Volatility, as well as the absolute price levels for some commodities (in particular gas and electricity), had already broken records in the last quarter of 2021. The levels for these two commodities remained high in France and other European markets in the first quarter of 2022, particularly as a result of the armed conflict in Ukraine.
To manage the price risk on these commodities, many companies, whether they are producers, distributors or users, operate on organized markets such as EEX or ICE. The preference for organized markets for these products, as compared to OTC markets is essentially due to the low credit risk, high liquidity and anonymity they provide. However, the level of volatility and the price level of a product have a strong influence on the amount of the initial deposit or initial margin (IM) that a clearing house requires to allow access to participants in these markets and limit the counterparty risk relating to each transaction as much as possible. These deposits are a cash outflow for those who participate in such organized markets and a cash inflow for the clearing house. They differ from variation margins (VM) which can be incoming or outgoing cash flows depending on the variation in value (unrealized profit or loss) of the position taken by a market participant since its last margin call payment.
The terms “costs of intervention” may seem inappropriate for IMs since it relies to a remunerated deposit that the company will recover at maturity. Nevertheless, for the party who pays it, it is a cash deposit that lasts the time of its participation in the market and might be a structural exposure. On the other hand, such remuneration (currently at very low rates given the market conditions of short-term interest rates) is often very far from the company’s weighted average cost of capital. It would obviously not be the first investment choice of a treasurer. Finally, the periodic review of the amount of IM by the clearing houses – in particular based on the volatility of the underlying position – requires strong short-term cash flexibility from treasurers.
While VMs are intended to protect the clearing house and its members from a default by a counterparty on changes in the value of its positions from one day to the next, one of the objectives of IMs is to protect the clearing house and its members from intraday market movements.
However, the amounts of cash mobilized within the framework of the IM to have the right to open positions on the organized markets can be very significant. During recent periods of extreme volatility, they could reach several tens of euros per MWh and represent significant amounts of cash deposits for operators who regularly operate on energy markets. The original purpose of IMs to protect the clearing house from the default of one of its members is generating unwanted effects. An excessive amount of IMs could act as a barrier to entry and prevent a willing participant from having access to organized markets or cause it to close existing positions, due to a lack of sufficient liquidity. The alternative would therefore be either operating on OTC markets and consequently increasing the credit risk present in the deal, or to reduce the outstanding amount of its price risk coverage and incur an increased operational risk compared to its usual mode of operation.
The growing materiality of these cash impacts for some companies, whether IMs or VMs, requires each exposed company to raise the right questions for their financial disclosures, both in terms of information communicated in relation to net debt as well as the impact of these cash movements in the cash flow statement.
As the conflict between Russia and Ukraine continues to persist, global commodity markets and energy prices continue to fluctuate based on a significant volatility, imposing a very high pressure on the cash exposures of the treasurers.
By François Holzman, Global Treasury & Commodities Leader, EY
Association française des trésoriers d'entreprise - AFTE
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