Analysis of Credit Risk Management Instruments in Petroleum Trading

This report provides a comprehensive overview of credit risk management instruments within the context of petroleum trading. It begins by highlighting the increasing complexity of financial markets and the associated risks, emphasizing the need for effective risk management strategies. The report then delves into various instruments, including master agreements, which govern over-the-counter derivatives transactions; master netting agreements, used to offset transactions and simplify settlements; and collateralization, which reduces credit risk through the pledging of assets. Further, it discusses counter trade, price adjustments in long-term energy contracts, financial guarantees, and credit insurance. Each instrument is explained with its purpose, application, and benefits, supported by relevant references. The report aims to equip investors and stakeholders with the knowledge needed to manage credit risk effectively in the volatile petroleum trading environment.

CREDIT RISK MANAGEMENT INSTRUMENTS
Petroleum trading and risk management

The increased globalisation and sophistication of the financial markets has not only
generated healthy returns for the investors over the years, but have also posed serious risk of
losses. Following is the explanation of range of the instruments of credit risk management
available to the investors to manage the risk.
Master Agreement: This refers to a standard document that is aimed at governing the
over-the-counter derivatives transactions. Some of the examples of the popular master
agreements are that published by the Futures and Options Association (FOA), International
Currency Options Market (ICOM), the International Swaps and Derivative Association
(ISDA), and the International Foreign Exchange Master Agreement IFEMA. The said
agreements are comprised of the terms that are applicable on the parties to a derivative
transaction namely the derivatives dealer and a counterparty. This is a standard agreement,
but is accompanied by a credit support annexure and a customized schedule which are
required to be signed by the parties. The said agreements are time and cost efficient and
facilitate the entities with more certainty in the terms of the transaction and minimise the
potential for misunderstandings.
Master Netting: A master netting agreement is referred to an arrangement between
the parties that is aimed at setting out the terms of the certain offsetting transactions or
contracts, and thus specifying the treatment for the same. The transactions are stated to be
offsetting each other when the transactions hedge each other or there are losses in one
transaction and profits in the other (Bank, 2017). The master netting agreement involves the
process of the net settlement the net amount of money due is computed owing to the result of
the contracts within the master netting agreement. The party that owes money is then required
to settle its debt by the payment of single payment in single currency. Thus, there is achieved
simplification of the third-party invoices and reduction of the multiple invoices into a single
one. The netting in foreign exchange leads to the benefits of improved pricing.
Collateralization: The process refers to the pledging of a property by a party that is
legally sound and valuable liquid in financial context, against the receipt of the loan by a
bank or a financial institution (Cerqueiro, Ongena & Roszbach, 2016). Thus, there is wide
credit risk reduction in the times of the volatile business environment as characterised by the
corporate collapses and the failure of the major hedge funds of an entity. The said
arrangement is generally opted when there is tight pressure on the credit limits and the same
are not easily available. The arrangements facilitate improved access to market liquidity,

improved pricing and is considered as the strategic process to drive the overall profitability
(Bloomberg, 2016).
Counter Trade: The arrangement refers to the reciprocal form of international trade
in which there is an exchange of the goods or services for other goods or services rather the
involvement of the hard currency. The said arrangement is generally opted for in the lesser
developed countries where there is a limited access to liquid funds for the exchange of the
goods and services with the other nations. Thus, the said measure is a part of an overall
import and export strategy and yields the benefits of the accessing the larger international
markets and opportunity to grow for the parties.
Price Adjustments: Price adjustment mechanisms are a general characteristic of a
long term energy contracts which ensures that the changes in the market are reflected in the
price for commodities supplied under the contracts (Lexology, 2012). The adjustment is also
known as the price review clause where one of the parties to a contract may initiate to amend
a part of or full of the contract as per the changes in the market. Some of the common
elements that form the said adjustment are a trigger event in business environment, procedure
to compute the adjust price, and the description of the factors or guidelines that are necessary
to be considered when computing the adjusted price. In addition, there is a mention of the
consequences in case no agreement is reached between the parties and the description of the
manner of the application of the adjusted price in the contract. Thus, the parties can prevent
the risk of losses due to significant changes the petroleum trading environment.
Financial Guarantee: A financial guarantee contract is a contract in which the issuer
(third party) is requited to make specified payments to reimburse the holder for a loss. The
loss occurs when a specified debtor (investor) fails to make payment to a specific creditor or
holder when due. The said financial guarantee contracts may take separate forms, such as a
letter of credit, an insurance contract, a guarantee, or a credit default contract. It is a non-
cancellable bond of indemnity which ensures that the principal and interest payments will be
made (Luciano & Nicodano, 2014). Thus, the risk is managed by the additional level of
comfort that the debt would be repaid even if the original debt holder fails to fulfil the
obligation. In addition, the contract ensures better credit rating for the parties.
Credit Insurance: These arrangements are generally used for the management of the
short term and medium term risk in the energy trading contracts like that of the petroleum
trading. The aim of the contracts is to minimize the risks of the impact of account receivable

losses to the businesses. The said agreements are aimed at providing an increased liquidity
for energy companies and the cost of the said insurance is generally kept very low in context
of the margin extended. Thus the said arrangements provide a great opportunity for the risk
management of losses of products like petrol where the industry is volatile and vast, have a
challenging political and economic environment and thus has a greater risk of corporate
collapses as compared to the other industries (Donlon, 2016). The trade credit insurance are
aimed at aligning with the business policies and cover mark-to-market exposure.

References
Bank, E. (2017). What Is a Master Netting Agreement? Retrieved from:
https://bizfluent.com/info-8660494-master-netting-agreement.html
Bloomberg (2016). Managing counterparty risk with collateral. Retrieved from:
https://www.bloomberg.com/professional/blog/managing-counterparty-risk-collateral/
Cerqueiro, G., Ongena, S., & Roszbach, K. (2016). Collateralization, bank loan rates, and
monitoring. The Journal of Finance, 71(3), 1295-1322.
Donlon, R. L. (2016). Using trade credit insurance in the energy industry. Retrieved from:
https://www.propertycasualty360.com/2016/02/26/using-trade-credit-insurance-in-
the-energy-industr/?slreturn=20190706024150
Lexology (2012). Price review clauses in long term energy contracts. Retrieved from:
https://www.lexology.com/library/detail.aspx?g=6f5f65fa-0e23-4917-b56e-
0bfd0e22f322
Luciano, E., & Nicodano, G. (2014). Guarantees, leverage, and taxes. The Review of
Financial Studies, 27(9), 2736-2772.