How counterparties can avoid going counterclockwise

By John Wengler, R. W. Beck Inc.

The one good thing that might be said about the recent publicity generated from Enron and other newsworthy up-heavals might be awareness. Finally, many are taking notice about the ripple effect left in the wake of this shake-up and are asking what to do now.

In essence, however, utility managers should consider their “credit risk,” which describes their financial exposure to a counterparty failing to honor their energy contracts. If there’s a short-list of things to do, utility managers should perform a check-up of their existing contracts (including netting agreements and other language), diversify their portfolios and concentrate on credit and risk management.

Taking inventory of the positions in your portfolio and the language within the contracts should be the first order of business. Classify each order of business by counterparty, coverage by master agreement, presence of custom contractual language, etc. Every manager should be able to answer many of the tough contract questions of what would happen if a counterparty defaults and what the probability is of the worst case actually happening.

The next step is to ensure that the utility diversifies its portfolios. Look to balance exposures to any single trading partner and reallocate and hedge their portfolios. Don’t forget to also ask counterparties to provide proof of reliability or credit enhancements.

In terms of risk management, if a manager is unsure about the status of the risk management efforts, perform the following test. Request a “4:15 Report”-trading houses generate this kind of report at the end of each trading day around 4:15 p.m., hence the name. The report describes the details on the mark-to-market profit-and-loss and maps the remaining risks in the portfolio. Basic risk measurements include such sensitivity analysis as delta and gamma (also known as the “Greeks”) as well as the “at risk” family of metrics including Value-at-Risk (VaR) and Cash-Flow-at-Risk (CFaR.) If this report is not available or if the manager does not understand it, the organization may have a potential problem.

Finally, let’s not forget fundamental financial management-return back to the basics of risk management. Make no mistake; if your firm is not already performing all these steps, it is likely that a financial loss will occur in the future. However, to implement and maintain credit and price risk management practices will require funding for information, computer systems and personnel. When considering the budget implications, just think about what might happen if you don’t perform the basics of risk management.

The recent publicity might actually help rather than hurt energy markets. Silver linings might include getting people to focus and understand their contracts; inspiring true portfolio diversification and inspiring organizations to get back to basics or to do the basics for the first time.

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Wengler is author of “Managing Energy Risk: A Nontechnical Guide to Markets and Trading” (PennWell, 2001) and a consultant with R. W. Beck Inc. He can be reached at 303-299-5252 or via e-mail at jwengler@rwbeck.com.

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