2010 in Houston, TX.
For further information on this event contact:
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