The S&P Liquidity Adequacy Ratio and its Role in Upper Management Decision Making - Energy Risk USA 2007 May 16th, Houston, Texas
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The S&P Liquidity Adequacy Ratio
and its Role in Upper Management
Decision Making
Energy Risk USA 2007
May 16th, Houston, Texas
John Wengler, Chief Risk Officer
Entergy Services, Inc.Overview
Calculating the ratio between available liquidity
and potential liquidity demands
The different S&P Liquidity Adequacy ratios by
energy sector
Perspectives from Standard & Poor’s
Communicating liquidity adequacy to upper
management to enhance decision making
Customizing your own stress scenarios
Industry Perspectives
Page 2Background on Entergy
Geographic Scale Entergy’s Business Model
Entergy’s Businesses Entergy Nuclear
30,000 MW electric • 6 non-utility units owned at
generating capacity 5 sites (5,000 MW) Supply/Demand Climate/Weather Data
Long Positions
2nd largest U.S. nuclear • 1 plant managed (800 MW) Environment Competitive Behavior
generator 45% of 07 earnings Fuel Prices Legislation/Regulation Structured
Structured Strict
2.6 million customers guidance midpoint Credit Markets Capital Markets Contracts
Contracts Risk
$10 billion revenues Limits
14,500 employees
Rigorous Asset
Asset
Analysis Development
Development
/Acquisitions
/Acquisitions
Portfolio
Portfolio
Current Management
Management
Point of Asset
Asset
View Disposition
Disposition
Structured
Structured
Business Create Contracts
Contracts
Business Create
Strategy
Strategy Options
Options Short Positions
Produce
Produce
Driven by: Products/
Products/
Markets Services
Services
Skills Competitor/
Utility Non-Nuclear Wholesale Industry
5 electric utilities (5 regulators) Scale Operational
Operational Achieve
Achieve
Assets Standards
4 contiguous states – Arkansas, Scope Excellence
Excellence Productivity
Productivity
1,500 MW non-
Louisiana, Mississippi, Texas Positions
nuclear wholesale
22,000 MW of generating capacity capacity owned Manage
Manage
15,500 miles of transmission Relationships
Relationships
lines
55% of 07 earnings guidance
midpoint (includes Parent &
Other)
Page 3The Methodology Helps Answer the Question of Whether a
Company Has Adequate Liquidity If …
The company was suddenly downgraded below
investment grade
and
Market prices instantaneously increased (or
decreased)
Page 4How to Calculate “S&P Liquidity Adequacy Ratio”?
It’s the ratio of: Primary Liquidity / Potential Liquidity Demands
Primary Liquidity
Unrestricted Cash
Unused and Available Credit Facilities
Discretionary Gas/Oil Inventory
Potential Liquidity Demands
Assumes negative Mark-to-Market exposure (MtM) with hard credit
thresholds would be collateralized with cash or Letters of Credit (LCs)
if firm is downgraded. Any corporate guarantees assumed to be
converted to cash or LCs
Negative MtM associated with contracts with adequate assurance (soft
trigger) is cash collateralized
Current 30-day accounts payable are immediately paid
Commercial paper with pay down terms in event of downgrade
Static margin at exchanges and regional transmission organizations
Triggers in various loans and contracts
Page 5How to Calculate “S&P Liquidity Adequacy Ratio”?
Two Ratios
CELA: Credit Event Liquidity Adequacy
MCELA: Market & Credit Event Liquidity Adequacy
Price stress by 15% for Year 1 and 20% or Years 2
and beyond
Same stress for all commodities
Test under both increase and decrease; report the
“worst case” outcome
The objective is to have $1 in liquidity to cover
every $1 in potential price-stressed liquidity
demands
This leads to a minimum ratio of 1.0x
It would be more conservative to apply this minimum
threshold to the MCELA ratio
Page 6Liquidity Adequacy Ratios By Industry Sector*
S&P Liquidity Adequacy Ratio1, by Industry Sector (2005)2
Downgrade3
w/out Price Downgrade3 with Price Stress5,
Stress, CELA4 MCELA6
Sector (Median) Median Lowest Highest
Exploration and production 5.90 3.78 0.40 5.30
Merchant energy 5.90 3.93 Not avail Not avail
Regulated electric utilities 2.98 2.11 0.90 5.50
Diversified 2.07 1.46 0.55 3.75
Utilities with large gas-marketing operations 1.23 1.09 0.75 1.85
Integrated oil, midstream and refiners 1.11 0.96 Not avail Not avail
1. Liquidity Adequacy Ratio = Liquidity / Potential Liquidity Demands. Objective is to exceed 1.0.
2. Source: S&P, "S&P Survey Highlights Weakness in Liquidity Risk Management in the U.S. Energy
Industry", 12-May-2005.
3. Downgrade to any credit rating below investment grade or call for adequate assurance.
4. CELA = Credit Event Liquidity Adequacy (Credit event only, no price stress)
5. S&P Price Stress assumes 15% for first 12 months and 20% for Years 2 and beyond.
6. MCELA = Market & Credit Event Liq. Adequacy (Credit event plus price stress)
*Source: S&P, “S&P Survey Highlights Weaknesses in Liquidity Risk
Management in the U.S. Energy Industry,” May 12, 2005.
Page 7Trends in Liquidity Adequacy*
*Source: Used by permission by Jeanny Silva, S&P
Page 8S&P’s Perspective of Recent Liquidity Adequacy Trends*
Average MCELA is up 16% relative to a year ago
Average primary liquidity is up 25%
Expanded bank lines account for most of improvement- up
42%
But unrestricted cash balances down 34%
While average total credit exposure is up only 9%
Increase in credit exposure mostly due to higher CP balances
Average total net exposure (MTM+60 day, after netting) is
actually down 4%
MTM still dwarfs 60-day exposure (on average)
Out-of-the money contracts are either rolling off or being
replaced
Collateral posted as % of total net exposure is only
marginally up (2%)
Counterparties have not reduced or otherwise modified
contract credit terms
*Source: Used by permission by Jeanny Silva, S&P
Page 9How Does S&P Incorporate Liquidity Adequacy Ratios
in its Analysis*?
CELA and MCELA ratios are only part of the overall liquidity
analysis. S&P also considers:
Upcoming debt maturities
Ability to tap capital markets
Ability to work with counterparties/banks to re-negotiate
collateral provisions or increase bank lines
Flexibility to postpone planned capital expenditures
Ability to exit one or more trading business lines if needed
*Source: Used by permission by Jeanny Silva, S&P
Page 10Some Additional S&P Feedback As long as ratio is greater than 1.0x, S&P has traditionally not addressed the ratio further with companies. The emphasis is larger for companies with trading, marketing and/or merchant activities More accepting of
Individual Companies Further Customize or Approach
Liquidity Adequacy from their Own Perspective
Informally surveyed firms on Philadelphia Utilities Index
Most companies use both S&P ratio method but also customize for their
needs
Company A
Created similar model 18 months before S&P first requested; focus on 95%
confidence interval; now considering 99%
Company B
Customizing for worst exposure which increases as prices fall but load volumes
increase. Uses 99% confidence interval. Instead of looking backwards, look
forward over next 90 days. We set risk limits on this measurement and notify as
needed.
Company C
Assume prices returns to historical peak levels plus two sigma accompanied by
a fixed cash drain scenario
Company D
Stress is in 40-50% range. Covert all exposures to BCF Equivalent (BCF).
Compare stressed liquidity demands against available headroom between
primary liquidity and non-stress liquidity demands. Headroom must always be
adequate, particularly during cash-flow “pinch point” months of January and
July.
Page 12Communicating to Upper Management
to Enhance Decision Making
Easy to understand, easy to calculate
Directly links to discussions with Treasury and
Bankers
The “S&P” Good Housekeeping Label helps
Most companies interviewed report both S&P
ratio and customized ratios to their risk
committees and Board of Directors
Page 13Different Graphical Presentation Approaches
Fictional data, does not represent Entergy or any company, and provided for illustrative purposes only
S&P Liquidity Adequacy Ratio Historical Liquidity Adequacy Ratio
Near-term liquidity / price-stressed margin calls (Fictional Company Data)
3.5
Downgrade Only
3.0 (CELA)
S&P Liquidity Ratio
2.5
Downgrade &
2.0 Price Stress
(MCELA)
1.5
1.0 Target (= 1.0)
0.5
0.0
Qtr A Qtr B Qtr C Qtr D Qtr E Qtr F Proj Proj
Qtr F Qtr G
Date
Liquidity and Potential Demands (Stressed)
Quarter A Change in Change in Quarter B Change in Change in Quarter C (Actual and Projections)
Liquidity Demands Liquidity Demands
80.0
70.0
60.0
50.0 Revolver (Avail)
$50 Cash
40.0
$
$40 $45 MTM
$30 $30
30.0 $35 60-Day Demands
20.0 $15
$10
$15 $15
10.0 $15
$20 $20
$15
$20
$10 $10 $10
$5 $5
0.0
A B C D E
tr tr tr tr tr
Q Q Q jQ jQ
ro P ro
P
Page 14Sample of Some Industry Perspectives*
☺
Overall positive industry attitude
&
Does S&P even use?
Helped put liquidity on map, even S&P author did not mention
among non-risk folks liquidity adequacy in Top 10
Does the job even if it is a bit utility issues
quirky Volatility assumptions inverted
Believes that there are more firms and too low
fighting to be BB+ to avoid death Adequate assurance is not 100%;
spirals more like 25-40% pay down
Looking for vendors to help ease Some firms cannot gather data in
calculation order to calculate
Commercial folks must identify or If focus on ratio, can drive
acquire liquidity source before “wrong behavior” by increasing
committing to new contracts liquidity to cover dangerous
Great for “apples to apples” liquidity drains
comparisons Will S&P focus instead on new
PIM?
* Informal survey of integrated electric utilities listed in the Philadelphia Utility Index
Page 15Summary
Relatively easy to calculate… can be customized
for internal analysis
Ratios differ according to underlying risk of
industry sector
Effective communication can enhance decision
making
Generally positive industry attitude even if
companies have not heard a lot of feedback from
S&P itself
Page 16For More Information
John Wengler
Chief Risk Officer
Entergy Services, Inc.
832-681-3367
jwengle@entergy.com
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