BP and Counterparty Risk

Several reporters have called me to ask about the implications of BP’s travails for its trading operations, and more crucially, for the markets broadly.  Here are some key points:

1. BP plc (BP) probably has the largest energy trading operation of any firm in the world.
2. There is a non-trivial risk of BP going bankrupt as a result of ballooning liabilities associated with the Gulf spill.  Don’t believe me?  Look at the company’s gargantuan CDS spreads.
3. BP’s counterparties are well aware of this, but are adopting a public “what, me worry?” response to any queries about BP’s counterparty risk.  Nobody wants to raise doubts that could be self-fulfilling and spark a run.
4. That said, in private they all are lacing up their running shoes, and putting contingency plans in place.  Nobody wants to be last in line if it looks like the company is teetering towards bankruptcy.  And knowing that the government is first in line to begin with cannot inspire confidence among those who have exposure to BP.
5. Things can move from “what, me worry?” to “Panic! Run for your lives! Devil take the hindmost!” very quickly, and in response to small shocks.  That is, situations like this are inherently non-linear, and small things can spark a run or a cascade that results in the collapse of BP’s trading operation in a stunningly short period of time.  I’m NOT saying this is a certainty.  I’m not even saying it is the most likely outcome.  I am just saying that such an outcome cannot be dismissed.  We’ve seen it happen too many times before.
6. The broader market consequences of a BP failure depend crucially on whether, in the event of a bankruptcy, its positions are in or out of the money.  Enron’s failure, which was not caused by losses on its trading book, was not that disruptive to the energy markets because counterparties generally owed Enron money, rather than the reverse; hence, these counterparties did not suffer losses with consequent knock-on effects.  Moreover, its failure did not cause large market price movements that worsened the company’s losses.  A BP bankruptcy similarly would not be caused by losses on its trading book, but by metastasizing liabilities from the spill.  It is possible that BP could go bankrupt, but there would not be knock-on effects because its trading book is profitable and it doesn’t owe counterparties money.
7. A known unknown is what effect a BP bankruptcy would have on energy prices, and what effect these price movements would have on the amount BP owes its counterparties.  Hypothetically, if its bankruptcy moves energy prices, and these price moves impose losses on BP, its trading partners will suffer some losses as the result of a BP bankruptcy and default.  The problem is, we won’t have any idea what the price response to a BP bankruptcy will be until it happens.

This situation is not an imminent crisis, but bears watching.  If it moves, it will not move slowly, but with stunning speed.