With a sharp downturn in prices and unclear future demand, the oil industry is facing major challenges in the wake of COVID-19. How will it adjust? What changes will we see? And, what are the implications for risk analysts across the industry?
Back in 2019, oil companies were working towards a new market model, following a transition phase towards zero-carbon targets, reduced sulphur content, second-generation biofuels and a host of other environmentally-motivated targets. Today, however, the COVID-19 shock, on top of the OPEC+ price war, has demolished these plans, leaving in their place a series of major challenges and risks. From producers and refiners to shippers and traders, the oil market has essentially entered a new phase of adaptation, where operators in all sectors must adapt to a brutal new reality in order to survive.
Credit risk and know-your-counterparty (KYC) analysts in oil trading will have to be acutely conscious of the implications.
History can tell us a few things. Previous oil market shocks have often given rise to mergers and amalgamations, and this one will probably be no different. When prices fall rapidly, the pressure on oil producers, especially smaller ones, is sudden and intense. Through merger they can achieve economies of scale and stay afloat. But, in the current oil market, producers must not only contend with low prices. They are also looking at a wholly uncertain outlook for demand. So, the speed of adjustment this time around could be rapid in comparison with previous shocks, and we may see imminent mergers, particularly in the US shale oil, offshore African and UK North Sea sectors.
KYC professionals have to use their judgement here.
After a merger, an external rating usually defaults to the weaker of the two pre-merger external company ratings, assuming they are broadly similar enterprises. Hence, a wave of mergers and decline in external ratings tend to suggest that physical oil trading credit limits will come under pressure, to reflect the weaker underlying industry-wide position. Another response to the crisis could come in the form of state intervention, perhaps in the form of oil company re-nationalisations, or, to address credit concerns, issuance of state guarantees of performance or payment. In mid-March, the Spanish Government took the unusual step of issuing a guarantee that marine fuels would be available at Spanish ports. If the crisis deepens and a sustained decline in revenues emerges, we may see Governments having to adapt as well, to rescue integrated oil companies to ensure that they can continue to function. While accustomed to evaluating performance and credit-standing of National Oil Companies (NOCs) in emerging markets, looking primarily at sovereign risks, KYC analysts might soon be evaluating state-owned companies or state guarantees in the US or Western Europe.
Other frailties exposed by the current crisis concern the oil refining sector.
When crude oil prices fall dramatically, refining margins are usually enhanced. The 2014 oil price shock created a boom in oil refining for precisely this reason, but once again the demand outlook, and very likely weaker oil products prices, will scupper any notion that refiners are set for a big upturn in their fortunes. European oil refining has long been suspected of being in a state of over-capacity, and the current shock could finally prove it. The US market is slightly different, with capacity utilisation rates in 2018/2019 touching 100% at times, so the scope to accommodate a downturn in US fuels demand through reduced runs is much greater. Refiners in Europe may have to adapt by altering their models to avoid closure, perhaps through conversion to second-generation biofuels production, or conversion to storage. Both have precedents in the UK, Italy and other markets. The storage option may be an easier first step. We have seen from the tanker market that storage demand could remain very high in the coming months and years, meaning that development of more fixed-point oil storage capacity may be a logical method of adaptation. KYC and credit analysts will have to look more closely at risks if refineries go down the storage route, for example how capacity is sold or traded, whether third party access is permitted, and how revenue is structured.
Away from physical markets, similar risks will emerge.
Oil derivatives trading is usually conducted under International Swaps and Derivatives Association (ISDA) standardised contracts. These carry a threshold and margining agreement, governed by financial covenants or external rating triggers. Normally, when a credit event occurs, such as a material adverse change in a counterparty’s credit-standing, or if the covenants are breached, the threshold is marked downwards. Current oil market conditions create a big dilemma for credit analysts, as a “kneejerk” tightening of terms in oil derivatives contracts could create more problems than it solves. If thresholds are cut, this could, depending on the scale of existing trades, trigger immediate margin calls. Manifestly, the cashflow implications for oil trading companies could be serious, but equally grave are the effects on market liquidity. Traders will not be encouraged to enter a new trade governed by a margining agreement, if it gives rise to an immediate margin call. Hence, a policy of implementing draconian threshold adjustments could simply kill off trade as well as causing needless risks for other participants.
Without doubt, the oil industry must now confront a period of adaptation as these new realities sink in. It will recover, as wholesale trade and transportation of goods and commodities has to survive. But the big questions now will refer to how the industry adapts, and how quickly it can do it.
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