Sovereign Risk 2019: rising civil unrest adds to trading uncertainties

Hong Kong’s weary citizens went to the polls this weekend after enduring months of civil unrest and tension. And voting patterns, which indicate support for further political reforms and concessions, tend to suggest that head-on confrontations with Chinese authorities will continue. The island state’s troubled experience this year has made it the main focus of attention for trading and shipping companies anxious about rising sovereign risks. But, it is by no means alone.

In Latin America, crisis-hit Venezuela has been a persistent source of concern in regional oil markets, and the risk of contagion is rising. LNG importer, Chile, has seen an escalation of political unrest, and Colombia, of some prominence in the oil, gas and LPG trades, has also entered a new phase of volatility in response to President Ivan Duque’s proposed austerity measures. The latter’s decision to seal its borders has fueled an already-tense regional situation, while violent protests in Bolivia and Ecuador are adding to a sense of alarm in the region.

How does sovereign risk affect oil, gas and bunker shippers and traders, and what methods of risk mitigation are at their disposal?

For sellers, sovereign risks include any slowdown or non-payment of invoices due to restricted access to foreign exchange or obstacles to trade and shipments in commodities caused by the imposition of unforeseen political measures. For buyers and traders of oil and fuels, events such as the loss of liquidity to unwind either financial or physical positions, loss of impairment of the ability to repatriate capital or loss of reliability of delivery of equity oil entitlements, state seizure or forced nationalisation of oil-producing assets, joint-venture enterprises or projects, all fall into the sovereign risk category. Changes in royalties charged in oil production projects, as recently proposed in Trinidad and Tobago, also add to financial risks faced by investors and off-takers.

Contractual solutions?

Distinctions may exist between methods of risk control in physical trades and in financial trades in oil, gas and shipping. If trading under a master agreement with a margining threshold, like an International Swaps and Derivatives Association (ISDA) or Forward Freight Agreement Brokers’ Association (FFABA) contract, clauses covering material adverse changes, for example to the external rating of a counterparty’s country of domicile by ratings agencies Moodys or Standard and Poors, could allow a margin call from a counterparty to cover exposures. This is easy enough to apply to financial trades like oil, gas or freight futures, but not so easy to apply to physical trades.

Other ways to mitigate sovereign risk, especially escalated fears over availability of foreign exchange, include requesting letters of credit (LCs) as security for a stand-alone trade, or requesting payment in advance for the supply of a commodity to an enterprise which is located in a region of higher risk. LCs issued by Hong Kong-registered banks for the import of a commodity could themselves now be deemed to carry higher sovereign risk due to the present unpredictable political situation, and hence may be seen as requiring confirmation by a bank in another jurisdiction which carries lower risk.

Establishing a balance

Payment in advance is often viewed as a draconian step. It is impractical where large exposures are concerned, and it is contentious in the sense that it might damage a trading relationship. But its impact could be softened by relaxation or renegotiation of other terms in the buyer’s favour, such as some form of discounts or sharing of certain costs. Or, it could be spread over a series of trades through some kind of initial margin posted by a buyer, rather like the initial margin required to be posted by trading members of an energy or commodity futures exchange.

Other solutions may exist. Credit insurance can be considered to guard against the risk of future non-payment from buyers of commodities. But this service is expensive and can be time-consuming, especially if it is to cover exposures in more volatile regions. Credit insurance may also require disclosures by the insured party to the insurer of details of the trading relationship being covered, which can be burdensome and bureaucratic, and could even compromise existing confidentiality agreements between the buyer and seller.

How the current political situations evolve in Hong Kong, Latin America and other areas of heightened sovereign risk, remains to be seen. But, the escalation of sovereign risk we have seen in 2019 reminds us of the great importance of vigilance, of monitoring credit exposures against jurisdictions and regions in times of abrupt changes, of know-your-counterparty principles, and of the need to devise and utilise innovative and flexible responses to fluctuating credit risks.

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Published on 27 Nov 2019

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