Preparing your business for a eurozone breakup?

09 Jan, 2012

The probability and timing of a disorderly eurozone breakup are difficult to predict.  But if a breakup occurs, the risk impact on most European energy companies is likely to be severe.  In last week’s article we set out why we believe there is a credible threat of a eurozone breakup in 2012.  This week we focus on some prudent risk management measures that can be taken to better prepare a company for the impact of a severe external shock. 

Assessing the risk

Most energy companies have a structured approach to assess the impact of risks on their business.  Typically this involves grouping key business risks into categories, e.g. market risk, credit risk, volumetric risk.  This provides a useful framework from which to understand the impact of an external shock.  The impact of a eurozone breakup will of course be company specific, however below we have listed some high level considerations against a categorisation of key energy company risks. 

Market risk

  • Falling commodity prices: The onset of the global financial crisis in 2008 is a fresh reminder of the risk of precipitous declines in commodity prices that can occur as a result of a rapid liquidity crunch and slowdown in economic growth
  • Periods of extreme commodity price volatility: The uncertainty associated with the impact of a eurozone breakup and policy response would be likely to drive extreme volatility, particularly given conditions of inelastic (unresponsive) supply curves in many commodity markets (e.g. coal)

Basis risk

  • Break down of basis relationships: Basis risk is common in energy portfolios given the limited liquidity in traded products available to hedge a diversity of physical exposures (e.g. location, duration, quality).  Basis risk is often contained by relatively stable correlation relationships between hedges and underlying asset exposures, but these correlations are liable to break down under conditions of extreme market stress.

Liquidity risk

  • Forward market liquidity contraction: a significant portion of market liquidity under normal conditions is driven by speculative trading (‘asset backed’ or otherwise) by energy companies and financial institutions.  In times of crisis, liquidity is likely to contract back towards basic exposure management and financial institutions may exit the market altogether.
  • Illiquid exposures become exactly that: When forward market liquidity contracts, pricing and liquidity for complex exposures and structured products may evaporate altogether.

Volumetric risk

  • Asset volume fluctuations: Uncertainty associated with the volume of asset exposures (e.g. via load fluctuations and production outages) may be exacerbated.  This is particularly the case with commercial and industrial customer load as companies face temporary shutdown (as in 2008) or default.

Credit risk

  • Loss of counterparties: A contraction in liquidity is likely to be accompanied by a contraction in credit worthy counterparties, particularly given the risk of a systemic banking crisis compromising financial institutions.
  • Default risk: The probability of the outright default of existing counterparties may increase sharply, with the potential to create sudden portfolio exposures by rendering supply or hedge contracts ineffective.

Exchange rate, interest rate and funding risks

  • Exchange rate risk:  A eurozone breakup may cause extreme FX volatility and the re-introduction of national currencies for countries currently using the euro.
  • Interest rate and funding risk:  Given corporate borrowing rates are driven by sovereign credit pricing, a eurozone breakup and the associated re-pricing of credit risk would be likely to cause severe fluctuations in the cost and availability of funding over all time horizons (trade finance to structural debt issuance).

Operational risk

  • Rapid evolution of systems and business processes: Operational risks are likely to be company specific but include for example the impact on systems and processes of a rapid re-introduction of national currencies.

Regulatory risk

  • Intervention: If market stress or company defaults threaten national security of supply, there may be heavy handed intervention by governments and regulators.

These are some higher level considerations of the risk impact of a eurozone breakup but the approach can be extended to drill down in more detail into the specific risks that an individual company faces.

Risk management response

Effectively confronting the threat of a eurozone breakup means recognising extreme uncertainty.  This does not mean that risk management is impossible, but it does compromise some approaches commonly used for risk analysis.  For example, the impact is likely to fall largely beyond the capacity of conventional ‘value at risk’ and ‘earnings at risk’ techniques calibrated using historical data. 

The simplest and most effective technique that can be applied to test a substantial shock is portfolio stress testing.  This can be done by trying to estimate the potential scale of the impact of different risks on portfolio exposures (2008 is a useful starting point, but a eurozone breakup would likely be more extreme).  Or a ‘reverse stress testing’ approach can be taken where risk factors are stressed to determine at what point the portfolio may face a critical issue.  There may also be value in stressing the input parameters of conventional ‘at risk’ tests, particularly if the behaviour and outputs of these tests are well understood within a company.

It could be argued that focusing on the impact of a disorderly eurozone breakup that may never occur, is a waste of valuable time and resources.  We strongly disagree with this logic.  The magnitude of the threat from an external shock of this scale warrants careful risk analysis and contingency planning to preserve portfolio value and ensure business continuity.  Taking a structured approach to the analysis of conditions of extreme market stress is likely to be a valuable exercise in understanding portfolio risk regardless of eurozone events.

But the possibility of a eurozone breakup is not all about risk.  There are also likely to be enormous value opportunities that emerge from market stress, particularly from the temporary mispricing of asset optionality, for companies that have the cash, flexibility and resources to pursue them.  But that is a topic for an article to follow.

Relevant articles:

Will the eurozone survive 2012?

A renewed credit crunch and European energy investment

The downside risks to energy markets intensify