is there any credit gurus here who can advise on this? im currently in a midoffice role in a startup physical commodities trading shop, currently looking into devising a credit policy from ground zero for my firm. credit risk management was never considered until recently, so there is no existing infrastructure to build on, no default data, ratings, analysis, or limits. what kind of data would you consider in defining the firm-wide risk appetite and some sort of "house" limits? i am thinking a combination of management input, budgeting plans, book capital...then allocating that to the various trading desks. a crude and simple approach...but im not exactly trained in credit risk. any pointers or directions?
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I was in this situation a few years ago, doing corp dev at a company with lots of commodity trading activity. A few of our largest buyers (mostly the trading arms of international oil companies) were already set up to receive reasonable payment terms, but a lot of our smaller counterparties had zero credit--meaning they either prepaid or were on a three-day settle. A couple of them constantly bitched to our traders about this, so the call came in: Cubechimp, figure out a credit system. Oh, and make sure XYZ Commodities gets $15 million of credit, and ABC gets $5 too. For this purpose, I was given private-side financials for several of these companies.
Having done approximatey ten gazillion debt deals in my banking life, my first instinct was to evaluate them based on standard credit metrics. Debt/EBITDA, EBITDA/Interest, free cash flow, and so on; unfortunatey, these are essentially meaningless for trading houses. None of the companies I analyzed would have been "creditworthy" based on these data points, which is fairly typical for commodity traders.
I ended up looking at days payables outstanding for a few of them and noting what their typical credit terms looked like. One could provide LCs through their bank, so monitoring them just meant checking their revolver headroom. At the end of the day, I didn't come up with anything particularly convincing: we had a target for how much credit to give out, and for control purposes people probably wanted me to generate a paper trail of credit math.
thats interesting cubechimp, but what if you did not know what the target for how much credit to give out was? my CEO basically is hoping i can help him "define" what the firm's risk appetite in dollar terms is. majority of what we are getting now is LC with very little credit, but i presume the intent is to limit the losses and still fix a limit on each company. i suspect you are actually right in that management just wants some official "numbers" they can justify to other stakeholders....
Sizing was essentially negotiated between the head trader and each counterparty, but generally the idea was to give them about a month of credit. These were pretty consistent deals for specific products and volumes, recurring maybe 2-3x monthly. In one case, it was barges of low-grade oil going to a tank farm to await a tanker moving bulk volumes to the Caribbean for use in power plants (hey, cheaper than getting undersea gas pipes set up...) In another, it was a bit of octane arbitrage: essentially, taking unfinished intermediate products left over from several Eastern refineries, and blending them into something useful on the Gulf Coast. In both situations, it would take weeks for the trading house to accumulate the volumes required to make the next 'leg' of the deal possible. The purpose of extending credit was to better-align the counterparties cash payments with the timing of the larger trade's proceeds. Since we profit (from higher prices on otherwise low-value products, and less storage space tied-up) and they're already paying to warehouse the volumes until they ship out, extending credit under those terms helped share the counterparties' working capital burden. That's definitely not an explanation an auditor would accept when examining how your company determines creditworthiness, hence my exercise in credit math for the paper trail.
In your case, it sounds like you're still at the credit strategy stage. I would take a look at your counterparties and get a sense for what their cash flows are, particularly for the next 'leg' of their arb. Obviously, scale relative to your company's overall cash / working capital position is important context; we typically had $150-200 million in the bank plus a really cheap revolver, so extending $20 million of credit in exchange for access to better margins on shit products and less pressure on our limited tankage was a no-brainer.
much appreciated your insights cubechimp. i ran through some house & product limit numbers with the management based on the firm's profit plans. head trader shot back arguing there isn't significant credit risk as they usually deal on LC or documentary collection so the limit boxes him up. that was pretty unexpected as i was under the impression that the CEO and him were already aligned for this credit sizing exercise but apparently not, seems like i am being "used" by the CEO to front this against the traders. so back to the drawing board for me. have to "massage" the numbers backwards i guess. your points on linking this back to working cap/ liquidity is a great lead. would i be on the right track to suggest putting on a volume or MTM limit on the firm, besides the credit limits?
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