Managing Credit Risk For Global Commodity Producers
Managing credit risk forglobal commodity producersBrian Gillespie, John Hackwood and Chris MihosMarch 2010
2010 PricewaterhouseCoopers. All rights reserved. “PricewaterhouseCoopers” refers to PricewaterhouseCoopers,a partnership formed in Australia or, as the context requires, the PricewaterhouseCoopers global network or othermember firms of the network, each of which is a separate and independent legal entity.
IntroductionThe global financial crisis has brought credit managementpractices back onto the boardroom agenda of mostlarge exporting producers. Credit exposure for a singlecustomer can be in the order of several hundred milliondollars for large producers. Despite the turmoil of thepast two years, many commodity producers still useunsophisticated credit risk management practices.This paper describes the credit risk issues faced byglobal commodity producers and highlights examplesof best practice in the areas of the assessment andmanagement of credit risk.
A. The return of credit riskCommodity credit riskIncreased default risk from buyersAs commodity prices and volumes rose steadily in theyears before the financial crisis in 2008, credit exposure ofcommodity producers grew silently and massively. Maskingthis exposure was the very low incidence of paymentdefault due to the burgeoning global demand which offeredmany alternative sale options to anyone with an unwantedcargo or available stockpile.From the middle of 2008, many commodity customersbegan to aggressively negotiate reductions to contractuallyagreed prices and in some cases deferring and cancellingshipments. This is unsurprising given that a shipmentof iron ore or coal purchased when prices were at theirpeak could be purchased on the spot market for tens ofmillions of dollars less by the time the loaded freighter wasin transit. Faced with increased customer reluctance toaccept contracted shipments, producers quickly began toquantify their credit exposures and realised the significantrisk of payment default they faced from some of theirbiggest customers.Commodity markets have become truly globalised overthe past two decades. Large users of raw materialssuch as steel mills, refineries and power stations nowdeal directly with commodity producers rather than thetrading houses that previously dominated internationaltrade in many commodities. Driving this change hasbeen commodity user access to foreign exchange andoverseas bank financing. More recently, commodity usersfrom emerging economies have also been able to dealdirectly with producers due to the adoption of internationalaccounting and reporting practices and better local capitalmarket regulation.Some producers who can ship CFR/CIF have exercisedtheir options to retain control of the cargo for longer andtherefore reduced their credit exposure for voyage time.However, these producers are generally able to maintainusual payment terms which place FOB shippers undermore pressure to maintain their existing terms.In this increasingly competitive supply environment, largeexport producers have been required to accept credit riskfrom a wider variety of international customers. Over thepast two decades, export producers have become moreaccustomed to huge credit exposures and more relaxedabout the financial standing of their customers as they viedto sell their product to both industrial sector customers andthe increasing number of trading houses focused entirelyon commodity speculation. For all but the most disciplinedof producers, the pressure to produce volume and preserveprice overpowered the ability to manage credit risk atacceptable levels. For many producers, the customertrack record of payment remains the only metric usedto assess the credit worthiness of a customer.Figure 1: Increasing credit risk500%Increasing credit risk exposureIncreasing default riskChange in price (%)400%300%200%100%0%-100%200620072008Thermal Coal Managing credit risk for global commodity producers2009Iron OrePlatinum2010
B. The credit risk challengePiloting through the global financial crisisSelling commodities on the global market requiresmajor exporting producers to enter into complex creditarrangements involving billions of dollars annually for thesale and transport of hundreds of millions of tonnes ofminerals across multiple legal jurisdictions.Steven Johnstone, Global Head of Risk and Assurance,Base Metals at Anglo American is clear about theimportance of credit risk: “Managing the complex creditarrangements required to sell our commodities as wepiloted through the global financial crisis put credit riskback on the main agenda for Anglo and all major miningcompanies”. Anglo American’s response to this industrychallenge was to develop a completely new global creditrisk process for coal sales which was fully implementedby June 2009 across the company’s main coal operationsin South Africa, Australia and the UK.Credit ratingsThe international rating agencies: Moodys and Standard& Poors (S&P) provide capital markets with the mostcredible and objective measure of creditworthiness forcompanies, financial instruments and sovereign nations.PricewaterhouseCoopers estimates that less than 20%of global commodity customers have an internationallyrecognised credit rating provided by a globally recognisedrating agency. Many customers rely instead on theirreputation for payment, the credit rating of one or moreof their shareholding entities or even the sovereign creditrating of their country of domicile when negotiatingpurchase contracts.There are many reasons why obtaining a credit ratingis difficult for some commodity customers. Many largecustomers are not listed on any stock exchange and haveno audited financial accounts available. Although English isthe international language of banking and shipping, manycustomers provide no information or only extracts of theiraccounts in English.There are some sectors where ratings coverage is commonsuch as power generation for example. However, manycommodity customers have complex or undisclosedownership structures. Most large industrial companiescontract through subsidiaries but only disclose accountsof the parent and rarely fully guarantee the subsidiary.Many trading houses rely upon their reputations earnedthrough decades of honest trading and typically don’tprovide any financial information.International credit agencies are still conscious ofpast criticisms of slow reaction to previous economicslowdowns which were followed by spectacular corporatefailures. Most recently, credit agencies quickly began tosystematically downgrade companies with high debt levelsor looming loan repayments which were perceived to bedifficult to roll-over in a tightening capital market.The challenge for the producers is therefore to produce areliable picture of the credit risk position of each customerthat can be relied upon to be consistent and comparableacross the many different types of customer operating indifferent sovereign jurisdictions.Tightening banking requirementsCompounding matters in the second half of 2008, wasthe fact that the banks were facing their own credit crisisand began to significantly reduce their own exposure toother banks. Although much of the external focus seemedto be on falling prices, the mechanics of the commoditytrading system also began to break down. Fear of defaultfrom customers or their banks began to hinder deals asproducers, customers and their respective banks tried toevaluate new levels of counterparty risk.Compliance procedures were tightened severely,particularly for banks operating in developing economieswhere many commodity customers are to be found.Payment risk had previously been transferred betweenbanks (for a fee) thus guaranteeing payment for theproducer. Banks in developed economies started to refuseto accept the payment risk from many customer banks.Banks and credit insurers have also reduced recourseand limited recourse risk coverage for customers in manysectors and countries. This places further pressure onthe producers who are forced to make a decision aboutwhether or not to trade without risk coverage. Customerswithout such arrangements still expect the producers toagree sale contracts, particularly longstanding customerswith perfect payment records.Many customers started (and continue) to find itimpossible to arrange letters of credit guaranteeingpayment to the producer. Producers in this situationface a difficult choice of either loading the cargo andaccepting full open account payment risk or cancellinga coal sale to a customer at a time when supply isexceeding demand.Managing credit risk for global commodity producers
Sovereign and sector riskCredit risk cultureSovereign and sector risk are important components ofoverall export credit risk. Even multinational corporationswith strong credit rating in their home country of domicilemay have wholly owned subsidiaries operating in muchriskier countries or sectors. Currency exchange restrictionsfor example can negatively affect the ability to trade inanything other than local currency particularly during timesof inadequate foreign currency reserves.Most major producers have managed to make it throughthe global financial crisis without a significant level ofpayment defaults. However establishing new credit riskgovernance procedures has become a priority for many.A good credit risk policy should result in theimplementation of a system that encourages themeasured and controlled risk necessary to selltarget volumes at healthy prices.Sovereign risk is also an important proxy that can be usedfor government owned corporations. There is considerableinformation available on sovereign risk due to the hugelyactive foreign exchange and bond markets and almost allsovereign nations are rated by both Moodys and S&P.Developing a good credit culture means embeddingcredit risk awareness and processes throughout thesales and finance functions. This is an important stepto avoid the inevitable conflict between the sales teamtrying to sell the product, the finance team trying tomanage debtors and the treasury team managingworking capital requirements.Sector risk is more difficult to determine and can changefrequently. However many customer sectors are inherentlyriskier than others. For example, a pure trading house withunclear ownership structure is a fundamentally different riskposition than a state owned power generator with a regularcash flow.The risk involved in selling to particular industries canchange considerably in a relatively short time due tomany factors as diverse as changing demand for product,debt exposure levels, global supply situations or evenenvironmental factors like abnormal weather.Sector and sovereign risk may not be an issue if a parententity with a good credit rating guarantees the debts for allits subsidiaries no matter the industrial sector or country ofdomicile. However, it is clearly important that the credit riskassessment process ensures that such credit guaranteesare in place. Managing credit risk for global commodity producersSeparation of tasksOne symptom of an unhealthy credit risk culture and poorcontrol process is the situation where sales people viewcredit risk as being of no concern of the finance function.They may even ignore clear warning signs of customerfinancial distress in their haste to close the deal.One way to help embed good credit culture and procedureacross the sales and finance function is to ensure cleartask separation when it comes to setting the credit limitfor a customer and agreeing a sale contract with thatcustomer. The level of separation (and authorisation) willtypically vary depending on the size of the credit limitrequired. Ensuring sales personnel are never responsiblefor managing the credit limits of their own customers isthe most basic level of control.
C. Managing the credit risk processUsing external credit ratingsUtilising international rating agency information fromMoodys and S&P is a key element of a sound creditmanagement methodology. Investment grade ratingsprovide the yardstick for acceptable counterparty risk andcontractual risk accepted with customers defined by ratingagencies as being below investment grade should typicallyreturn a higher level of reward.Entering into a contract with counterparties consideredbelow investment grade requires caution, greater businessjustification and should be accompanied by a greater levelof monitoring.However, producers must bear in mind that it is thecustomer that pays for a credit rating for the primarypurpose of facilitating their own borrowings andinvestment. Some companies pay for ratings because theydon’t disclose financial information to the wider market.During the global financial crisis, some companies chose todiscontinue their use of credit agencies when their ratingsbegan to drop and threatened to fall below investmentgrade as defined by the major agencies. Even when ratingsare available, they must be treated with caution. Creditratings agencies are not responsible for verifying theaccuracy of the financial data supplied to them. The recentfinancial crisis demonstrated that even accurate historicalfinancial information is not always a good indicator of creditworthiness.Key external indicators such as share-price movementcan give an immediate indication of deteriorating financialposition even when the credit rating remains good. Internalqualitative measures such as late payments for recentshipments or erratic re-scheduling of shipments may alsogive a better indication of credit risk position than thecurrent credit rating.producer to move beyond historical measures and thinkcarefully about the factors that impact credit worthiness oftheir particular customer base.Figure 2: Customer financial informationKey assessment areaRiskCalculationWeighted risk1Risk rating2 3 4 51 Size20%1 8,249m0.2012 Net assets20%1 3,935m0.2013 Liquidity (Current ratio)15%1143%0.1514 Liquidity (Acid test)15%388%0.4535 Profitability20%36%0.6036 Gearing10%443%0.407 External credit rating0%0No rating0.00Weighted average100%2.0042Managing to limitsA credit limit is defined as the total amount of outstandingdebt that a producer is prepared to accept from acustomer. A credit limit is one of the most important keycontrol points in the credit management process.To be effective a credit limit is not a guideline but a‘hard stop’ control that needs to be taken seriously by allparticipants and a disciplined approach taken to potentialbreaches, increases and renewals.Shipments are seldom uniformly spread so whereprudent, limits may need to be set to allow for spikes involume. Managing this process in real time is incrediblydifficult when a producer sells/contracts multiple shipmentsfrom different ports/countries to the same customer. Itbecomes even more complex if the customer is purchasingthrough different legal entities with multiple destinationports which may not even be in the same country. Tocompound this problem further, many global producerssell/contract from more than one legal entity operating indifferent jurisdictions.Developing internal credit ratings for customersFor the reasons outlined above, the development of aninternal credit rating system is vital for producers thatsell on the global market. This process must be robustand wide-ranging enough to produce comparable riskmetrics for customers operating across different sectors,in different sovereign jurisdictions and with varying degreesof publicly available financial information. The processmust also be able to take into account complex ownershipstructures which also typically cross different legaljurisdictions. Implementing such a system requires aWeightingFigure 3: Risk factorsKey assessment area1Company riskWeightingRiskRiskWeighted risk60%3.001.80320%3.000.6030.402Sector risk3Sovereign risk20%2.00Weighted average100%2.801234523Managing credit risk for global commodity producers
FINANCIAL STATEMENTSBALANCE SHEETReporting PeriodMonths in Reporting PeriodRarely will a producer be able to contractually restrictshipments under a tight internal credit limit so managingto limits sometimes requires operational adjustmentssuch as monitoring vessel nomination and acceptancewhich is another key control point in the export creditprocess. Once a vessel has been accepted it is verydifficult and expensive to stop the cargo proceeding to thecustomer. An effective and efficient credit process musttherefore incorporate the functionality to forecast futureexposure levels based on latest shipping and expectedpayment schedules.Other methods that can be used to manage to internallimits include retaining title and control of the cargo forlonger eg changing from FOB to DES terms. However inthis situation, marine insurance arrangements will thenbe recommended. Trade finance and credit insurancemay also be used to sell down risk to trade banks andcredit insurers which can involve discounting receivables.However each of these options has an associated cost.The right tools for the jobMany producers still use unsophisticated credit riskmanagement practices consisting of ad hoc processes andrudimentary software tools at best. However universal useof a standardised credit assessment tool is an importantpart of the credit management process.Producing a standard set of software tools helpsstandardise credit risk assessment and ensure easyand consistent management reporting of the credit riskportfolio. Implementing such tools also helps producersunderstand credit trends, in particular customer sectors orgeographies and allows monitoring of the history of bothindividual customer and portfolio credit risk.The biggest barrier to developing a software tool is thelack of a consistent credit risk assessment process tosystemise in the first place. The credit risk policy and creditrisk assessment process are often absent or outdated andrequire significant effort to put in place the agreement ofall stakeholders across the organisation. Understandingand systemising the many parameters to be consideredwhen reaching a credit decision is the first step towardsimplementing a robust and standard methodology.The following steps are the typical sequence that must befollowed to implement a credit risk tool: Determine credit risk policy Determine key control points for sale/shipping Design credit assessment process Design reporting formats required Design tool logic Build, test and implement tool Managing credit risk for global commodity producersEuro (Millions)31-Dec-0831-Dec-071212Cash & EquivalentsTrade Accounts ReceivableInventoryOther Current AssetsTotal Current AssetsABCDNet Fixed AssetsIntangibles (goodwill, etc.)Other Non current AssetsTotal Non-Current AssetsEFGFigure 4: Credit risk assessment toolTOTAL ASSETSTrade Accounts PayableLoans PayableOther Short Term LiabilitiesTotal Current ng Term DebtLOther Non-current LiabilitiesMTotal Non-Current LiabilitiesShare price movementEuro (Millions)TOTAL LIABILITIES31-Dec-0831-Dec-07Ownership structure1212TOTAL EQUITY Status with industryFINANCIAL STATEMENTSBALANCE SHEETReporting PeriodMonths in Reporting PeriodCash & EquivalentsTrade Accounts ReceivableInventoryOther Current AssetsTotal Current AssetsABCDNet Fixed AssetsIntangibles (goodwill, etc.)Other Non current AssetsTotal Non-Current AssetsEFGIndustry trendRelationship historyCreditworthy news & eventsTotal Liabilities & EquityINCOME STATEMENTReporting PeriodMonths in Reporting PeriodTOTAL ASSETSTrade Accounts PayableLoans PayableOther Short Term LiabilitiesTotal Current LiabilitiesHIJProvisionsLong Term DebtOther Non-current LiabilitiesTotal Non-Current LiabilitiesKLMTOTAL EQUITYTotal Liabilities & EquityFinal RecommendationINCOME STATEMENT17,3819,3798,00215,5137,9887,525Total Operating ExpensesEBITDAP6,0241,9785,4632,062Depreciation & AmortisationEBITQ1,1608181,119943Loan Interest & Other Borrowing ExpenditureOther Non Operating ExpenditureNon O
C. Managing the credit risk process Using external credit ratings Utilising international rating agency information from Moodys and S&P is a key element of a sound credit management methodology. Investment grade ratings provide the yardstick for acceptable counterparty risk and contractual risk accepted with customers defined by rating
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Executive Summary 6 . Company Overview 7 . Basel III Overview 7 . Capital Requirements and Management 12 . Capital Summary 14 . Credit Risk 16 . Overview 16 . Wholesale Credit Risk 18 . Retail Credit Risk 20 . Counterparty Credit Risk 22 . Securitization Credit Risk 26 . Equity Credit Risk 30 . Operational Risk 33 . Market Risk 35 .
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