VeraSun Energy’s Chapter 11 bankruptcy filing on October 31 sent shockwaves across the grain industry. Farmers and elevators with high-priced sales suddenly were unsure whether those contracts would be honored. Sellers wondered whether it’s safe to trade with VeraSun after the filing date. The Pilgrim’s Pride Chapter 11 filing a month later only added to the uncertainty, leaving most managers unsure how lessen counterparty credit risk on any sale contract.
Carrying a basket of risks
Counterparty credit risk on sales was a new addition to a basket that was already overflowing: freight, financing, quality, default risk, basis, spreads, producer origination alternatives, and everything in between. Smart managers know every business has a limit to how much risk it can tolerate. Imagine a basket with a fixed capacity; put too much in the basket and it can tip over or split apart. Even if the basket holds together, keeping track of the contents is difficult if the basket is overflowing. The manager’s challenge is to find the best blend of risks to carry: enough risks to create sufficient profit opportunities, diverse enough to ensure no single risk can tip the basket, balanced so different sectors of the business can operate, and with sufficient working capital and credit to accommodate the basket’s financing needs. But even that approach is not enough. Management has to sort through the contents and search out less obvious risks.
Consider both probability and the loss potential of risks. One outcome may have a very low probability but with dire consequences if it occurs. Another problem may occur more frequently but cause only minor loss. Watch them all, but focus on the high-cost risks. Be realistic — just about anything is possible given the volatility of prices this year and turmoil in the global financial markets. Inflation could return, interest rates could rise, and commodity futures could move sharply in either direction.
Time affects decisions. Strategies and decisions that seemed reasonable, even prudent, at first, can turn into a disaster when conditions change. A general manager knows, for example, that carrying a large inventory of high-priced fertilizer ownership bought last summer became a major risk within months. As an offset, this manager could decide to reduce basis ownership of grains, and to diversify grain sales among buyers to lessen counterparty exposure. He might opt to liquidate soybean ownership to reduce credit demands and help balance the firm’s risk basket. Another manager might also lock in futures carries on grain hedges as another safety net if the elevator can’t ship the grain quickly. Last summer many elevators were glad to make forward priced sales where possible to reduce the margin calls from short futures, only to discover the cost of that solution is even greater — counterparty credit risk. There’s no single “right” way to balance a firm’s risks; what’s important is to quantify the maximum potential loss, reduce exposure when necessary, and check your basket regularly.
Counterparty credit and performance risk
Most elevator managers carefully documented and monitored open purchases as futures soared earlier in 2008, then sighed with relief as prices retreated before harvest. But that relief was short-lived when VeraSun failed and Pilgrim’s Pride followed. Suddenly it became public that VeraSun had sizable forward high-price corn purchases, near $7/bushel in some cases. Elevator managers discovered to their horror that a firm in Chapter 11 and the bankruptcy judge can legally void such contracts. That is permissible according to Christopher Giaimo with Arent Fox, outside counsel for the National Grain & Feed Association in Washington. A debtor such as VeraSun has a fiduciary duty to maximize the value of its bankruptcy estate. He further clarified that if the debtor determines a contract is a liability it can reject and terminate the contract(s), but must do so in its entirety, subject to approval of the court. The non-debtors — sellers in this case — cannot terminate such contracts on grounds the debtor is in default. The bright news is that a firm in Chapter 11 may actually become a better counterparty during the reorganization.