June 15, 2010 / 9:10 PM / 9 years ago

Analysis: BP stress highlights risks of OTC derivatives

NEW YORK (Reuters) - The sudden pressure on BP Plc’s stock and bond prices and its cash flow after the massive oil spill in the Gulf, may provide a warning against allowing industrial companies an exemption from U.S. proposals to force more derivatives trading onto exchanges and clearing houses.

U.S. lawmakers this week are expected to approve a financial reform bill that will require most contracts in the $450 trillion “over-the counter” or privately traded derivatives market be routed through clearinghouses, which guarantee the trades, in order to reduce risk associated with a counterparty failure.

Industrial companies such as BP, however, are expected to win exemptions as they have argued that central clearing would make hedging their business risk too costly.

While industrial companies do not pose the same risk as large financial institutions, some have large derivatives exposures.

“There are some notable positions particularly among the large commercial hedgers like oil companies, that pose a moderate risk though not an alarmingly large one,” said Darrell Duffie, professor of finance at Stanford University in California.

“If a large industrial company fails and its counterparty was depending on their performance, the counterparty would be harmed unless they provided collateral,” he said.

BP is one of the largest corporate users of derivatives and enters into commodity and other private derivatives, in addition to exchange traded contacts. The company reported around $10 billion in derivatives assets and over $9 billion in liabilities at the end of the first quarter.

Competitor Royal Dutch Shell also reported $20.45 billion in derivatives assets and $18.74 billion in derivatives liabilities at the end of 2009. Derivatives assets at the company had been as high as $40.62 billion at the end of 2008, while liabilities stood at $38.87 billion.

Other large users include airlines, mining companies, agriculture firms and conglomerates General Electric and Berkshire Hathaway, which also use derivatives as part of their large finance businesses.

PRESSURE COOKER

BP is viewed as unlikely to file for bankruptcy, at least near term, though falls in its bond and share prices in recent weeks have shown how quickly even a strong company can come under pressure.

“The amount of destruction of wealth, earnings power and tangible common equity that can occur in any entity in a short period of time is pretty drastic and something that’s seen as an extremely capitalized entity can be called into doubt in a very short amount of time,” said Brian Yelvington, analyst at Knight Libertas in Greenwich, Connecticut.

The cost of buying credit default swaps on BP’s debt has jumped more than twelvefold in the past two months on concerns over the company’s exposure to the Gulf of Mexico oil spill.

The CDS has also increased as bank counterparties buy protection on the firm. The company’s five-year CDS costs have jumped to 515 basis points, or $515,000 per year to insure $10 million for five years, from around 40 basis points in April, according to Markit Intraday.

Bank of America Merrill Lynch this week ordered its traders not to enter into oil trades with BP that extend beyond a one-year timeframe, suggesting concerns over the company’s credit quality may be rising.

Some market participants question the benefits of exempting industrial firms like BP from clearing houses.

“Exemptions for some users mean that bilateral counterparty risk will remain in the market for all,” the Swaps and Derivatives Market Association, a group of brokers and buyside firms that are pushing for greater adoption of central clearing and exchange trading, said on Wednesday.

Exemptions also lower transparency and increase trading costs, it said.

Risks of uncleared trades can be high as collateral posted to reduce the risk of the contracts is in many cases based on a company’s credit rating, which can change quickly.

Fitch Ratings, for example, on Wednesday cut BP’s ratings by six steps to BBB, two steps above junk territory, from AA.

“The leverage afforded BP and other large corporates is based upon their creditworthiness, while a central clearing counterparty provides margin posting based on positions and the amount of risk introduced to the system,” said Knight’s Yelvington.

Ultimately the risk posed by industrial companies will depend on how effective hedging strategies employed by their bank counterparties are.

“It’s ok to exempt them from central clearing providing that their positions are collateralized or at least the dealers set aside a sufficient amount of capital to cover the positions in the event that they are not cleared or collateralized properly,” said Stanford’s Duffie.

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