Buyer's Credit Risk from a Supplier's Viewpoint

October 2009

• Evaluating a buyer's credit risk is an important task for suppliers, and overlooking this type of risk for fear of offending buyers may turn out to be a very costly move.
• If a buyer is unable to accept and pay for its contracted natural gas supplies because of financial difficulties, the supplier will likely sell the gas on the open market. If prevailing prices for the commodity are lower than the contract price, the supplier will sustain a loss.
• Buyers stand to gain when responsible suppliers help to protect their own long-term viability by following practices that ensure their customers have the ability to meet their purchase obligations.

From a supplier's point of view, the credit risk of a buyer is an important aspect of any natural gas transaction. At the same time, it can be one of the more difficult elements of the transaction as overt questions intended to assess credit risk may be interpreted as criticism or doubt about the integrity of a buying firm's business policies or operations.

When a supplier sells natural gas, there is always some level of risk that it will not receive timely payment from the buyer. Therefore, a supplier will want to take actions to ensure as much as possible, that it will receive payment from the buyer according to the terms of the transaction. To determine the credit situation of a buyer, a supplier will analyze publicly-available information about the firm (e.g., annual financial statements), and may conduct interviews with key buyer representatives.

In many cases, suppliers permit buyers to purchase gas on credit, thus allowing the buyer to obtain the gas now while paying later. The determination of a credit limit depends on the supplier's evaluation of the credit quality of the buyer. For buyers of large quantities of natural gas, it is unlikely that obtaining a credit limit from only one supplier will be sufficient for the buyer's needs. As a result, large-volume gas purchasers will tend to maximize their potential total credit limit by diversifying their portfolio of suppliers through the establishment of contracts with several suppliers.

When a buyer's creditworthiness is determined to be less-than-ideal, the supplier and the buyer may agree to more frequent payments (e.g., payment made two weeks after gas delivery, rather than four weeks), lower credit limits, or even prepayments for the gas. While such measures may seem irritating to the buyer, it is important to keep in mind that a supplier is simply behaving like any other business by not exposing itself to undue levels of risk.

If a buyer is unable to accept and pay for its contracted natural gas supplies because of financial difficulties, the supplier will likely sell the gas on the open market. If prevailing prices for the commodity are lower than the contract price, the supplier will sustain a loss. This loss can be aggravated if the supplier had acquired the inventory from a source other than its own production operations. In fact, many large energy companies operate "trading" arms, and buy and sell gas from other parties in addition to selling their own production. Some financial parties, like banks, trade gas while having no production of their own.

For example, a supplier may sell gas on November 1, 2009 for delivery throughout all of 2010 at a cost of $6/GJ, which it bought from a producer at $5.95/GJ. The supplier earns $0.05/GJ for every GJ sold as it receives payment from the buyer during the course of 2010. However, if the buyer declares bankruptcy and is unable to honour its purchase contract, the supplier may be forced to sell that gas at the prevailing market price. If the prevailing price for gas to be delivered in 2010 were $5/GJ, the supplier would lose $0.95/GJ. (Of course, this would not be problematic if the prevailing price were higher than the contracted sale price or the cost paid by the supplier in obtaining the inventory from the producer.)

Evaluating credit risk is an important task for suppliers and overlooking this type of risk for fear of offending buyers may turn out to be a very costly move. This type of evaluation is especially important for publicly-traded suppliers as these companies are under greater scrutiny and ultimately responsible to individual shareholders. Shareholders would most certainly oppose business practices that increase the chance of the supplier suffering losses. Buyers need to understand that credit risk applies to any line of business, including suppliers of natural gas. And ultimately, buyers stand to gain when responsible suppliers help to protect their own long-term viability by following practices that ensure their customers have the ability to meet their purchase obligations.

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