Credit-Capacity Boosts

Despite modest economic improvements in the financial markets, credit remains relatively difficult to obtain and, when it is available, it’s expensive. So, it’s more important than ever for companies to develop strategies to optimize their credit capacity.

Managing mark-to-market (MtM) margin calls on hedges can be a significant drain on liquidity. But oil and gas producers have a variety of options to choose from to help reduce the amount of collateral required, such as cash or letters of credit. These methods can support their hedge strategies and help increase capital available to them to fund drilling or exploration opportunities. Producers won’t be able to eliminate the need to post collateral, but the new credit structures can significantly reduce the amount of collateral needed.

Qualifying producers can employ three innovative credit structures to increase their credit capacity. The master netting agreement (MNA) allows producers to net their accounts receivable from physical sales against MtM exposure from hedges.

The non-margining unsecured credit structure (NUI) allows producers to hedge to a predetermined level without being margined. A third option is the non-margining secured credit structure (NSI), which is similar to the NUI product but includes a security interest/mortgage on producers’ assets.

An additional way to reduce hedging costs is the threshold option, which can be combined with one of the credit structures or used independently.

Not every risk-management option is going to work for every producer. Careful review and analysis are required to determine if the benefits and potential risks are applicable to each producer. If these structures are appropriate for the producer, they can provide flexibility and support growth.

Vetting Providers

To properly optimize these structures, producers should work with a trusted energy risk marketer that can provide access to both financial and physical products. Further, diversifying risk-management providers is critical, as many producers learned during the banking crisis in 2008. Selecting a provider is not a simple or easy decision. Here are factors producers should take into consideration in the selection process:

Commitment to the energy business. In a cyclical industry—like energy—it’s important to know the energy risk marketer can manage the cycles. Historically, companies with energy production as a business core are very familiar with and prepare for such cycles.

Counterparty credit risk/Diversified providers. Energy risk marketers should be creditworthy and have a strong balance sheet. Producers should diversify their portfolio with financial and nonfinancial counterparties.

Products and services flexibility. A critical component of flexibility is the ability to offer physical and financial products, which is key to customized solutions. For example, to utilize the MNA option, the energy risk marketer must be able to competitively purchase the producer’s physical gas and/or crude in addition to offering a full slate of financial products.

Established framework and policies. Energy risk marketers should have strong business principles, coupled with strong internal controls with checks and balances in place.

Customer focus. Energy risk marketers should be focused on producers’ needs and have the knowledge, relationships and experience to enter new markets and develop solutions that will address ever-changing market conditions.

Maximizing Benefits

Producers often fail to optimize their liquidity in managing their potential hedge exposures. They are simply tying up too much liquidity for margin calls, which reduces the amount of funds available for capital expenditures. In fact, they may be able to access additional credit capacity to manage margin calls with options that they may not even realize exist.

These risk management options/credit structures are appropriate for a variety of producers both large and small.

Master Netting Agreement: Physical account receivables netted against financial MtM exposure

If producers can sell their physical product to the same counterparty they hedge with, they can generally use an MNA to increase their credit capacity. Only energy risk marketers with physical trading capabilities in the market and a strong credit rating should be considered for this option.

Non-margining, Unsecured Credit Structure

A non-margin, unsecured credit structure (NUI) allows producers to hedge up to a pre-determined limit without the risk of being margined. And since the hedge provider is unsecured, there is no requirement to pledge assets, thus eliminating the need for approval from secured lenders. This product is an obvious choice for qualified producers because they can easily increase liquidity without encumbering assets or drawing down limited credit lines.

Non-margining, Secured Credit Structure

The non-margin secured credit structure (NSI) is similar to the NUI except that producers’ assets secure the hedge provider’s MtM exposure, making it an option for those who may not qualify for the NUI. This structure allows producers to hedge to a pre-determined level without having to post margin if prices increase. If the producer’s lender already has a lien on the assets, an inter-creditor agreement will need to be negotiated between the producer, lender and hedge provider.

Although the lender may oppose including the hedge provider in the agreement, adding a creditworthy, non-financial energy risk marketer gives producers access to better pricing and increased price transparency, and reduces their exposure to the financial sector.

Threshold Option

The threshold option enhances liquidity by allowing producers to purchase “puts” without paying the usual upfront premium, and if prices stay above set levels, the producer never pays a premium.

If prices do fall to the point that all the triggers are breached, the premium would exceed that of a normal put option—but at that point the producer is paying for protection when needed. This option is useful for producers that are required to hedge, but don’t want to lose the upside.

There has been significant interest in these credit structures and, while not appropriate for every producer, they have allowed both large and small producers to increase credit capacity and support growth in challenging financial times.

Ted Behrens is director of risk management for Shell Energy North America (US) LP, a subsidiary of Royal Dutch Shell Plc and a leading energy marketing and trading company in North America.