← The HC Commodities Podcast
The HC Commodities Podcast
Credit Risk in Uncertain Times with Jan-Peter Onstwedder
00:50:44
Today, we discuss credit risk and stress testing in volatile and uncertain times. What is the function of credit risk within the commodities sector? How crucial is it? What does good look like - how best to organize, lead and deliver it? And what do we mean by stress testing? And how can organizations make themselves more robust for the future? Our guest is Jan-Peter Onstwedder. Jan-Peter has been head of commodity risk groups for global banks as well as at trading organizations and is now an Enco Insight Partner. As an Enco Insight partner, JP is providing independent, peer -to -peer, advice and to leaders within organizations that are developing or strengthening their risk and trading functions. For more on Enco’s advisory network visit: https://www.encoinsights.com/solutions/insight-partners
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Foreign.
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Welcome to the HC Commodities Podcast, a podcast dedicated to the commodities sector and the people within it. I'm your host, Paul Chapman. This podcast is produced by HC Group, a global search firm dedicated to the commodities sector. Today we're talking credit risk and stress testing in volatile times. What is the function of credit risk within the commodities sector? How crucial is it, how best to organize it, and what do we mean by stress testing? And how can organizations make themselves more robust for the future? Our guest is Jan Petter Onsveder. Jan Petter has been head of commodity risk groups for global banks as well as trading organizations and is now also signed up to be an ENCO Insight Partner. As an ENCO Insight Partner, Yanpeda is providing independent and peer to peer advice and advisory work to organizations that are developing or strengthening their risk functions. Just a quick note, I'll be attending Benchmark's flagship US event, GigaUSA 2025. It's in Washington D.C. on June 3rd and 4th and and if you happen to be there, love to meet. The event is great. I'll put links in the show notes if you have interest in attending and certainly recommend it to anyone in the critical minerals world. As always, you can really support the show by leaving us a positive review on the platform you're listening on and as always, I hope you enjoy the episode. Jan Petter, welcome to the show.
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Thank you both. Glad to be here.
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So you're a seasoned professional, if I may call you that, across market and credit, in fact all forms of risk as it pertains to the energy and commodities world and had a global career within that. But today we're zooming in on credit risk as something I would say that was perhaps less at the forefront five, six years ago and the recent events of COVID then obviously the volatility within commodities, the energy crisis in Europe, Russia's invasion of Ukraine, now tariffs have pushed it right to the forefront. So we're talking about credit risk and then we're talking about actually what it is and then stress testing around it. But can you at a very basic level, can you help us understand what credit risk is and then sort of the basic organization and goals of a credit risk group or professional within the energy and commodities world.
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Yeah, certainly happy to. So at its most elemental, most basic, credit risk is just a risk that a another company or entity that you're dealing with is not able or not willing to fulfill its obligations. So in a very simple sense, if you're a bank and you lend money, that's a Risk that your borrower doesn't repay or isn't able to repay. NSA is not able to or not willing to. It is not always a case of lacking the financial resources or capability to repay or fulfill obligations. Other things could get in the way and sweet. We grouped that under the heading of not willing to rather than not necessarily not able to. You can even include things like performance risk. There are import restrictions or export restrictions or capital controls or other things that governments or third parties can do to make it impossible for an individual company to fulfill all its obligations. And I phrase it as fulfilling obligations to include the performance risk. So if you have a contract with a mining company, then that contract says that that mining company will deliver a certain amount of a certain quality of product over a certain time period. If for whatever reason it fails to do so. That too is a form of credit risk or counterparty risk. People make a distinction between credit risk and counterparty risk, certainly in the banking world, with counterparty risk being that for trading counterparty. So if you're buying and selling a security with other firms or things like that, that is typically seen as counterparty risk. And in the banking world, traditionally credit risk really comes out of the lending part of the organization. But it all comes down to the same thing. That risk that some other party, some party that you have a contract with is not able or not willing to fulfill its obligations. Now, because credit risk in that sense comes in so many different forms and in so many different parts of an organization, it is quite important, as you said, to get the organization structure right and to get the the mindset within a risk organization right.
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We're bucketing in credit and counterparty risk is essentially one and the same thing when it comes to fulfilling obligations. Before we talk about how you organize that group, what are the basic tools and things that a credit risk professional is using and looking at to be able to determine whether to contract with a particular counterparty or to take a given risk.
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A
So what you're really talking about is how do you assess the probability right at risk that somebody want to perform the probability that that happen? And a lot of credit analysis or counterparty analysis comes down to trying to form a view on that probability. You can get very sophisticated, as you do in consumer credit with very detailed scoring models where you literally get very detailed predictions of the probability of failure of a counterparty. You can do a little bit of that in the corporate world. Less accurate because it's less data. It's easy to calibrate a statistical model. But most of the tools come down to trying to predict how likely it is that the company is not able to fulfill its obligations. So that a lot of that is statistical models, rating models and things like that. But it's also fundamental analysis looking at balance sheet and income statements and cash flow statements, trying to understand what might happen to a company counterparty that would stop it from being able to fulfill its obligations.
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B
So you've got, if I take that sort of analogy of our credit score, which is sort of, you know, us Americans live and die by, you've got. There's a lot of public information that you can get on public organizations, but increasingly over the last 10 years, you've had a move towards organizations that are privately held within the commodity trading world for a variety of reasons. And obviously most of the startups are privately held. It's a very opaque sector. If you're contrasting a credit risk professional with say another sector, what makes commodities unique and indeed hard, that actually means, you know, you do see higher salaries and you know, these are rare and unique individuals to get to get right.
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Yeah, it's true that the commodity sector is one of those that has its unique set of challenges. If you're trying to do credit risk, you highlight the point quite, quite often the companies are small, privately held. You don't necessarily have the same financial information as you would do for a larger publicly traded company. Quarterly information is almost unheard of. Semiannual is difficult to get. Annual information is usually available, but with a significant time lag. And so you can see companies publishing fairly rudimentary information as much as three to six months after the end of a financial close on an annual basis. So then you're talking about information that is 15 to 18 months out of date in many ways by the time you have it on your desk and try to make decisions on. Secondly, of course, for all trading companies, not just commodity trading companies, the situation of 12 months ago or even six months ago isn't all that relevant. Things can change very, very quickly. All trading companies, including the commodity trading world. And so getting timely and up to date and useful information is a challenge. It's also why you tend to look a little bit to other mitigants, other ways of managing the fundamental risk. Then you would insert a lending to large corporates or in different sectors.
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Right. And those are letters of credit and other, you know, physical offtakes and all that piece.
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Agreed, Agreed. So often you look to another bank that has a closer relationship with that trading company and say you know them better. Are you prepared for a Fee to take on that incremental credit risk. And you can do that, for example, via letter of credit. And there's other tools as well. But it all comes down to the same thing that says, yeah, I don't know that company well enough to have a view to be comfortable with the credit, but its house bank or one of its closer banks has capacity and is willing to take on that risk. And we have various different tools to mitigate that. Another one is of course, that you look at the underlying commodity. Because a lot of the transactions here, you have some underlying parcel, some shipment or stockpile or whatever, this, a container full of metal, a tanker full of oil that you can look to and say, oh, I can take that, I can take security over that underlying commodity collateral as a good mitigant to the credit risk. And what you're then effectively saying is, look, if the counterparty isn't able to prepay or repay me, I'll take title over that commodity, I'll sell that and I'll use that to extinguish the debt, the underlying obligation. And that's much more popular in the commodities world than it is in many other industry sectors.
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B
And then one more piece before we lean into that organization and setup bit, which is we'll explain why that's so key. But I guess in that sort of landscape of how this has reemerged as a key. I mean, it never wasn't a key and vital function. It's just now there's so much more exogenous impacts going on that mean it is one of those has obviously been rising interest rates. The cost of money has gone up. That's changed a lot of the economic equations around commodity trade, commodity trade finance. The second is, of course, is when we've gone from a very free trade world or a globalized world to one now that is obviously well publicized is fracturing in many senses. And a lot of the tariffs it was or sanctions it was, they come down mid contract, which means that the counterparty cannot fulfill that obligation as well. So can you just on that piece, how much of the role of your credit risk professional Counterparty professional is also now having to be very aware and understand what could happen in government policies as hard as that currently is over the next six, 12, 15 months.
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Yeah, if somebody had a sale on crystal balls, I think they'd make a mint at the moment, wouldn't they? It has always been important to look at the environment because you can never differentiate. Well, you can differentiate a little bit distinguish a little bit between Sort of external risk and risk more internal to a company. So in other words, it's financial situation, etc. But you never really know enough from financial statements. So you always need to think about what environment does a company operate in what country, where does it get its contracts, where are its counterparties? Because you have that sort of the risk of a domino effect on you. If one of the critical trading companies in a chain defaults, then it affects other companies in that chain. And most companies are resilient enough that they could live with a failure on a single transaction. But not all of them are. And sometimes it goes wider than a single transaction. So you do always have to think about the environment in which companies operate. And obviously then that is subject to change like everything else. But it is particularly difficult to understand the likelihood of changes in say, government regulations. And that is because it is a political process where people make decisions under a variety of different sets of pressures or influences, et cetera. And that process in handpicks is less predictable than even say price risk in an oil market or let alone things in the securities market. Or even interest rates where the driving forces for central banks to change short term interest rates are relatively well understood. So you can look at economic predictions of inflation and have a reasonably good sense of is the likelihood that rates go up higher than the likelihood of rates go down or being stable for political processes. And that includes banking regulation or other forms of government intervention that is just inherently less predictable. And yeah, that has become more important over time. I would agree with that. Certainly over the last few years.
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B
Okay, so then moving towards this sort of one of the inherent challenge is sort of this asymmetry of, of risk in some sense for the team and the, and the commercial teams wanting to do the deal and the middle office wanting to protect the organization and protect the downside. Because of course, you know, you get it wrong. It can obviously be terminal for the organization or at least, at the very least very, very impactful. You get it right and everything just goes normal. Then no one sort of. It's not like the credit risk team are getting a pat on the back. It's just the commercial team have done the deal. So there's kind of this, I'm not really explaining it very well, but it's that how do you become a custodian and a gatekeeper and have an effective credit and counterparty risk structure and organization that enables the business to do business which is very competitive, very fast paced speed of decision matters. And of course, you know, it's inherently about taking risk both on the market side, which we're not covering today, but also to some extent operating in the developing world where it might be to secure supply that you know others can't. And you're there first with the best price in the barge type stuff. And that's where it comes down to how do. And this is sort of really the challenge where your career in leadership is a testament to, and obviously the work you're doing with Enco Insight Partners, advising clients around this is how do you get that balance right? How do you create an effect effective organization, a structure that enables the business to do business, but also protects it and manages that sort of what is. Can be a contentious relationship.
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Yeah. And it's a contentious or adversarial part that you have to avoid. Point number one is if you're in an adversarial relationship between the risk function and the front office, truly adversarial, then something's gone horribly wrong because that is just never productive. It frustrates people on both sides. You end up with good people leaving or being pushed aside, if not, if not outright fired or sidelined in an organization having no influence. And that doesn't help anybody because as you say, it may not always look like it, but the risk functions, whether it's market risk or credit risk or operational risk, are critical for the long term health and survival and profitability of an organization. So the first thing to do is to avoid that adversarial relationship. In order to do that, both parties have to be willing to listen to each other and try and understand. It's a bit like building trust in any kind of human relationship. Ultimately it's person to person, team of people to team of people. If you can't have a decent conversation, you can't understand, you can't try and understand how the other person looks at a deal, a situation, etc. Then you're in trouble. And so that's the first part you need to try and get right and, and impress on people on both sides of any kind of organizational structure is you can't be in an adversarial relationship for the long term. It just does not work.
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How do you do, how do you do that? Like, I mean, it's all easy to say, but is that about clarity of mission, clarity of boundaries, or is it purely sort of the right chemistry in the teams? Is it sort of, I mean, how have you coached your teams to not end up in that situation? How do you actually do that? Because it sounds easy, but it is there's a lot. There's a lot there that could, you know, can make it, you know, it naturally tends towards potentially being adversarial.
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True, true. And it's, it's particularly difficult if you have changes in a team or if you're trying to build a team, because the easiest way to unite a group of people is to create a common enemy. Right. And so if you're building a team, it's very easy to create some sense of cohesion in a team by talking about us versus them. Yeah, they're the ones that get things wrong, they're the ones that are pushing too hard or they're the ones that are always blocking everything to be done. And if you hear that language, if you hear it a lot, you always can hear a little bit of it. But if you hear that a lot, then it's a good indicator that you're not in the right place when it comes to the relationship. How do you avoid being adversarial? The first thing is go talk to people. And rather, actually I shouldn't say go talk to people, go listen to people because that's the first step. If you're in a risk function and you look at a bunch of traders and you see demands for credit lines or demands for market risk activities, etc. First thing to do is to try and understand why that comes from, what are they trying to do and why, what are the incentives? What do they see the commercial opportunities and try and understand that and play that back to them and at the same time bring in the whole issue that says, okay, but everything you do involves a certain amount of risk. Now the traders will keep it simple. Traders, bank relationship managers, etc. It's all the front office folk. The front office folk are primarily responsible for managing the business opportunity and owning the risks that come with it. What we're trying to do from a middle office or control function perspective is help with that, provide technical expertise on how do you assess the risk, provide a little bit of help with the judgmental aspects of it, but also have a good conversation about what are the right risks to take. If you have 2 or 3 billion different opportunities of making a million dollar profit, which one is the lower risk and why would you prefer that and having that conversation. And it literally has to be a two way street. It has to be a conversation about what's your business strategy, what are you trying to achieve, what are then the inherent risks that you have to take on, how do we manage that? And then I think it's very important that particularly from the risk, from your perspective, you never get a sense of talking down to people or trying to think that you know better. You may be a better expert in credit analysis than a trader is, but the moment that you start thinking that you know better about their business, what they should do or start thinking about that was a particularly stupid trade to make or anything like that, again, that's a good indicator that you're on the wrong path. It has to be a relationship of mutual respect. And you can only get that if people communicate clearly with each other.
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Yeah, and then I interrupted you on the organizational side, which I side, which I guess is how do you position, how do you get an independent, powerful, but effective credit risk function? Indeed, this goes for all actually risk functions. How do you structure it, position it within the organization? And then we'll come on to some of the thornier issues about reward. But you know, organizationally, how do you, how is it best sat within the leadership structure and within the broader structure of a trading group?
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I think the best way to get it right is to realize that risk is an important component of the decision making in a business. But it's not the only component. And it is not a component you can lift out of the entire approval process. Every trade you do as a business, every contract you sign, every loan you make, every is effectively a transaction. Sometimes small and short term and very routine, sometimes large, infrequent, very complicated. But every one of those is a transaction. And in a professional organization, every transaction like that goes through some sort of approval or decision making process. That might be very simple because a trader might operate under clearly delegated authority and say, I can do this trade, I can buy that contract, sell that material, whatever it is, et cetera. That's very straightforward, very simple, but it is still, when you think about it, bit more conceptually part of a recognized and identified and known decision making process. And it's the clarity of the decision making process that I think is critical for getting the organizational structure right. You need to think about what it is you do as a business before you design your organizational structure, not the other way around. Because the structure and the way people are and the job descriptions has to fit and serve the business purpose. Not trying to shoehorn the business purpose into some template of organizational structure that somebody might have told you about. So you need to start with what are decisions we make as a business, the small ones, the routine ones that we want to do under delegated authority, the big ones is strategic ones, that senior management or even a board of directors has to be involved in. And that's a continuum, of course, and you pick maybe just two levels, maybe you need five levels depending on the size and the complexity of your organization. But that's step one. We have to be clear about the decisions you take, who's going to take them, how formal do we have to make that process, what are the necessary inputs into that process? And when you do that and you sit down with people and say what are those decisions? Then you discover that some of the inputs that you need in that decision making process are indeed risk issues. You need to know the market risk, you need to know the credit risk, you need to know legal risks and things like that. And then you need to figure out, okay, what information do I need in order to make that kind of decision? That sounds too heavy handed. And for a simple decision of buying and selling a futures contract, it is. Of course you do that under delegated authority. You don't need that whole structure to be brought to bear on every small transaction. But let's say you're going to sign a five year offset off their contract. You do want to have a good review by all interested parties, all looking holistically at is this a deal we should be doing? And then you have to be very careful that you understand what everybody's input is and who ultimately is the decision maker and that you can support that decision maker with the right analysis, the right amount of information at the right point in time.
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B
It must be very hard in the sense what it is hard in the sense that this sort of the, there's no counterfactual available, there's no control group. So a great job done by a great credit risk manager or leadership or group essentially results in no issues. You know, and there's no sort of, there's no visible. In other words, the, the more visible the asymmetric visibility. I should say if there is a failure, everyone knows it's very clear what went wrong. But day to day, ongoing, well run operations, there aren't the issues right. It's business as normal. I don't know if I'm explaining again that correctly, but how do you go about sort of building a team that feels valued, incentivized and that is recognized for good work essentially in the absence of problems.
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Part of this is just asking and listening to what the front office says about risk function. And again the natural tendency is to say they're stopping us from doing business, I could do more if they were more realistic or whatever the language is that is being used Sometimes a little bit more polite, sometimes a little bit less polite. But there's always going to be that tendency to say, yeah, maybe you should do a better job on X, Y and Z. You do have to listen to that and take that into account. I want to push back a little bit on this whole. You can tell that a credit risk function is doing a good job when you have no losses, which is more or less what you were hinting at. That's not necessarily true, is it? Because you may say my objective is to have no credit losses. But that's not always the right objective. And certainly if you're in a bank and you have thousands and thousands of clients, it is unrealistic and unnecessary to strive for zero credit losses. The good question is, can you keep the credit losses to some level that we've in advance deemed to be acceptable? And that gets to the whole idea of a risk appetite. Right. You need to set as a business, and I mean holistically as a business, not as a risk function. As a business, you need to set a risk appetite. What's the risk we can take? What are the losses we can afford to take without endangering the business? And then the job of the risk function is to design the controls around it to make sure that you work within that identified risk appetite. But that risk appetite does not have to be zero. And in many cases it should not be zero. It should just be a known amount with a known probability of that happening. And that's not necessarily easy to achieve, but it's a much better place to start off from then to say, I don't want any credit losses.
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Yeah, yeah. I guess I was thinking more sort of the catastrophic events, right, where, where you're, you're dealing with a particular, you know, whether it's missing stuff in Asia or whatever. You know, I think we all know sort of these. But, you know, what you don't want to be is in the headlines, right? As you say, you know, you're not. There aren't some losses, then you're not actually enabling the business to take the risk it needs to to succeed in commodity trading. But what you definitely don't want to do is end up in the headlines because you've. Your partner has. Your counterparty. Turns out it was bricks rather than copper or something like that.
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Right.
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I know there's those extreme examples.
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Yes. Yeah, that's, that's a, that's a nasty one. Right. It's a combination of operational credit risk that gets you into that situation where you think you Own or have bought something and it isn't what you think it is. It's a horrible situation to find yourself in, don't get me wrong. And you can do a lot of things to avoid it or to minimize the probability of that happening, but I'm not sure you can in commodity trading, totally eliminate it all the time.
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No, but you can't account for fraud, right? I mean, you know, this is all assuming everyone's working at the best intent to fulfill a contract for the most part.
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Yeah, agreed. And fraud is not all that common, but it's also sufficiently frequent, if that's the right word, that it would be naive to think it never happens. And so you do have to think about it. You can group it under all these sort of not unforeseen. Mr. Donald Rumsfeld used to know the known unknowns. Right. You know, that this kind of thing happened, but you don't know when or how or exactly what for.
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It was terrible to hear that phrase. Now you applied to America.
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Yeah.
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A recent article. But which kind of brings us nicely onto the next topic. I want one more thing. I'm really enjoying this. When it comes to actually sort of a global team, how crucial is it that there is true global coverage? And by that I mean you've got regional experts. When it comes to credit risk and.
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A
Counterparty risk, it obviously depends on the nature of the business. But if you are a global trader or a bank operating in global commodity markets, then there are major regional differences and even individual country differences in terms of industry practices, market practices, but also contractual arrangements and legal. We haven't spoken much about the legal aspects of it, but the contract and the legal arrangements and bankruptcy law and things like that are all very critical components of my managing credit risk. Right. The way you structure a transaction is to try and mitigate certain risks. That will only work if your contract is properly executed, properly documented, valid under the appropriate laws, and if you can find the remedies and things like that. And so a good credit risk manager becomes quite knowledgeable about the law and is a good partner on the legal side because they are. They have to work hand in glove. And that is inevitably, of course, jurisdictions are still different around the world. You can do a lot under English law and English English law, contracts can be enforced in many jurisdictions and courts around the world. But you do have to know that, and I've over my last 10, 15 years in particular, spent a lot of time with lawyers pouring over contracts and asking the questions of, yeah, is this enforceable in country X and if it goes wrong, what can we do and how do we. For example, if you rely on the shipment of oil as collateral, how do you actually take possession of that? Can you take title? Can you prove that you have title? Can you instruct a master of that vessel? Can you discharge the oil? Are you free to sell it? How do you document all of that? All these things are important that all of that is depending very much on your legal contracts and specialists. And those definitely need to have legal officer, regional and local expertise.
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B
Yeah. Well, we've certainly seen on the HC side, our search side in commodities, just a big increase in demand for not only risk professionals but also general counsels, legal advisors because of the complexity that's building up and within that complexity also the swiftness of change, the volatility around those, the policies and the circumstances. As you say it's. And that is, you know, that has, it's been record years for the commodity traders but they have been seeing inflation in the number of people that they actually need to be able to transact this business, which is quite different, I guess to 10 years ago. The energy and resources sector is experiencing unprecedented change. To help companies navigate this world and.
- [28:19]
A
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- [28:25]
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- [28:28]
A
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- [28:39]
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- [28:42]
A
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- [28:50]
B
Longer term consulting project@encoinsights.com Time is running away from us. I want to talk about straight stress testing.
- [28:58]
A
Yes.
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B
And which, you know, to me, I think I just end up in a sort of gibbering state on the floor of paralysis, not wanting to do anything when you start actually thinking about the cask. I guess this is a, an analysis of the cascading impacts of some sometimes small events that can become systemically problematic and risky for your organization and indeed at times even the markets. And we've had some recent examples obviously with the liquidity crisis, particularly in Europe. We covered on this podcast at the time, there's been a lot of work and we had various professors on, you know, talk about are commodity traders too big to fail? All this kind of thing. But, and people can look through the catalog on that. But what do you mean by stress testing? Are these sort of separate scenario processes that, you know, why do them and what are they? Basically?
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A
Yeah, so just stress Testing is, is one of those areas that a lot of people have seen or tend to see as a panacea that if you, if you look particularly in the market risk world and even in the credit risk world, all the quantitative techniques you use, value at risk on the, on the market risk side or things like that, or ratings on the, on the corporate credit side, all of them are useful, but they all have their limitations. And because there are limitations sometimes come to the fore that things have gone wrong and the risk system has failed kind of narrative, you then tend to look to stress testing and say you should use stress testing to cover the limitations of your mainstream everyday quantitative techniques. And that's valuable and fair, but you do have to be careful how you design that stress test then. So if you think about it, all the quantitative tools that we use normally to assess what is the risk in a transaction and therefore, yeah, is it acceptable, is it not acceptable? How much should I get paid? And all those other good decision tools have their limitations, as I said, and they can sometimes miss things. And so a good stress test starts by, or designing a good stress test starts by thinking about, well, what are the risks that are not covered by these everyday tools? And if I can assess the probability of default of a corporate counterparty sufficiently accurately and adequately, do I really gain an awful lot by just stress testing these probabilities? I kind of know what the answer is going to be anyway. I don't need to do an awful lot of work on that side. However, I can look and say, for example, you mentioned that a lot of companies are private and therefore you don't have the same detailed financial information as you do for publicly held companies. What if one of your largest counterparties all of a sudden gets taken over by private equity fund, puts on a whole load of different capital structure and therefore all the historical financial information you have is, is no longer very useful. What do you do is that, you know, that's a simple one, a counterparty stress test on a single counterparty. All of a sudden I may have exposure to a company that I lack the information I used to have to assess their credit risk. What do I do in a situation like that? You can then broaden that a little bit and say, well, what if there's a legal change in a particular country and I used to rely on collateral in that country and so I deal with a whole bunch of not particularly credit worthy counterparties or traders, but I'm okay because I've got collateral, I have nice haircuts against it, I know how to enforce it and it's a legal change. And then all of a sudden you go like, oh, now what do I do? And I think the key thing about the stress testing on that side, the scenario of what if? And then what do I do? Is to think about the second component just as much as the first. It's wonderful to think and think of all sorts of brilliant scenarios and there's people out there who do a great job devising all these scenarios of what happens if China starts to more aggressively move against Taiwan, what happens if, and so forth and so forth. And there are thousands of these scenarios. And as you can see, you can find yourself in a bit of paralysis of there's just so much uncertainty in the world. But the question is which ones are relevant?
- [32:57]
B
I mean, and just, just before we talk about, because I think we can, we can play, we discussed a couple that we can play out and, and show the cascading and the severity nature, but also the fact that if you get it right and you do think about which ones are relevant and put in some mitigation, it can stand you in really good stead. Just out of interest, you know, what scale of, like in a large American bank, for example, do you have an entirely separate stress testing team that are kind of, you know, white haired, sort of pale, you know, shaking, you know, weak hearts type guys who have, and girls who've, you know, spent too long looking down, you know, the black hole of some of this stuff? I mean, at what scale do you, or, you know, how is this done? Is it done? Every credit manager will have some time thinking about this or people just organically come with, hey, we thought about this. I saw a headline just how do you, how do you sort of institutionalize a bit less of the day to day and a bit more of the what if panoramic view and thinking about that lens?
- [34:01]
A
Yeah, it's a good question actually. It's a very good point. In a large bank and I trust that all banks in all large companies are a little bit the same. You do tend to have the opportunity to put a small team of specialists together who can do that crystal ball gazing and come up with the scenarios and also develop some of the tools to answer the question of, well, what could happen if. Certainly in banks you see that and it often starts with a more fundamental economic view. If you have an equity research team, for example, they're a great source of these what if scenarios. Yeah. Because they tend to think about that from an equity market coverage perspective. Tends to have very Good industry knowledge can put together some very good scenarios and questions about what happens. You can then distribute that through a risk function and say, okay, if a scenario like this plays out, what does that mean for the part of the risks or for the risk in the part of the organization that you're responsible for? That's a pretty traditional way to do it. Can be very useful, particularly from a top management perspective that says, okay, in this scenario we see some swings and roundabouts but the overall effect is manageable. Or in this scenario, oh my God, we've got big losses in every part of the organization. We really have to be careful about this particular scenario. We need to do something to mitigate it much better. But personally I find that kind of top down scenario analysis somewhat limited. You do occasionally identify the scenario that you didn't already know about as a vulnerability and that you had not already put mitigating factors in place and, but it's pretty rare. What I find more interesting about you tend to see more on the bottom up basis is to go the other way on the stress test and to start thinking about what could hurt us rather than trying to think of all possible scenarios. And so you could look, when you said before, if you're negotiating a long term offtake deal, you can really think about, well, what could happen that would make this deal a big loss maker for us, what are the factors that could go wrong? And then you start thinking about how likely are they day and can I do something about it? And that's sort of what the bank of England used to call the reverse stress test. What would happen for me to lose a million, 10 million, 100 million, a billion dollars out of a single event? Now is that even possible? What would that event look like that can give you a different set of insights into the portfolio of risks that you're running? And I find in many cases a more useful insight.
- [36:16]
B
Yeah, because I guess at some point there are some, you know, events that essentially mean, well, you know, we're all back in the stone Age anyway. So you know, like if, if X happens, then actually, you know, none of us are turning up to work tomorrow, you know, all the, you know, the next 365 days kind of thing. So they're, they're effectively not useful. But actually that lens of this particular deal or this particular office, what would, what would cause it to lose, you know, X amount and, and work from there just to make this a bit more concrete. Right. So, and actually, you know, if you look at the, the global financial crisis, you look at the recent liquidity crisis. Clearly some of this, you know, this wasn't stress tested out or if it was, it was seen as so ludicrously and unprobable that no one really did much about it. Some did and made a lot of money out of it. Obviously, if you kind of look just. I guess we're using this as an example, but a potentially relevant one. Much of the liquidity management in the world, but particularly in the commodities markets, is based around US Treasuries. That must be percolating up in terms of some people starting to question what would happen if. Can you just talk to us a little about that scenario? Not to sort of scare myself, but everyone else. But you know, that seems a particularly relevant one where this could have a profound cascading impact and is not necessarily out of the realms of probability over the next couple of years.
- [37:38]
A
I hope it's still a low probability probability. But yeah, it's sufficiently different from zero probability that you should start thinking about. So the context about it is a bit like this. All commodity trading firms and all business, all firms in general need to have sufficient liquidity, just access to cash, ready cash to meet their obligations. Sizing that is a whole different situation. But you need to have enough for your business. You can hold that in bank lines, you can hold that in cash, and you can hold it in cash alternatives like, as you say, US Trust Treasuries, of course, very popular because that market has been incredibly deep and liquid. If you own even tens of millions or hundreds of millions of dollars worth of U.S. treasuries, as a rule, you can sell that and turn it into cash very, very quickly and at very, very low cost. If that market malfunctions and it has had hiccups in the past at a somewhat more technical level. But if that market seriously malfunctions and all of a sudden you would not be able to get at that cash quickly enough to turn those treasury holdings into cash quickly enough, then yes, that could have one of those nasty little domino effects. Because you could just see the situation where one midsize firm has been a little bit naive about it manages its liquidity. 90% of its liquidity is tied with Treasuries. The treasury market has its major failure, that firm then defaults the next day on its obligations because they can't make payment. It's a small company, it's not particularly credit worthy, doesn't have a big bank group. And oh, by the way, the banks have a problem too because a lot of their Liquidity sits in Treasuries. So the banks are not going to be that keen to provide a lot of cash liquidity at that point because they themselves are constrained by having so many holdings of U.S. treasuries. So now you've got a company literally failing that. Then you bring in cascading, by the way, you may find that other companies have had a large amount of business with this particular small company that has failed. And so then you get a domino effect and that could happen. What do you do against it? Well, typically firms fail in a scenario like that because of lack of liquidity. In this case that's also the root cause of the scenario, the fact that Treasuries are no longer liquid or not sufficiently liquid. But the mitigant against almost all stress test scenarios or almost all potentially catastrophic scenarios is twofold. You need to have enough loss absorbing capacity, that is capital. You need to be big enough in equity to absorb a loss at least in the short term. And you need to have liquidity to stay in business to not default. And so in this case the obvious answer to this is diversify away how you manage your liquidity. Don't put all your eggs in one basket. Don't have all your liquidity tied up in US Treasuries. It's a nasty bomb because as I said, you can't look to the banking market at that stage to provide you with liquidity because the banks themselves will feel the effect.
- [40:19]
B
It's almost sort of at the why bother level if that starts happening. But I guess the other one that is very relevant is tariffs, but actually more export controls, right?
- [40:29]
A
Yeah.
- [40:29]
B
If you suddenly see India stop shipping rice, or more pertinently China stop shipping certain metals, that too can have quite a. And it's obviously this isn't just limited to the energy commodity markets. If you're in, you know, in other parts of the, the energy sector, offshore drill, whatever it might be, and you can't get vital components that could have significant impacts. How do you go about thinking about that? Is the answer the same? Which is can you get diversity of supply? Can you in this case loss making? Can you stockpile that kind of piece?
- [41:00]
A
Well, we've seen stockpiling, right? So we've seen a lot of stockpiling of metals in the US prior to tariffs actually going into effect. And one of the consequences that has been dislocation between prices for physical metal in the US and say futures prices where you can take delivery anywhere somewhere else in the world because all of a sudden there's this risk that metal that has to be imported in the US could be hit with a significant tariff, whereas metal that is already in the US prior to the tariff staking effect is not subject to that. And so you get this massive dislocation between prices that normally speaking stay closely aligned. And so one of the interesting questions there is if you have relied on price relationships remaining stable and you're hedging risk in one commodity, in one location, in one form, with a instrument that is in a different location, maybe in a slightly different form, or it may be even a slightly different underlying commodity, then you need to start thinking seriously about all these tariffs and all these trade wars and say will those price relationships still hold up? If you've hedged onshore copper in the US with futures based in Europe, say, maybe even denominated in a slightly different country or currency, then that relationship could easily break if it hasn't already done so. So those are some of the things to think about. The impact of things like tariffs, export controls, input controls, et cetera, bifurcates that quite neatly, right? If you're in a very short term transactional environment, then by and large it's a shock and you get maybe a one off hit. But you can adjust fairly quickly. Prices will adjust and therefore if your main business is finding supply in Africa or South America and shipping it to China or to Europe or to the us, trade flows will change, price relationships will change, but almost certainly your business model will survive just fine. You just need to have enough capacity to survive the initial shock, but long term. And if you're in a business of having 5 year, 10 year, 15 year contracts like much of the LNG business, then potentially that could be a much different impact, right? You could see certain business models this being uprooted completely and no longer being viable because the particular trade flow that you rely on is no longer viable. And oh, by the way, those, all those contracts that you've signed, you now have to unravel. That's a lot of work. That could include penalties, that can include cost of breakage. You have a risk of being sued for non performance or having to sue counterparties for non performance. Some of those counterparties will be government or semi governmental entities or saying it's force majeure because government actions, etc. So it becomes very, very messy. And just the friction that generates if you have long term contracts is particularly tricky at the moment. It's very difficult to assess.
- [43:53]
B
One final piece. How is technology changing this function? I'm just thinking of you know you've got, you know, all these contracts, I imagine finding a sophisticated way of trying to break them down into their component parts using AI, you know, having them stored in a manner that you can stress test against these contracts easily without having to sort of, you know, pour through them individually. You know, I guess that's one example. How is technology changing this function?
- [44:22]
A
I know of two elements where maybe even three where there is a lot of activity. One is, as you said, for example, you have a lot of different contracts and you might want to think about if country X changes its tax laws, what's the impact? Being able to find every contract, be able to pull out the appropriate clauses. It says, here's my sensitivity to tax law in Australia or in Germany or the US or whatever it is would save a massive amount of time and reduce some uncertainty. Right. I remember a situation, a company I worked for many years ago, but 20 years ago, I think Enron failed. And at the time we knew exactly which Enron entities we dealt with, except that one of the subsidiaries of this company discovered about two years later another contract with an Enron entity somewhere else in the world. And that's a nasty kind of surprise that you really don't want. So being able to avoid that using the AI tools and the search tools tools to go through all the documents and find the things that you're worried about at a particular point in time would be a massive time saving. And I know there's a lot of work being done. Let's say credit analysis, just financial analysis, which starts with relatively well known ratio analysis and thinking about financial statements, etc. Has long been automated to a certain extent. The weakness in the automation has always been although accounting statements are relatively uniform, companies have a certain amount of statements discretion. And so you read not just the financial statements, you have to read the notes to the accounts. And interpreting the notes to the accounts has always been something where the technology has not been good enough to more than do a little bit of help with finding things. But it's been a credit analyst who has to sit there, think about it and work that into analysis. I could well imagine that forms of AI can take over a lot of that work and actually can read the notes to the financial accounts, make sense of them and say, oh, the way this company treats lease obligations is a little bit unusual. Therefore we need to make the following adjustments to the financial ratios and that has an impact on our credit analysis. That's an area to where I know a lot of work is being done at the moment. Already.
- [46:21]
B
Yeah. And it could therefore in turn, actually again, coming back to the stress testing, how quick can a credit contagion spread now if all the algorithms are reading the same stuff and interpreting them the same way? Right.
- [46:34]
A
Well, you have an equity world already. The wonderful situation that you've got AI tool tools creating press releases based on some information that the company gives you, that the press release is being drafted by AI, on the other hand, of the asset managers and the sell side analysts using AI tools to beat that press release and turn it into analysis. You've got robots talking to robots as opposed to people talking to people.
- [46:56]
B
Yeah, yeah. Wait, wait, are you another AI bot?
- [46:59]
A
Exactly. But how that, how that plays out, I don't know. Does it speed up things? It might. I don't think it's risky enough that it will speed up things to the point that it can spiral out of control. Like you see in the securities trading market, where sometimes you see these spikes in markets where it's clear that a whole bunch of algorithms have either tripped some particular trigger and got out or traded more.
- [47:23]
B
I think we're straying into market risk. But we saw that earlier this year with a press release that came out that turned out to be erroneous about gas flowing through another part of Eastern Europe and you saw a huge drop in gas prices. That response was essentially, I assume, ultimately driven by AI scraping media and, and triggering cells. So it, it's certainly there and it's just another. You've, you've, you know, you, the rapidity of which events unfurl now is so much faster as well. Which kind of, I guess again points to kind of that, that immediacy of, well, that ever more emphasis on building robust platforms and having that sort of what if scenario front of mind kind.
- [48:05]
A
Of thing going forwards and having a contingency plan. Right. We know that these things can happen. We know that you can get a dislocation in the trading market. Any futures market, no matter what you're doing, is subject to that because you've got a whole bunch of these algos. So you should have a plan that says if the market, I rather, when hedging has one of these major hiccups and the price goes completely out of whack because there's some short term trading volume. What do I do? Do I follow that price and adjust my hedge ratios or whatever it is, etc. Or do I say, hold on a second, that's, that's an artificial market. It will come back in line with what I think is reality. Therefore I'm just going to sit on my hands and do nothing. Which could be a very valid response. But it's incredibly difficult in the heat of the moment to have that discussion. You need to think about it in advance. Yeah, right. You need to have a plan prepared. So contingency plans, which is just really thinking through with a group of people. What would we do if the following happens Is incredibly useful.
- [48:58]
B
Yeah. And you know, and we're in a period when lots of organizations, particularly asset backed organizations, a big theme of the podcast this year are building out trading capabilities. A lot of that emphasis comes down on what and who you need on the commercial side. But hopefully I think this sets to demonstrate that actually having a functioning, an effective risk group is worth its own weight in gold, both in enabling business but also protecting from the downsides. And obviously that's part of you being on board with Enco Insights and providing senior advisory work to our clients and organizations out there who are interested. I'll put links in the show notes, but Jan Pero, I found it fascinating. I really enjoyed having you on. Hopefully we don't have some kind of emergency pod in the future where some of these events have happened.
- [49:47]
A
You never know.
- [49:48]
B
You never know. But really appreciate your time.
- [49:54]
A
Hello, I'm David Hunt, Founder and Managing Director at Hyperion Search. Founded over a decade ago, Hyperion Search has helped organizations from major utilities to startups recruit their leadership teams and key individual contributors to accelerate both their growth and the energy transition. Our three main verticals are renewable power, energy storage and E mobility. The energy transition and the talent that delivers. It has been our passion since day one. To find out more, visit hyperionsearch.com or listen to my Leaders in Cleantech podcast, available on all platforms.
- [50:27]
B
Thank you for listening. To find out more about HC Group, our global offices and our expertise in search of within the commodities sector, please visit www.hcgroup.com.