The recent slump in the price of oil is already having far-reaching consequences for corporates and their treasury departments. In this article, we consider what treasurers might be faced with were we to see yet another big collapse in the commodity’s market price. Considering the impact of the most recent price shock will be key to understanding how such a scenario might play out.
Who guessed in the summer of 2014 that the price of a barrel of oil would be less than half of its value by the beginning of the following year? One or two now very wealthy hedge fund managers aside, the answer was almost nobody.
Back in June 2014, a barrel of West Texas Intermediate (WTI), a commonly used market benchmark, would have set a buyer back $109. By January 2015, the price hit $48 – a decline of around 55%. One year later, in January 2016, the benchmark had slipped to below $27 a barrel, its lowest in nearly 13 years.
Although this event was the fourth market correction oil has seen since 1980, financial markets seem to be perpetually surprised by large swings, hence the ‘price shock’ label. The difficulty experts have in predicting where the price will go next poses a challenge for market participants given how hugely consequential price shocks can be for the global economy. Soar too high and the oil price will, as we saw during the 1970s, trigger deep recessions. Plunge too low and the oil price can spell trouble for economies which are geared around production.
Corporates are subject to a similar dynamic. A very low oil price is usually good news for some companies – downstream oil consumers – and bad news for firms producing the commodity. The consequences for treasurers of another dramatic decline in the price will, for that reason, vary accordingly between individual companies and sectors.
Very broadly, the implications are likely to fall principally within the field of risk management for treasurers of manufacturing companies, airlines and manufacturers, who consume oil and its derivatives. Treasurers of oil producers, on the other hand, may face much bigger challenges. Just as we have seen in the wake of the most recent correction, the very survival of some companies may hinge on how well their treasury adapts in the face of the challenges it poses in the area of liquidity management and funding, as well as risk management.
Attempting to forecast precisely the timing and extent of the next price shock would be a perilous endeavour. But by looking back at how the last market correction played out, treasurers can get some sense of what might be in store when it eventually comes around.
Credit crunch reprise
Perhaps the most troubling of all that might be in store is a potential repeat of the sort of turmoil we saw at the height of the last financial crisis. Back then, of course, a banking crisis was triggered when billions of dollars of dodgy subprime loans sold and then resold by banks and investors began to unravel and default. Those defaults then put those who had bought and sold the securities under near existential pressure.
If there is another, even bigger oil price shock in the coming years, experts worry we could see a spill over into the credit markets of similar proportions. All the ingredients would appear to be already there in the markets. According to data from Barclays, junk-rated energy producers expanded their borrowing on the bond markets 11 fold to $112.5bn at the height of the shale boom from 2004 through to 2014. This debt is naturally becoming a lot more challenging to service with the price of oil where it is now, and defaults are beginning to mount. In 2015 alone, 42 oil companies filed bankruptcy proceedings, according to law firm Haynes and Boone. Were the price of oil to go into freefall again in the near future, the numbers could get even worse.
If there was a very significant drop in oil prices I think the impact could be almost similar to the housing crisis that we had in the US. It will perhaps not be quite of that magnitude, but I think the credit tightness that we saw back then, could definitely remerge if we started to see new lows in oil.
Daniel Stauffer, Commodity Risk Management Consultant, Intl FCStone
“If there was a very significant drop in oil prices I think the impact could be almost similar to the housing crisis that we had in the US,” says Daniel Stauffer, Commodity Risk Consultant, Intl FCStone. “It will perhaps not be quite of that magnitude, but I think the credit tightness that we saw back then could definitely remerge if we started to see new lows in oil.”
Specifically, Stauffer believes the tipping point would be WTI breaking through the double bottom around $25.50 set back in February 2016 and began heading towards the “high teens”. “That would really start to cause some pain,” he says, “and unfortunately the fear would spill over into the credit and equity markets, potentially leading to credit constraints throughout the wider economy.”
Upheaval upstream
Perhaps, then, the aftermath of the next major oil price shock will look not too dissimilar to what we saw back in late 2008 and early 2009. During that period corporates learned, some the hard way, of the existential importance of effective cash and liquidity management. When banks begin to become more selective in their lending, treasurers have little option but to look more closely at how they can get the most out of their own resources. Using new technologies as an enabler, many treasuries have since endeavoured to centralise operations to achieve better visibility and control over liquidity and, ultimately, put isolated pockets of cash to work.
In the energy sector, we have been seeing a revival of this trend over the past several years. Indeed amongst oil producing companies – and firms heavily exposed to oil producing economies – the 2014 oil price shock put treasury efficiency in the spotlight like never before.
“When the crude price was around $148 per barrel, these companies were somewhat flushed with cash,” explains Lance Kawaguchi, Managing Director and Global Sector Head, Resources and Energy Group for HSBC’s Payments and Cash Management product group. “They didn’t worry that much about efficient liquidity management.”
A prolonged down cycle in energy prices impacts these companies a number of ways. The first effect is that liquidity begins to dry up. The second is that companies’ credit ratings are put under downward pressure, leading to a decline in debt capacity. Thirdly, staff levels are commonly reduced leaving treasuries tasked with doing more with less. That banks say interest in liquidity solutions has been growing in the oil dependent nations of the Middle East in particular lately is not perhaps that surprising then. “It’s a hot topic,” says Kawaguchi. “In fact, liquidity has been the number one topic for clients in every country I’ve visited this year.”
Kawaguchi says more clients now want to know what industry best practices are with respect to liquidity management. They want to know what practical steps they can take to acquire better visibility over trapped pockets of cash and they want to know about solutions that can help them bring this cash home in an expedient fashion.
Many of them are still carrying out their cash forecasting manually on spreadsheets he discovered. If there is a bright side to the turmoil an oil price shock can provoke, therefore, Kawaguchi thinks it is that it at least encourages treasuries to think about how legacy processes and systems for liquidity management might be due for a revamp. “What is so exciting for us at the moment is that these companies are now focusing and investing in ways to improve their days sales outstanding (DSO) and days payables outstanding (DPO).”
Growing awareness
Along with a renewed focus on working capital, a new oil price shock might also precipitate a change to risk management processes. Although conventional wisdom says a low oil price is good news for airlines, car manufacturers and other heavy consumers of the commodity for whom oil is a significant influence on revenue, a new approach to hedging commodity price risk may be just as necessary for these firms as for their upstream counterparts. In fact, the extent of the volatility seen in energy commodity markets since the oil price began to plummet in 2014 has already precipitated a review of risk management technology and processes at some companies producing finished goods derived from oil or oil derivatives.
To begin with, more companies are showing an appetite for using derivative instruments to offset their oil exposures, rather than simply agreeing to do a forward buy on the physical. “We have been seeing an influx of new clients, both on the consumer and producers side, who have been enquiring about hedging products,” says Intl FCStone’s Stauffer. “Many of these new customers are companies who have never hedged before. If a treasurer or CFO was not familiar with hedging commodities before the downturn, they should be familiar with it now.”
The traditional model in which responsibility for managing commodity risks commonly resides with the purchasing department is also being questioned by a growing number of companies. Many are now endeavouring to incorporate the management of commodity risk into treasury departments. After all, not only are corporate treasurers experts in managing market risk, trading derivatives and hedge accounting: they also have an advantage in that they are able to look at commodity related risks more holistically, understanding better their relationship with other forms of market risk.
“What we’ve seen over the last 18 months or so is that CFOs and treasurers are becoming increasingly focused on breaking down the barriers between procurement and treasury,” says Mark O’Toole, Vice President of Commodities & Treasury Solutions for OpenLink. For a vendor like OpenLink, which offers companies the means to obtain better visibility of both commodity and financial risks through a single platform, this is evidently good news. Indeed, O’Toole says his team have been inundated over the past twelve months with enquiries from multinationals, including a number of household names, now looking to take a more integrated approach.
But it may take the pain of another price shock and spell of severe volatility for some companies to make the switch from the way they have traditionally approached commodity risk management. “Something I am still noticing within some treasury departments is that treasurers say they are managing FX risk, for example, but are completely ignoring the FX exposure that comes from the procurement side of the business – their commodity exposures,” O’Toole says. “Procurement may have a lot of commodities denominated in US dollars, so you may be buying a physical commodity and it has an embedded exposure already built in it. However, that is not always visible inside treasury, so you may have a large outlier that treasurers may not be accounting for in their overall positions.”
Technology can help in giving treasurers the visibility they need over such exposures by providing faster access to data that is part of the network. It is common, O’Toole says, for OpenLink to go into companies and find numerous different systems in place covering different areas such as cash management, currency, credit, investment and debt and enterprise risk management and procurement. Consolidating all of this data onto a single platform – as OpenLink do – can benefit corporates not only by reducing the cost of paying different vendors, working with multiple integration pain points, but also in terms of operational efficiency. Positions taken by the purchasing team affecting a particular exposure are automatically visible to treasury and accounting teams.
Perhaps one of the reasons some companies have been slow to make such changes is that, like the oil producers only now beginning to work on working capital efficiency, it is only lately market conditions have highlighted the shortcomings of the traditional approach. According to the Deloitte Global Corporate Treasury Survey 2015, only 22% of the treasurers surveyed cited commodity price risk management as a system functionality used by treasury. Were there to be yet another price shock in the near future, one might reasonably expect to see still more companies reaching the conclusion that an integrated approach is required.
Preparing for the unexpected
Looking at how the recent collapse in oil prices was felt in the treasury community evidently tells us a lot about how the impact of a hypothetical future market correction might be felt. We can see that another oil price shock, together with the market volatility that usually follows such a correction, would mostly likely force companies downstream and upstream to review traditional treasury processes and consider new ways of working – as many have already been doing since the last price shock.
Under pressure to implement drastic cost cutting measures, upstream oil producing companies (and others closely linked to oil producing economies) will be strongly incentivised to focus on optimising working capital and liquidity management. Meanwhile downstream, we may see yet more companies in oil exposed sectors such as manufacturing, retail, food and beverages, seeking to actively hedge their exposures with financial derivatives for the first time and develop more advanced and integrated procurement and treasury methodologies.
It would be better, of course, to begin taking action now rather than waiting until the pressure of a crisis necessitates it. Although few people could have guessed the timing and the scale of the last oil price crash, the number of price corrections we’ve seen over the past several decades suggests they are events worth preparing for. In the long run, the changes introduced by companies in the wake of the recent oil price shock should be a very positive development for treasurers and their companies. The time is now for treasurers to take the lessons that can be drawn from the last price shock and start planning for the next one.
