Episode Transcript
[00:00:00] Speaker A: A lot of players decide not to do the KYC on their own, but to rely on some vendor. It's not an excuse to completely outsource that. You need to keep a portion of the process and at the end of the day, it's your responsibility to know exactly who you're trading with.
[00:00:18] Speaker B: Welcome to the Next Imperative, a podcast hosted by AM Energy leaders tackling key issues and trends in the industry.
[00:00:29] Speaker C: Hello, my name is Jeff Angulo and I'd like to welcome you to the Next Imperative. Recent growth in LNG export capacity in the US is creating an opportunity for North American natural gas producers to increase their revenues through marketing and trading of LNG internationally. Along with that comes significant risks. In this opening episode of our global gas marketing and trading series, we're going to talk about compliance risks, regulatory risks and market risks. Joining me for this discussion are LNG thought leaders and Alvarez and Marsal managing directors Alberto Corvo and John Corrigan. Gentlemen, welcome to the Next Imperative.
[00:01:03] Speaker B: Thank you.
[00:01:04] Speaker A: Thank you, thank you. Good to be here.
[00:01:07] Speaker B: So when we talk about the risks associated with LNG trading, these risks are not new, especially for the global majors who've been trading internationally for a long time. For the large independents and the midsize independents, they'll be taking on new risks as they move to new geographies, especially in some of the international and marine based trade. So that is something that I think they all need to be thinking about. And Alberto, I'll let you start off with a little bit of discussion of what this means for somebody who's new to the international geographies.
[00:01:49] Speaker A: Yeah, so that's what's going on. I mean, the moment you start trading with foreign entities, you start being exposed to a number of new risks and obviously new regulations, new things you got to comply with and all of that. But an interesting point, it's really you are taking on, whether you like it or not, whether you understand it or not, the number of risks that you got to manage. And big players that have been doing FX and trading commodity internationally have done this for a long, long time and so have international banks and all that. And there's a lot of instruments that are available to manage that. But all of a sudden once you start getting into this, you need to be able to manage multi pronged risk.
And when I mean manage risk, it means a number of things. The first thing is do I understand what the risks are and do I have a place where I can see them all? And so this requires having a platform where you can monitor what's going on both at this particular point in time and having what is called a ladder of what the risks are. So if you're expected to deliver certain currencies or to receive certain currencies in the future, all of a sudden you have created some FX exposure to you. You're expecting to get this kind of currency and translate it to this amount of dollars. That may or may not happen. And so because the payment may or may not be coming exactly at that time, or because obviously the currency fluctuates and you have taken that exposure. So that's the first thing knowing what those are. The second thing is be able to understand how big is their impact is. And that's where having a simulation tool can be particularly useful, which is, has been going on for decades. So it's a very well understood thing, but it requires selecting what this tool needs to be. Having a tool that fits your needs without being too complicated or too simple, and then being able to have some scenarios that you apply consistently or ad hoc and say, okay, what happens if? What happens if?
And then having a policy and an ability to actually minimize that risk by saying, okay, I'm willing to take this particular kind of risk, but this I would like to hedge and how am I going to hedge it? How much is it going to cost for me to hedge it and what am I going to give up by doing that? So it's all. And maybe because I'm a technologist background, but it's all about having a platform that allows you to monitor this.
And yeah, so I don't know in your experience, John, what you have seen in the market.
[00:04:48] Speaker B: Yeah, I think we're seeing a lot of people embracing the risk.
The challenge, I think a lot of our, our people that we talk to have is, you know, until you get used to playing in that space, there are a lot of risks that you're sort of unaware of. So early on you can get caught out whether it's international credit risk, whether it's somebody along the chain doesn't do the pricing correctly. You mentioned a lot of these risks that, you know, once people are aware of them, they either need to hedge them or price them into the transaction. And I think that's where people really struggle early on is how do I calculate those and you know, A, capture them, B, calculate them and C, embed them into the transaction pricing or our hedging program. And that, that's a difficult thing thing to do right out of the gate. And to do that, you know, sort of go up that learning Curve quickly. A lot of these people need to be hiring people from other companies, other sectors that are used to these international risks and really understand how to calculate those risks and quantify those risks. And maybe you can talk about how people quantify those risks.
[00:06:15] Speaker A: Yeah, yeah, yeah. And just for the sake of the discussion, for this first part of the discussion, we're going to assume that everything happens perfectly once you decided what to do. So we're not going to talk about operational risk. That will be, you know, we'll talk about it in a few minutes. But the first thing is let's assume that everything from an operations perspective runs perfectly fine. So you need to be able to understand, okay, if I'm expecting this quantity of this currency being delivered on this date, what happens to me if it gets delivered sooner, hard, but later?
And the second is, what happens is the effects moves up and down, which it does consistently, how much am I exposed? And do I want to take a risk or do I want to color the risk or do I want to just hedge myself for downside risk? What do I want to do? And having a tool to calculate that and shock that and have an idea that that's very, very important. The other thing and is how do I buy insurance? Because you made a very valid point. Who pays for this risk insurance? Right? Do I want to put it into the, do I want to put it into the trade that I'm making? Do I want to, Is it the cost of doing business? Am I being. And to be able to make that decision, you need to understand how much is it going to cost me to do that. And that's where recently actually there's been a lot of advances with AI that allows you to set up some parameters and say, okay, I'm willing to give up this much upside if I'm in the FX risk, if I can be protected this much on the downside. So a caller structure is probably cheaper than a pure option.
What am I willing to do from a time perspective? What am I willing to do on a credit perspective? People may decide that they're going to need more time to pay or I could be on the receiving end of that.
So that allows you to create automatic scenarios and say, okay, this is the minimal cost that I could do for this and then kind of go execute. And there's, there's a number of broker deals that are offering this. But for you to be able to do that, it requires you to understand very clearly what those risks are. So there's a number of platforms. Are they out There that allow you to do that. Some are simpler, some are more complicated because also you don't want to get into a platform that is too complex and then it becomes very hard to manage.
The data is too complex, the volatility surfaces are too complex. Where do you get the data? And you're exposing yourself to a risk of the platform itself.
So depending on, as you said, who you hire, who you're working with, then you need to adjust for that. I always make an equivalent regarding to aviation, yes, 747 will take you to the other side of the world, but it's a very complex machine to operate and it takes a very trained crew to. To operate it safely.
Cessna 152, much simpler, does much less. But it's a learning plane. So you gotta know, do you want to be. At what point do you want to be in. And there's an infinity spectrum in the middle. And also how you manage that, what are you doing? How do you set it up? That's where we are seeing our clients, quite frankly, do that. Starting to move in that direction and understand, okay, how am I going to. Because it can become a pretty substantial competitive advantage to understand exactly what you're doing and what you're charging and how you're charging and what you're exposed to. And it avoids surprises and makes both the person that runs trading and the CFO sleep at night, as we say in Italy, with two pillows, not one.
And so that's an advantage. I see you smiling.
You've probably seen this before, seen it before.
[00:10:15] Speaker C: And to your point, the other side of your trade is going to be very sophisticated and going to have all these tools in all likelihood, and you need to be the equivalent.
[00:10:23] Speaker B: Yeah. And when we talk about the operations, you know, we'll talk about operational risk. And one of the things is people do these transactions. There's a lot of infrastructure that you're going to need in terms of risk management that you don't need in domestic trading, whether it's liquids or natural gas. But if it's, you know, in the US the time horizon of your exposure is very short. Right. You put gas in the pipe, that's the day you transact. You don't have to wait six weeks to get to affect the transaction. So there's a lot of things that I think people know inherently and they're just sort of struggling about how do I capture all that, how do I make sure I'm covered for that? And you mentioned the platforms and AI, and I think that's Going to be a key concern for people is what platforms will support the international transactions versus the platforms that serve the domestic market. And are there platforms that cover both effectively and that? I don't know. Alberto, do you have any thoughts on that?
[00:11:35] Speaker A: I mean, look, the perfect platform does not exist.
And I always say it's like making a tight jacket fit. Sometimes it pulls on the shoulder, sometimes it pulls on the sleeve.
You may be able to get it right, but then you gain weight or you lose some weight and then all of a sudden it's off. So it's always a trade off. So it's very difficult for someone to say, oh, this is your right platform. That's one of the things that I always recommend to clients is if you're going to get an advisor or if you're going to go talk to someone, make sure that they don't have a horse in the race. Because you know the. You got to find the right thing for you that gives you the right, that is the right compromise. There's not going to be the perfect, the perfect solution. That said there, it's a, it's a very well understood problem. It's a thing that has been going on for four decades and in other sectors. And then it's possible to leverage platforms that were born for other sectors into this and actually get the best of both worlds. Get something on the commodity side that understands commodities very well, delivery, inventory, all of that. And get something on the financial side that understands all the financial side very well. And then bring it together. And that brings me to the next step, which is, okay, imagine that you have a full, very clear view of all your trades, all your exposures. You have shocked them, you have understood them. You feel comfortable that your hedging strategy protects you in the right way. Now we're going into the realm of the operations. And so it's really important to when you design for a platform, have a cradle to grave kind of approach to the trade. Which means, how do I originate this trade? Who are my counterparties? What is the trade? What is the change in my risk, which is the part we were talking about. But then all of a sudden you're executing the trade, so you're getting the trade. How do I confirm the trade? Do I make sure that what the trade is, is what I have agreed with?
Make sure that if there's some margin maintenance or there's some things that need to be paid during the life of the, of the transaction, if it's a swap and you need to make payments that those Payments happen that you're not exposed from that, from that perspective, you're in default.
And then all the way to the closing of the transaction, seeing the impact on your portfolio and your book and then continuing with the follow up. And it requires a platform that does all of this or a combination of platforms that do all of this because presumably these shops have already something and then together with that also have an operations team very, very strong.
And coming from technology, I was always wondering, oh, why do you need operations? You got computers. And then once I started doing operations, I understand, yeah, they'll only get you to a certain part of the way people do fat finger trades. People have misunderstanding, there are issues.
Two systems may calculate collateral slightly differently and once you start ballooning up the underlying, the difference can be significant. And so you got to be able to handle all of that. So all of a sudden you're taking on a huge relief of financial risk and a much better understanding of your financial risk. But if you don't do the operational side very well, then you're taking on operational risk and you may be surprised or God forbid, back in the day when things were not very well understood, that the difference between a future and a forward it seems, oh, you know, at the end of the day everything will be okay. Yes. But the delta of the two transactions is substantially different because you have maintenance margin and companies have become bankrupt on that.
So you need to be able to understand all of these things and the system that you rely on down and, and your policies and the procedures and the whole orchestra needs to play in a certain direction.
That said, it can even become a profit center and for sure it's a center of understanding. In my view. It's like, okay, you don't need to make money on this because maybe you don't want to become a trading shop, which is fine, but at least you don't want to lose money or be surprised and that that is worth money.
[00:16:11] Speaker B: Yeah, exactly. Well, you mentioned something along the way that I think is, is unique to the international trade and it's made the headlines recently and that's the compliance areas around know your customer and fcpa. And I've always been taught, you know, FCPA is the bad one because that's the one that can send you to jail.
[00:16:34] Speaker A: So I know your customer too.
[00:16:36] Speaker B: Yeah. Know your customer will as well. So those are two big ones, especially in the international arena. And what do you think the best? You know, do some of the platforms help you manage that with compliance and reporting? Or is this something that you Just need solid processes and governance for, I mean both.
[00:16:58] Speaker A: So the, the platforms that you generally use for trading are, are more focused on the trading and by the time you enter a counterparty you have already done your kyc.
And for KYC there's tools that are available in the sense that you have a tracking of what you did.
A lot of players decide not to do the KYC on their own, but to rely on some vendor, definitely vendor data that is available, but also vendor to do a lot of work. That said, it's not an excuse to not to completely outsource that you need to keep a portion of the process and at the end of the day it's your responsibility to know exactly who you're trading with so you can leverage outside. But you still need to have a capability in house to be able to monitor this.
And again working with someone who has done this before, it allows you to define policies as to okay, what's a low, medium, high risk, what are the procedures that I'm going to follow, what are the thresholds that I'm going to apply, what are the renewals, how often do they need to do the KYC again for all these people?
And let's not forget when KYC really came to the forefront was after 9, 11 for the Patriot Act. So the Patriot act brought on all of these things for very, very good reasons and it has created all of this exposure and then regulation was amended and was added. And so it's very important to make sure that you are compliant. It's very important that you have your own.
Even if you decide to outsource, you can outsource part of the work but not the responsibility. And then yes, there's tools that facilitate at least the tracking and the understanding and then the trigger of the different things. But it's a very important part when you start dealing with third parties. FCPA is a little different.
It should be easy to comply, just don't do that kind of stuff.
But kyc, there's so many levers and there's so many things that it's a very, very serious endeavor to get going when you start a program like that.
[00:19:23] Speaker B: Excellent, thanks.
[00:19:25] Speaker C: What contract risks are out there? New entrant coming in. What do they need to be looking out for?
[00:19:29] Speaker B: I think the contract risks are kind of interesting because when you trade natural gas there's is this in standard contracts. So when you do a back to back transaction you, you know that, you know, because the contract terms are similar, you have some transparency into whatever risks that you own and which ones you can pass on to your supplier, your customer and back and forth. With lng, we've got different contracts for spot transactions and term transactions. And a lot of the term, you know, long term LNG contracts may have different terms and conditions that have placed different levels of risk on different parties. And when you go from. When you're buying a spot cargo from somebody with a term contract, those provisions don't necessarily line up and you may find yourself owning a risk that you thought you were going to be able to push upstream, but you can't because the contract provisions difference. So there's a lot of things that you know, whether it becomes a credit risk or a legal risk or just a financial risk, you have to be cognizant of what contracts are going up against which cargoes and things of that nature.
[00:20:50] Speaker C: Make sure you understand the fine print.
[00:20:51] Speaker B: Exactly the fine print. And it's different all the time. There is a move now to move towards a standard contract.
[00:20:58] Speaker C: Good.
[00:20:59] Speaker B: Which would be helpful. I think every, every other trading, commodity trading segment has done it. It's just that this is such a new, I mean we've been trading spot lng for maybe 10 years, maybe 15, so it's still very new.
And the volume is now that I think it's, it's time for a standardization. But there's stuff already out there that is going to be legacy that you have to be careful of.
[00:21:25] Speaker C: Right.
[00:21:25] Speaker A: And on the upside financial contracts they are by and large, unless it's very, very exotic derivative or very tailor made and even then there's standard forms. That part, it's pretty standard. So you understand clearly what you're getting into and what are the ins and outs of that particular trade and what it is. The thing what you need to understand is do I really understand what it is that I'm exposing myself to once I start making this kind of trade? Because you will be surprised. Sometimes it looks a certain way. But then particularly with instruments that are non linear in terms of derivatives, surprises can come pretty quickly.
And also it's very important to hedge what technically is called the Greeks. So you understand what's your delta? Do you want to hedge your delta? You have your Vega, you know, your volatility exposure, how you're going to hedge for that. And then there's.
Even if you hedge, for instance your FX with FX contracts, as a result of getting to FX contracts, you may have some interest rate exposure that you want to hedge. And again having a platform that allows you to have a consolidated view of the different exposures and of the different risk and of the different scenarios, that is a lifesaver. That's why these vendors that are out there, that can help. And again, when you decide to going to this market and to protect yourself and to start trading, it's very important to, to have a clear understanding and then to get something that is as tailor made as possible and work with someone that has done it before. And the clients that I've had that have been successful is clients that they have not said, oh, this is what we did before, we just want to do it but with a different tooling. It's understanding that by bringing new tooling, you know, we may need to look at how we do things differently. But that has been so empowering and has brought out so much benefit that it compensated for the fact that you had to retrain your resources to think in a different way.
[00:23:52] Speaker B: Right. And there's one topic, I don't know, if this falls into operational, we may pick it up a little bit again there. But for here the notion of, you know, when you go, when you sell natural gas into the pipeline system in the U.S.
you know, you deliver the gas on the delivery date and that's your transaction date. There's, you know, when you move over to lng, you've got weeks of that gas that you're carrying as inventory. And that inventory needs to be hedged both from a value perspective and a currency perspective. And you know, these things are not, you know, you're talking about tens, twenties of millions of dollars of floating inventory. And depending on what hedge instruments you choose, you may have some mark to market working capital issues. Well, number one, you've got a large working capital issue that you didn't have before because you've got this floating inventory. The second thing is if you use options or futures to hedge the delivery date, then you've got a margin cash flow risk. And even if you have a low var, you may have a lot of cash flow exposure because of the timing of that hedge. Especially if you're doing multiple hedging, multiple cargoes at one time. Under a term deal, you could have hundreds of millions of dollars of margin calls just because of a price increase where your VAR doesn't increase much because you're covered.
But boy, that, that margin call can get pretty expensive.
[00:25:36] Speaker C: Pretty expensive.
[00:25:36] Speaker A: Yeah, yeah.
And it's a delta risk, right? The fact that yeah, at the end maybe things will converge, but in the meantime they can be very different and you're exposed to that and is the famous John Merriweather apparently said that markets can stay insolvent more than you can stay liquid. Sorry, market stay irrational for longer than you can stay liquid. So it's true, things can be out of whack for a while and you need to put up the margin calls. Again, not to sound senile, it's having a clear platform that allows you to understand everything that you're getting into. Because the first step to being protected is to understand what those risks are. And once you understand what are the risks that you're taking in all those areas that you said, then you can start getting protected or at least know when you're taking a risk and know why you're taking that risk. And it's a bit the same from an operational risk.
What are you doing? How are you doing it? And then there's all sorts of obligations that you're taking on once you start trading in size.
Like you need to do surveillance, you need to understand what's going on in your trading shop, how do you make sure that everything is done the way it's supposed to be done? Alerts get triggered if things go out of whack.
And again, that's a whole conversation about no real time monitoring, false positives, management of those false positives, reduction of those false positives. Again, we have had some considerable success using AI to reduce false positives or at least the process of the false positives because some of these platforms by nature have 99.4, 99.5 of false positives. So being able to bring it down a chunk, that helps with the cost and also with the tranquility that you know, you're not clicking, clicking, clicking for something and then you, the thing that actually was a problem escapes you. So there's a lot of moving pieces.
But I think that far from scaring people, the point here is this is a very well understood problem. This is a very well understood thing and there's very clear solutions, there's very clear solutions for different needs and for different current infrastructures. Because also what you don't want to do is say, oh, okay, game over, we're going to do it completely differently. We're going to throw a grenade and change the way we are. We are managing everything. No, no, no, you want to keep as much as possible and then add onto that and create the minimum disruption and with the maximum benefit. And again having a very tailor made approach.
It's key. And then, then we have the second order things that you to start thinking about, which is okay, now we got this phenomenal system where am I going to get the data? How much is this data going to cost me? Where what data do I get? How are we going to again that's another thing that you need to start thinking about where are these feeds which feeds to take.
And also it's not only at the beginning is over time there tends to be a creep of adding more and more and more data and then you got to go back and say okay am I using this data because data is not cheap. Right. And so you got to go in that direction and yeah.
[00:29:10] Speaker C: To our audience thank you for joining Alberto, John and I for this robust discussion on the market risks associated with LNG trading on the world scale. John, Alberto, thank you very much for your time.
[00:29:20] Speaker B: Thanks.
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