Credit Risk Commodity Producers

7/30/2019 Credit Risk Commodity Producers

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2010 PricewaterhouseCoopers. All rights reserved. PricewaterhouseCoopers reers to PricewaterhouseCoopers,a partnership ormed in Australia or, as the context requires, the PricewaterhouseCoopers global network or othermember rms o the network, each o which is a separate and independent legal entity.


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The global nancial crisis has brought credit management

practices back onto the boardroom agenda o most

large exporting producers. Credit exposure or a single

customer can be in the order o several hundred million

dollars or large producers. Despite the turmoil o the

past two years, many commodity producers still use

unsophisticated credit risk management practices.

This paper describes the credit risk issues aced by

global commodity producers and highlights examples

o best practice in the areas o the assessment and

management o credit risk.

Introduction


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Managing credit risk or global commodity producers2

Commodity credit risk

As commodity prices and volumes rose steadily in the

years beore the nancial crisis in 2008, credit exposure o

commodity producers grew silently and massively. Masking

this exposure was the very low incidence o payment

deault due to the burgeoning global demand which oered

many alternative sale options to anyone with an unwanted

cargo or available stockpile.

Commodity markets have become truly globalised over

the past two decades. Large users o raw materialssuch as steel mills, reneries and power stations now

deal directly with commodity producers rather than the

trading houses that previously dominated international

trade in many commodities. Driving this change has

been commodity user access to oreign exchange and

overseas bank nancing. More recently, commodity users

rom emerging economies have also been able to deal

directly with producers due to the adoption o international

accounting and reporting practices and better local capital

market regulation.

In this increasingly competitive supply environment, large

export producers have been required to accept credit risk

rom a wider variety o international customers. Over thepast two decades, export producers have become more

accustomed to huge credit exposures and more relaxed

about the nancial standing o their customers as they vied

to sell their product to both industrial sector customers and

the increasing number o trading houses ocused entirely

on commodity speculation. For all but the most disciplined

o producers, the pressure to produce volume and preserve

price overpowered the ability to manage credit risk at

acceptable levels. For many producers, the customer

track record o payment remains the only metric used

to assess the credit worthiness o a customer.

Increased deault risk rom buyers

From the middle o 2008, many commodity customers

began to aggressively negotiate reductions to contractually

agreed prices and in some cases deerring and cancelling

shipments. This is unsurprising given that a shipment

o iron ore or coal purchased when prices were at their

peak could be purchased on the spot market or tens o

millions o dollars less by the time the loaded reighter was

in transit. Faced with increased customer reluctance to

accept contracted shipments, producers quickly began to

quantiy their credit exposures and realised the signicant

risk o payment deault they aced rom some o their

biggest customers.

Some producers who can ship CFR/CIF have exercised

their options to retain control o the cargo or longer and

thereore reduced their credit exposure or voyage time.

However, these producers are generally able to maintain

usual payment terms which place FOB shippers under

more pressure to maintain their existing terms.

A. The return o credit risk

Figure 1: Increasing credit risk

-100%

0%

100%

200%

300%

400%

500%

2006 2007 2008 2009 2010

Changeinprice(%)

Thermal Coal Iron Ore Platinum


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Managing credit risk or global commodity producers

B. The credit risk challenge

Piloting through the global nancial crisis

Selling commodities on the global market requires

major exporting producers to enter into complex credit

arrangements involving billions o dollars annually or the

sale and transport o hundreds o millions o tonnes o

minerals across multiple legal jurisdictions.

Steven Johnstone, Global Head o Risk and Assurance,

Base Metals at Anglo American is clear about the

importance o credit risk: Managing the complex credit

arrangements required to sell our commodities as wepiloted through the global nancial crisis put credit risk

back on the main agenda or Anglo and all major mining

companies. Anglo Americans response to this industry

challenge was to develop a completely new global credit

risk process or coal sales which was ully implemented

by June 2009 across the companys main coal operations

in South Arica, Australia and the UK.

Credit ratings

The international rating agencies: Moodys and Standard

& Poors (S&P) provide capital markets with the most

credible and objective measure o creditworthiness or

companies, nancial instruments and sovereign nations.

PricewaterhouseCoopers estimates that less than 20%

o global commodity customers have an internationally

recognised credit rating provided by a globally recognised

rating agency. Many customers rely instead on their

reputation or payment, the credit rating o one or more

o their shareholding entities or even the sovereign credit

rating o their country o domicile when negotiating

purchase contracts.

There are many reasons why obtaining a credit rating

is dicult or some commodity customers. Many large

customers are not listed on any stock exchange and have

no audited nancial accounts available. Although English is

the international language o banking and shipping, many

customers provide no inormation or only extracts o their

accounts in English.

There are some sectors where ratings coverage is common

such as power generation or example. However, many

commodity customers have complex or undisclosed

ownership structures. Most large industrial companies

contract through subsidiaries but only disclose accounts

o the parent and rarely ully guarantee the subsidiary.

Many trading houses rely upon their reputations earned

through decades o honest trading and typically dont

provide any nancial inormation.

International credit agencies are still conscious o

past criticisms o slow reaction to previous economic

slowdowns which were ollowed by spectacular corporate

ailures. Most recently, credit agencies quickly began to

systematically downgrade companies with high debt levels

or looming loan repayments which were perceived to be

dicult to roll-over in a tightening capital market.

The challenge or the producers is thereore to produce a

reliable picture o the credit risk position o each customer

that can be relied upon to be consistent and comparable

across the many dierent types o customer operating in

dierent sovereign jurisdictions.

Tightening banking requirements

Compounding matters in the second hal o 2008, was

the act that the banks were acing their own credit crisis

and began to signicantly reduce their own exposure to

other banks. Although much o the external ocus seemed

to be on alling prices, the mechanics o the commodity

trading system also began to break down. Fear o deault

rom customers or their banks began to hinder deals as

producers, customers and their respective banks tried to

evaluate new levels o counterparty risk.Compliance procedures were tightened severely,

particularly or banks operating in developing economies

where many commodity customers are to be ound.

Payment risk had previously been transerred between

banks (or a ee) thus guaranteeing payment or the

producer. Banks in developed economies started to reuse

to accept the payment risk rom many customer banks.

Banks and credit insurers have also reduced recourse

and limited recourse risk coverage or customers in many

sectors and countries. This places urther pressure on

the producers who are orced to make a decision about

whether or not to trade without risk coverage. Customers

without such arrangements still expect the producers toagree sale contracts, particularly longstanding customers

with perect payment records.

Many customers started (and continue) to nd it

impossible to arrange letters o credit guaranteeing

payment to the producer. Producers in this situation

ace a dicult choice o either loading the cargo and

accepting ull open account payment risk or cancelling

a coal sale to a customer at a time when supply is

exceeding demand.


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Sovereign and sector risk

Sovereign and sector risk are important components o

overall export credit risk. Even multinational corporations

with strong credit rating in their home country o domicile

may have wholly owned subsidiaries operating in much

riskier countries or sectors. Currency exchange restrictions

or example can negatively aect the ability to trade in

anything other than local currency particularly during times

o inadequate oreign currency reserves.Sovereign risk is also an important proxy that can be used

or government owned corporations. There is considerable

inormation available on sovereign risk due to the hugely

active oreign exchange and bond markets and almost all

sovereign nations are rated by both Moodys and S&P.

Sector risk is more dicult to determine and can change

requently. However many customer sectors are inherently

riskier than others. For example, a pure trading house with

unclear ownership structure is a undamentally dierent risk

position than a state owned power generator with a regular

cash fow.

The risk involved in selling to particular industries canchange considerably in a relatively short time due to

many actors as diverse as changing demand or product,

debt exposure levels, global supply situations or even

environmental actors like abnormal weather.

Sector and sovereign risk may not be an issue i a parent

entity with a good credit rating guarantees the debts or all

its subsidiaries no matter the industrial sector or country o

domicile. However, it is clearly important that the credit risk

assessment process ensures that such credit guarantees

are in place.

Credit risk culture

Most major producers have managed to make it through

the global nancial crisis without a signicant level o

payment deaults. However establishing new credit risk

governance procedures has become a priority or many.

A good credit risk policy should result in the

implementation o a system that encourages the

measured and controlled risk necessary to sell

target volumes at healthy prices.Developing a good credit culture means embedding

credit risk awareness and processes throughout the

sales and nance unctions. This is an important step

to avoid the inevitable confict between the sales team

trying to sell the product, the nance team trying to

manage debtors and the treasury team managing

working capital requirements.

Separation o tasks

One symptom o an unhealthy credit risk culture and poor

control process is the situation where sales people view

credit risk as being o no concern o the nance unction.

They may even ignore clear warning signs o customer

nancial distress in their haste to close the deal.

One way to help embed good credit culture and procedure

across the sales and nance unction is to ensure clear

task separation when it comes to setting the credit limit

or a customer and agreeing a sale contract with that

customer. The level o separation (and authorisation) will

typically vary depending on the size o the credit limit

required. Ensuring sales personnel are never responsible

or managing the credit limits o their own customers is

the most basic level o control.


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C. Managing the credit risk processUsing external credit ratings

Utilising international rating agency inormation rom

Moodys and S&P is a key element o a sound credit

management methodology. Investment grade ratings

provide the yardstick or acceptable counterparty risk and

contractual risk accepted with customers dened by rating

agencies as being below investment grade should typically

return a higher level o reward.

Entering into a contract with counterparties consideredbelow investment grade requires caution, greater business

justication and should be accompanied by a greater level

o monitoring.

However, producers must bear in mind that it is the

customer that pays or a credit rating or the primary

purpose o acilitating their own borrowings and

investment. Some companies pay or ratings because they

dont disclose nancial inormation to the wider market.

During the global nancial crisis, some companies chose to

discontinue their use o credit agencies when their ratings

began to drop and threatened to all below investment

grade as dened by the major agencies. Even when ratings

are available, they must be treated with caution. Creditratings agencies are not responsible or veriying the

accuracy o the nancial data supplied to them. The recent

nancial crisis demonstrated that even accurate historical

nancial inormation is not always a good indicator o credit

worthiness.

Key external indicators such as share-price movement

can give an immediate indication o deteriorating nancial

position even when the credit rating remains good. Internal

qualitative measures such as late payments or recent

shipments or erratic re-scheduling o shipments may also

give a better indication o credit risk position than the

current credit rating.

Developing internal credit ratings or customers

For the reasons outlined above, the development o an

internal credit rating system is vital or producers that

sell on the global market. This process must be robust

and wide-ranging enough to produce comparable risk

metrics or customers operating across dierent sectors,

in dierent sovereign jurisdictions and with varying degrees

o publicly available nancial inormation. The process

must also be able to take into account complex ownership

structures which also typically cross dierent legal

jurisdictions. Implementing such a system requires a

producer to move beyond historical measures and think

careully about the actors that impact credit worthiness o

their particular customer base.

Managing to limits

A credit limit is dened as the total amount o outstanding

debt that a producer is prepared to accept rom a

customer. A credit limit is one o the most important key

control points in the credit management process.

To be eective a credit limit is not a guideline but a

hard stop control that needs to be taken seriously by allparticipants and a disciplined approach taken to potential

breaches, increases and renewals.

Shipments are seldom uniormly spread so where

prudent, limits may need to be set to allow or spikes in

volume. Managing this process in real time is incredibly

dicult when a producer sells/contracts multiple shipments

rom dierent ports/countries to the same customer. It

becomes even more complex i the customer is purchasing

through dierent legal entities with multiple destination

ports which may not even be in the same country. To

compound this problem urther, many global producers

sell/contract rom more than one legal entity operating in

dierent jurisdictions.

1 2 3 4 5

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Size 20% 1 $8,249m

Net assets 20% 1 $3,935m

Liquidity ( Current r atio) 15% 1 143%

Liquidity (Acid test) 15% 3 88%

Profitability 20% 3 6%

Gearing 10% 4 43%

External credit rating 0% 0 No rating

Weighted average 100% 2.00

Risk ratingKey assessment area Weighting Risk Calculation Weighted risk

0.20

0.20

0.15

0.45

0.60

0.40

0.00

3

3

2

1

1

1

4

Figure 2: Customer fnancial inormation

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Company risk 60% 3.00 1.80

Sector risk 20 % 3.00 0.60

Sovereign risk 20 % 2.00 0.40

Weighted average 100% 2.80

RiskWeighting Risk Weighted riskKey assessment area

1

2

3 2

3

3

3

Figure 3: Risk actors


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Rarely will a producer be able to contractually restrict

shipments under a tight internal credit limit so managing

to limits sometimes requires operational adjustmentssuch as monitoring vessel nomination and acceptance

which is another key control point in the export credit

process. Once a vessel has been accepted it is very

dicult and expensive to stop the cargo proceeding to the

customer. An eective and ecient credit process must

thereore incorporate the unctionality to orecast uture

exposure levels based on latest shipping and expected

payment schedules.

Other methods that can be used to manage to internal

limits include retaining title and control o the cargo or

longer eg changing rom FOB to DES terms. However in

this situation, marine insurance arrangements will then

be recommended. Trade nance and credit insurance

may also be used to sell down risk to trade banks and

credit insurers which can involve discounting receivables.

However each o these options has an associated cost.

The right tools or the job

Many producers still use unsophisticated credit risk

management practices consisting o ad hoc processes and

rudimentary sotware tools at best. However universal use

o a standardised credit assessment tool is an important

part o the credit management process.

Producing a standard set o sotware tools helps

standardise credit risk assessment and ensure easyand consistent management reporting o the credit risk

portolio. Implementing such tools also helps producers

understand credit trends, in particular customer sectors or

geographies and allows monitoring o the history o both

individual customer and portolio credit risk.

The biggest barrier to developing a sotware tool is the

lack o a consistent credit risk assessment process to

systemise in the rst place. The credit risk policy and credit

risk assessment process are oten absent or outdated and

require signicant eort to put in place the agreement o

all stakeholders across the organisation. Understanding

and systemising the many parameters to be considered

when reaching a credit decision is the rst step towards

implementing a robust and standard methodology.

The ollowing steps are the typical sequence that must be

ollowed to implement a credit risk tool:

Determine credit risk policy

Determine key control points or sale/shipping

Design credit assessment process

Design reporting ormats required

Design tool logic

Build, test and implement tool

Design principles o the tool

l Balances leading and lagging indicators

l Links the credit risk assessment to a structured

credit limit estimation

l Integrates the credit risk assessment rating to contract risk

or unsecured customers

l User riendly and eective ormat to increase risk

assessment process eciency

l Automated unctionality to analyse customer inormation

l Leverages external credit ratings rom Moodys & S&P

l Incorporates sovereign risk ratings

l Provides both a quantitative and qualitative perspective to

allow or an inormed credit risk assessment

Figure 4: Credit risk assessment tool

2

$ 50,000,000

2

Final Recommendation

Credit Risk Assessment - Authorized Approval

Approverscomments:

Recommendedcredit risk rating(Please select):

Submitted forapproval by:

Frequency of review required:

Dateof approval:

Approversname:

Approverssignature

Recommendedcredit terms andsecurity (ifapplicable):

Pleasediscuss reasons for creditterms, creditlimitand any potentialadjustment tothe overallcredit risk rating

Recommenders comments:

Recommendedcredit limit: $USD million (ifapplicable):

Reporting Period

Months in Reporting Period

BALANCE SHEET

Cash & Equivalents

Trade Accounts Receivable

InventoryOther Current AssetsTotal Current Assets

Net Fixed Assets

Intangibles (goodwill, etc.)

Other Non current Assets

Total Non-Current Assets

TOTAL ASSETS

Trade Accounts PayableLoans Payable

Other Short Term LiabilitiesTotal Current Liabilities

ProvisionsLong Term Debt

Other Non-current Liabilities

Total Non-Current Liabilities

TOTAL LIABILITIES

TOTAL EQUITY

Total Liabilities & Equity

Euro (Millions)

3 1- De c- 08 3 1- De c- 07

A

B

C

D

E

F

G

H

I

J

K

L

M

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FINANCIAL STATEMENTS

, .

Revenue

Cost Of Goods Sold

Gross Profit

Total Operating Expenses

EBITDA

Depreciation & Amortisation

EBIT

Loan Interest & Other Borrowing Expenditure

Other Non Operating Expenditure

Non Operating Income

Net Before Taxes

Tax Expenditure

Extraordinary Income or (Loss)

Minority Interest Income or (Loss)

Euro (Millions)

31-Dec-08 31-Dec-07

12 12

N

O

P

Q

R

S

T

U

VW

17,381 15,513

9,379 7,988

8,002 7,525

6,024 5,463

1,978 2,062

1,160 1,119

818 943

606 5630 0

156 147

368 527

130 158

117 602

0 0

355 971NET INCOME AFTER TAX

Reporting Period

Months in Reporting Period

INCOME STATEMENT

Qualitative Quantitative

Share price movement

Ownership structure

Status with industry

Industry trend

Relationship history

Creditworthy news & events

External credit rating

Balance sheet

Income statement

Market segment

Country o operation


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Adopting a portolio view o credit risk

Adopting a portolio view o credit risk allows customercomparison and also a measure o aggregate credit risk

which can be segmented by geography, industry sector or

risk category. The portolio view o credit risk is typically

the view that should be presented regularly to both board

level risk committees and the executive management team.

One company who have implemented a new approach to

credit risk is Anglo American plc who implemented new

global credit risk policy, processes and tools in June 2009.

Francois Jacques, then Global Head o Marketing or Anglo

Coal was very clear about the need to adopt a portolio

view to assist management decision making. At the

customer level, we had to introduce a robust set o tools

and policies to cope with the new world we now operate in.But without risk there is no return and it is vital that we also

understand our exposure to each industry sector and o

course each country that we sell to.

It is suggested that to obtain a balanced portolio view,

aggregate credit risk should be reported by:

customer

customer sector

product (commodity)

producing mine

country o production

country o destination

The portolio view o customer credit risk should highlightany imbalance o risk exposure to particular sectors

and geographies or closely related customer entities in

particular. Well presented portolio summary data will help

minimise short term credit risk and also steer business

volumes to customers and sectors with stronger credit

positions. This should result in a healthy well balanced

customer portolio in the longer term.

Trade nance, credit insurance and

banking relationshipsTrade banks and credit insurers play an important role in

providing the nancial mechanisms needed to acilitate

trade between producers and customers such as letters

o credit. Banks can also acilitate participation in the

credit deault swap market which can provide coverage

o payment deault risk on customers at the more credit

worthy end o the spectrum. The banks in eect accept the

transer o trade risk rom the customer or a price. They

can also eectively provide risk cover or open account

business on either a disclosed or silent basis although

typically this will involve tight contract terms or a bill o

exchange as part o their security. However the cost o

such nancial mechanisms can be extremely high orcustomers with high credit risk.

Trade nance is an important aspect o the credit

management process and must be managed tightly to

avoid unintended unsecured risk. The credit risk protection

provided by letters o credit used to secure payment or

a shipment commonly become invalid due to the inability

o the producer to comply with the strict documentation

requirements o the bank. In the event o payment deault

in such circumstances, the producer has no recourse to

the issuing or conrming bank and has wasted time and

money conrming the letters o credit.

Trade banks and credit insurers are excellent sources o

inormation or commodity producers. Banks typically have

proessional credit departments with deep inormation. It

is in a banks interest to share credit related inormation

with the producers using their services where it is legal to

do so. However ew producers systemise the collation o

appropriate data rom their banking partners in a proactive

and timely manner as part o the credit risk process. Since

the onset o the global nancial crisis, banks have become

accustomed to receiving urgent requests or inormation

rom producers to help resolve credit decisions.

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$30

$35

$40

$25

$20

$15

$10

$5

$0

Credit risk rating

Creditlimit($millions)

Very low risk Low risk Medium risk High risk Very high risk

$Zm/1%High risk

$Ym/41%Medium risk $Xm/58%

Low risk

Figure 5: Credit risk profle Customers


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Brian GillespiePartner

ConsultingBrisbane, AustraliaPhone: +1 2

[email protected]

Brian is a Partner with PricewaterhouseCoopersin Australia leading Strategy and OperationalImprovement assignments in the Resourcessector. In recent years he has worked on largeprojects with Xstrata Coal, Anglo American,BHP Billiton, Rio Tinto, British Gas, Santos,Dalrymple Bay Coal Terminal and QueenslandRail Coal Division.

Brian holds the degrees o BSc and MBAand is a Chartered Engineer with the Instituteo Engineering and Technology in the UK.Brian also sits on the National Executive

o the Chartered Institute o Logistics andTransport, Australia.

About the authors

Chris MihosSenior Consultant

ConsultingBrisbane, AustraliaPhone: +1 2 [email protected]

Chris is a Senior Consultant withPricewaterhouseCoopers in Australia.He has advanced knowledge o the miningindustry, across credit risk management,business operations and large scalecontractual agreements.

Chris recent responsibilities have included thedevelopment and global implementation o acredit risk management policy, procedures andassessment tool or a large mining company.Chris has worked on large projects with Anglo

American, Santos, BHP Mitsubishi Alliance,

Queensland Energy Resources, QueenslandRail, Queensland Water Commission, Rio Tintoand Stanwell Corporation.

Chris holds the degrees o Bachelor oCommerce and a Bachelor o Business Law.

John HackwoodDirector

ConsultingBrisbane, AustraliaPhone: +1 2 000

[email protected]

John Hackwood is a Director withPricewaterhouseCoopers in Australia. Hespecialises in trade nance and credit riskmanagement or the export mining sector withparticular experience in iron ore, manganese,thermal coal and metallurgical coal. In recentyears John has ocused development o policy,tools and processes to control logistics andnance risk or mining producers.

John previously worked or the BHP BillitonMarketing Group in Singapore, Comalco

Aluminium in Australia and Anglo American

Sales and Marketing Group also in Australia.Johns experience with these miningcompanies included the roles o creditcontroller, nance manager, commercialmanager and senior accountant.

John holds the degree o Bachelor o Businessand has a Graduate Diploma in Applied Finance.

Australian Energy and Resources

Industry Leader

Michael Happell, Melbourne

Telephone: +1 80 01

Email: [email protected]

Australian and Global Mining LeaderTim Goldsmith, Melbourne

Telephone: +1 80 201


Russia and Central and Eastern Europe

John C. Campbell, Moscow

Telephone: + 9 9 29


Canada

Paul Murphy, Toronto

Telephone: +1 1 91 822


United Kingdom

Jason Burkitt, LondonTelephone: + 0 20 21 21


United States

Steve Ralbovsky, Phoenix



Latin America

Colin Becker, SantiagoTelephone: + 2 90 001


South Arica

Hugh Cameron, Johannesburg



China

Derrick Ryley, Beijing



Rita Li, Beijing

Telephone: +8 10 2


India

Kameswara Rao, Hyderabad



PricewaterhouseCoopers,

Riverside Centre,

12 Eagle Street, Brisbane QLD 000

GPO Box 10, Brisbane QLD 001

Australia

Oce: +1 2 899

Facsimile: +1 02 09

Website: www.pwc.com.au

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Credit Risk Commodity Producers