ConocoPhillips, the third largest integrated energy company in the U.S. with global annual revenues of over USD57 billion, anticipates purchasing credit derivatives for the first time to offset counterparty exposure. The firm is setting up a proprietary credit risk model that will factor in credit derivatives hedges in preparation for the move, said an official in Houston. The firm is already an active user of commodity and interest-rate derivatives for risk management purposes, he added.
Credit derivatives are increasingly favored by many energy corporates as a risk mitigation tool. American Electric Power has began using the instruments over the last year and intermittently buys credit protection to hedge its exposure to trading counterparties, according to Frank Hilton, v.p. and chief credit officer in Columbus, Ohio (DW, 5/11). Bob Gay, head of fixed income strategy at Commerzbank Securities in New York, noted that for corporates with large credit risk portfolios, the contracts may be used to minimize the risk of "one rotten apple spoiling the whole bucket."
Many corporates, however, are disappointed with credit derivatives and argue that they are overpriced and ineffective at protecting trading books. Kenneth Leong, independent risk controller at gas and electricity distributor Consolidated Edison in New York, said that although Con Ed has made many enquiries with dealers about potentially buying credit protection on its counterparties, the corporate has thus far not seen many benefits.
Many of the names that corporates want to hedge against are not available. Liquidity is often limited to stable enterprises, Leong noted. Once a problem arises with a particular counterparty it is generally too late to buy protection because concerns are already priced into the default swap spread, he added. The size of the corporate's exposure also influences the utility of a credit derivative. Small exposures can often be better dealt with by internal analytical measures, he said.
The credit derivatives market is still young and is initially focusing more on structured products and large portfolio users than individual corporates, noted Gay. Liquidity will steadily improve and at some point even smaller corporates will have more liquid credit-default swaps, he predicted.
