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Treasury Hot Topics Seminar Record price and volatility levels > need to start hedging your commodity exposures? 19 February 2009 PwC Agenda Audience perspective A view on the markets Evolution of Commodity Markets Where philosophy meets strategy CRM related issues Wrap up and conclusion Agenda Audience perspective A view on the markets Evolution of Commodity Markets Where philosophy meets strategy CRM related issues Wrap up and conclusion Audience perspective Audience perspective Share your point of view Question n°1 – Treasurer’s viewpoint How would you rank your company’s exposure to commodity risk compared to other financial risks? PricewaterhouseCoopers Slide 4 Audience perspective Audience perspective Share your point of view Question n°2 – Management awareness How would you qualify your company’s top management level of awareness to commodity price risk issues? PricewaterhouseCoopers Slide 5 Audience perspective Audience perspective Share your point of view Question n°3 – Identification and quantification Does a centralised view of your company’s commodity exposures exist and are these exposures quantified? PricewaterhouseCoopers Slide 6 Audience perspective Audience perspective Share your point of view Question n°4 – Where is the exposure managed Where is the commodity price risk managed within your company? PricewaterhouseCoopers Slide 7 Audience perspective Audience perspective Share your point of view Question n°5 – How is the exposure managed What type of instrument do you use to manage the commodity price risk? PricewaterhouseCoopers Slide 8 Audience perspective Audience perspective Share your point of view Question n°6 – Financial instruments type What type of financial instrument do you use or would you consider using to manage the commodity price risk (multiple answers possible)? PricewaterhouseCoopers Slide 9 Agenda Audience perspective A view on the markets Evolution of Commodity Markets Where philosophy meets strategy CRM related issues Wrap up and conclusion PricewaterhouseCoopers ICE Brent Chinese imports 04/01/09 04/10/08 04/07/08 04/04/08 04/01/08 04/10/07 04/07/07 04/04/07 04/01/07 04/10/06 04/07/06 04/04/06 04/01/06 04/10/05 04/07/05 04/04/05 04/01/05 04/10/04 04/07/04 04/04/04 04/01/04 04/10/03 04/07/03 04/04/03 04/01/03 04/10/02 04/07/02 04/04/02 04/01/02 04/10/01 04/07/01 04/04/01 100 = 04/04/2001 A view on the markets Chinese Imports – ICE Brent – LME Copper 700,00 600,00 500,00 400,00 300,00 200,00 100,00 0,00 Source: Bloomberg data and PwC analysis Time LME Copper Cash price Slide 11 PricewaterhouseCoopers 04/01/2009 04/10/2008 04/07/2008 04/04/2008 04/01/2008 04/10/2007 04/07/2007 04/04/2007 04/01/2007 04/10/2006 04/07/2006 40 04/04/2006 04/01/2006 US Airways 04/10/2005 04/07/2005 ICE Brent & Airlines Filings 04/04/2005 80 04/01/2005 100 04/10/2004 04/07/2004 04/04/2004 04/01/2004 04/10/2003 04/07/2003 04/04/2003 120 04/01/2003 20 04/10/2002 04/07/2002 04/04/2002 04/01/2002 04/10/2001 04/07/2001 04/04/2001 USD/Bbl A view on the markets Brent 160 Northwest & Delta Airlines 140 United Airlines Air Canada US Airways Aloha Airlines Brent 60 Maxjet Airways Aloha – ATA – Skybus – Frontier – EOS Airlines 0 Dates Source: Recession.org and PwC analysis Slide 12 -10 PricewaterhouseCoopers 01/01/2009 01/10/2008 ICE Brent 36 Months – ICE Brent Spot 01/07/2008 40 01/04/2008 01/01/2008 01/10/2007 01/07/2007 01/04/2007 01/01/2007 01/10/2006 Backwardation 01/07/2006 01/04/2006 01/01/2006 01/10/2005 01/07/2005 01/04/2005 01/01/2005 01/10/2004 01/07/2004 01/04/2004 01/01/2004 01/10/2003 01/07/2003 01/04/2003 20 01/01/2003 01/10/2002 01/07/2002 01/04/2002 01/01/2002 01/10/2001 01/07/2001 01/04/2001 01/01/2001 USD/Bbl A view on the markets Brent - From a backwardation to a contango market (1/2) Contango (+) / Backwardation (-) Contango 30 Contango Back 10 0 -20 -30 Time Source: Bloomberg data and PwC analysis Contango (+) Backwardation (-) Slide 13 PricewaterhouseCoopers 31/01/2007 30/11/2006 30/09/2006 31/07/2006 31/05/2006 Time 31/01/2009 30/11/2008 30/09/2008 31/07/2008 31/05/2008 31/03/2008 31/01/2008 30/11/2007 30/09/2007 31/07/2007 31/05/2007 31/03/2007 Source: Bloomberg data and PwC analysis 31/03/2006 31/01/2006 30/11/2005 30/09/2005 31/07/2005 31/05/2005 31/03/2005 31/01/2005 30/11/2004 30/09/2004 31/07/2004 31/05/2004 USD/Bbl 31/03/2004 31/01/2004 A view on the markets Brent - From a backwardation to a contango market (2/2) 160 140 120 100 80 60 40 20 140-160 120-140 100-120 80-100 60-80 40-60 20-40 0-20 0 24-M Spot Slide 14 A view on the markets Commodity Markets Volatilities (cont’d) Volatility Drivers • Political Risk (e.g. oil and gas) • Weather (e.g. temperature levels, hurricanes in the U.S impact electricity and gas prices) • Storage capacity and availability of Supply help reduce the volatility (i.e. electricity cannot be stored and is consequently the most volatile commodity). • Shortage expectations or bottlenecks in production / refining process • Short-end of the price curve is significantly more volatile than the Longend. PricewaterhouseCoopers Slide 15 A view on the markets 100-days historical Vol – ICE Brent – LME Copper – LME Zinc 80,00% 70,00% 60,00% 50,00% 40,00% 30,00% 20,00% 10,00% Source: Bloomberg data and PwC analysis 0,00% 01 01 02 02 03 03 03 04 04 04 05 05 05 06 06 06 07 07 07 08 08 08 8/ 2/ 5/ 9/ 1/ 5/ 9/ 1/ 5/ 9/ 2/ 6/ 0/ 2/ 6/ 0/ 2/ 7/ 1/ 3/ 7/ 1/ 0 1 0 0 0 0 0 0 0 0 0 0 1 0 0 1 0 0 1 0 0 1 / / / / / / / / / / / / / / / / / / / / / / 22 26 01 04 08 14 17 21 26 29 02 08 12 15 21 25 28 04 07 12 16 19 ICE Brent PricewaterhouseCoopers LME Zinc Cash price LME Copper Cash price Slide 16 PricewaterhouseCoopers 21/11/2008 21/08/2008 21/05/2008 21/02/2008 21/11/2007 21/08/2007 21/05/2007 21/02/2007 21/11/2006 21/08/2006 21/05/2006 21/02/2006 21/11/2005 21/08/2005 21/05/2005 21/02/2005 21/11/2004 21/08/2004 21/05/2004 21/02/2004 21/11/2003 21/08/2003 21/05/2003 21/02/2003 21/11/2002 21/08/2002 21/05/2002 21/02/2002 21/11/2001 21/08/2001 21/05/2001 100-days historical Vol A view on the markets Volatility and contracts maturity 80,00% ICE Brent 100-days historical Volatilities 70,00% 60,00% 50,00% 40,00% Spot 3-M 12-M 24-M 30,00% 20,00% 10,00% 0,00% Source: Bloomberg data and PwC analysis Time Slide 17 Agenda Audience perspective A view on the markets Evolution of Commodity Markets Where philosophy meets strategy CRM related issues Wrap up and conclusion Evolution of Commodity Markets A Bit of History From Butter and Cheese… The Butter and Cheese Exchange of New York was founded in 1872.. You may better know its today’s name: NYMEX. Today, the Exchange is the world's leading energy and precious metals market. PricewaterhouseCoopers Slide 19 Evolution of Commodity Markets A Bit of History… (cont’d) … to a wide range of commodities: from oil, gas, electricity and metals to… Vegetable Oil, Cheese, Eggs, Pork Bellies… CO2 and Weather… Today, a high number of market places exist and can be used for hedging or speculating on Commodity Risk PricewaterhouseCoopers Slide 20 Evolution of Commodity Markets From physical to financial markets (1/2) Zeebrugge Hub daily average traded volumes and daily average physical throughput 2000,0 an -0 M 1 ay -0 Se 1 p01 Ja n0 M 2 ay -0 Se 2 p02 Ja n0 M 3 ay -0 Se 3 p03 Ja n0 M 4 ay -0 Se 4 p04 Ja n0 M 5 ay -0 Se 5 p05 Ja n0 M 6 ay -0 Se 6 p06 Ja n0 M 7 a 1800,0 1600,0 1400,0 Month 1200,0 GWh 1000,0 800,0 600,0 400,0 200,0 Ja n0 M 0 ay -0 Se 0 p00 Ja n0 M 1 ay -0 Se 1 p01 Ja n0 M 2 ay -0 Se 2 p02 Ja n0 M 3 ay -0 Se 3 p03 Ja n0 M 4 ay -0 Se 4 p04 Ja n0 M 5 ay -0 Se 5 p05 Ja n0 M 6 ay -0 Se 6 p06 Ja n0 M 7 ay -0 Se 7 p07 Ja n0 M 8 ay -0 Se 8 p08 Ja n09 0,0 Month Physical Throughput daily average Net Traded daily Average Source: huberator.com PricewaterhouseCoopers Physical Throughput daily average Net Traded daily Average Slide 21 Evolution of Commodity Markets From physical to financial markets (2/2) Average daily World Oil production and Brent traded Average daily Oil production and Brent Futures traded (Thousand Bbl) (Thousand barrels) 350.000 300.000 Thousand Bbl 250.000 200.000 150.000 100.000 50.000 2008-10 2008-7 2008-4 2008-1 2007-10 2007-7 2007-4 2007-1 2006-10 2006-7 2006-4 2006-1 2005-10 2005-7 2005-4 2005-1 2004-10 2004-7 2004-4 2004-1 2003-10 2003-7 2003-4 2003-1 2002-10 2002-7 2002-4 2002-1 2001-10 2001-7 2001-4 2001-1 0 Month Wold oil production (Average KBbl / day) PricewaterhouseCoopers Average of FUT_AGGTE_VOL (KBbl) Source: Bloomberg data and PwC analysis Slide 22 Evolution of Commodity Markets Development of New Markets – Weather Derivatives • Correlation between their business and climate: - Hot summer of 2003, hot winter 2006-2007, rainy summer 2007… - Concerns regarding global climate change and its impact • Weather fluctuations is a risk against which companies may wish to be hedged • Slow to take-off of hedging products due to: - Complex relationship between weather and business performance - “Uniqueness” of the relationship between the business and the weather (creation of basis risk and sub-optimal hedges) - No medium-long term valuation method (due to uncertainty of weather forecast) and lack of speculators who could add liquidity in the market PricewaterhouseCoopers Slide 23 Evolution of Commodity Markets Development of New Markets – Weather Derivatives (cont’d) Example 1: Correlation between temperature and electricity demand in Spain in 1983 and in 1998 Source: Journal of applied meteorology, August 2001, Volume 40, p 1418 PricewaterhouseCoopers Example 2: Influence of T° and rainfalls on the corn yield Source: WRMA lesson 1a Weather effects on Crop yields, December 2004 Slide 24 Agenda Audience perspective A view on the markets Evolution of Commodity Markets Where philosophy meets strategy CRM related issues Wrap up and conclusion PricewaterhouseCoopers Slide 25 Where philosophy meets strategy Would you be Winnie the Pooh or the Tigger "Don't underestimate the value of Doing Nothing, of just going along, listening to all the things you can't hear, and not bothering.“ ~ Winnie the Pooh "True mastery can be gained by letting things go their own way. It can't be gained by interfering." ~ Lao Tseu Source:http://financialphilosopher.typepad.com/ PricewaterhouseCoopers Slide 26 Where philosophy meets strategy The call for action “The market can remain irrational longer than you can remain solvent” ~ Keynes The basic 4 steps approach: 3. Manage 1. Identify 4. Control 2. Measure PricewaterhouseCoopers Slide 27 Where philosophy meets strategy The 4 steps approach (1/5) 1. Identify what the exposure is? • Locate the exposure: - In which subsidiaries, for which products? - Within purchases, sales, transformation process? • Identify physical contracts (firm commitments, forecasts) and indexed contracts creating exposure 2. Measure the exposure and your sensitivity • Quantify the exposure (consider netting of exposures, natural hedges,…) • How much does the commodity price represents within my cost structure? • Assess earnings sensitivity to commodity price taking into account - Commodity price volatility - Volume risk (demand elasticity) PricewaterhouseCoopers Slide 28 Where philosophy meets strategy The 4 steps approach (2/5) 3. Manage the exposure in line with the company’ strategy and objectives (1/4) • Key input from management: - CFO, Treasurer, Sales Director, Purchase Director, Production Director, Country Managers • Objectives should be aligned with: - Company business model - Company risk appetite - Shareholders expectations • Typical objectives: - Zero exposure - Reduce earnings volatility - Lock-in margins and ensure medium term visibility for the business PricewaterhouseCoopers Slide 29 Where philosophy meets strategy The 4 steps approach (3/5) 3. Manage the exposure in line with the company’ strategy and objectives (2/4) How can we manage the risks? • Choice of methodology and instruments: - Financial hedges - Purchase / sales contracts re-negotiation - Find natural hedges - Process re-organisation • Centralised V.S. decentralised processes: - Identification of exposures - Reporting process to Group Treasury - Follow-up of forecasts versus actuals - Hedging decision and execution process PricewaterhouseCoopers Slide 30 Where philosophy meets strategy The 4 steps approach (4/5) 3. Manage the exposure in line with the company’ strategy and objectives (3/4) What are the economic and accounting impact of selected strategy? • What are competitors doing? Which are the accounting implications of the economic choice made,… How to implement? • Provide training to key stakeholders: - In which subsidiaries, for which products? - Within purchases, sales, transformation process? • Customise and automate exposure reporting - Tools, reports,... PricewaterhouseCoopers Slide 31 Where philosophy meets strategy The 4 steps approach (5/5) 3. Manage the exposure in line with the company’ strategy and objectives (4/4) 4. Control the achieved performance • Benchmarking versus - “No hedge” scenario - Alternative hedging scenario • Consider whether we achieved our primary objectives - From an economical standpoint (cost effectiveness, competitiveness,…) - Accounting (do we reflect the economic reality in the accounting?) PricewaterhouseCoopers Slide 32 Where philosophy meets strategy The quantification exercise (1/3) Measuring the exposure • Across the Group - Netting opportunities - Local monopolistic markets / legal constraints / non-market driven prices • Natural hedges / price pass-through mechanism - Working in both ways • Competitive environment / market practice • Client acceptance for price increase in bull market • Client acceptance for no price decrease in bear market - Time lags between purchases and sales • How does the commodity volatility impact - Cost structure - EBIT - Other (covenants working capital requirements,…) PricewaterhouseCoopers Slide 33 Where philosophy meets strategy The quantification exercise (2/3) Base case Measuring the sensitivity of the cost structure: Air France – Base case HY08 Source: AirfranceKLM website 14.000 12.000 2.972 10.000 8.000 12.983 EUR Mio 6.000 4.000 639 2.000 0 Costs Employees commercial & distribution costs Fuel costs PricewaterhouseCoopers Revenues Aicraft costs Handling charges Revenues Margin Landing fees and end route charges Other Margin Slide 34 Where philosophy meets strategy The quantification exercise (3/3) Measuring the sensitivity of the cost structure: Air France simulated costs: • No hedge – 60% jet fuel increase – 50% pass through via fuel surcharge Source: AirfranceKLM website and PwC simulations Simulation - No hedge; 50% pass through 16.000 892 14.000 4.755 12.000 10.000 8.000 12.983 EUR Mio 6.000 4.000 2.000 0 -253 -2.000 Costs Employees Handling charges Fuel surcharge revenues PricewaterhouseCoopers Revenues Aicraft costs Other Margin Landing fees and end route charges Fuel costs Margin commercial & distribution costs Base Revenues Slide 35 Where philosophy meets strategy The need for adequate CRM policies "Only in quiet waters things mirror themselves undistorted. Only in a quiet mind is adequate perception of the world.“ ~ Hans Margolius • • PricewaterhouseCoopers Avoid bad timing for decision taking. E.g. - Hedging jet fuel price in July - Clearly sets the rules of the game, the expectations of the stakeholders Policies should cover - Goal - High level strategy - Rationale - Roles & responsibilities - Reporting requirements – KPIs Slide 36 Where philosophy meets strategy Choosing the right strategy upfront (1/2) "When the mind is in a state of uncertainty the smallest impulse directs it to either side.“ ~ Terence (195/185 - 159 BC) Avoid asking yourself the right questions at the wrong moment • • • • • Historical comparison of potential strategies Building simulation tool Running what-if analysis Using stress testing … Knowing upfront potential impact of Commodity prices should enable you to react more quickly and more appropriately PricewaterhouseCoopers Slide 37 Where philosophy meets strategy Choosing the right strategy upfront (2/2) Weighted average quarterly Jet fuel pruchase price Historical simulation of jet fuel hedging strategies 1.000 Source: Bloombreg data and PwC analysis 900 Jet fuel price (USD / Ton) 800 700 600 500 400 300 200 Hedge build-up period 100 Comparability period 0 Q1 2003 Q2 2003 Q3 2003 Q4 2003 Q1 2004 Q2 2004 Q3 2004 Q4 2004 Q1 2005 Q2 2005 Q3 2005 Q4 2005 Q1 2006 Q2 2006 Q3 2006 Q4 2006 Q1 2007 Q2 2007 Q3 2007 Q4 2007 Quarters Scenario 1 - No Hedge PricewaterhouseCoopers Scenario 2 - Systematic Hedge Scenario 3 - Hedge Ratio Cube Slide 38 Where philosophy meets strategy Finding the Best Hedge Do financial instruments exist for the commodities I am exposed to? • Yes - Are these OTC or exchange traded derivatives? - Is the price transparent? - Is there enough liquidity? And for which maturity? - What would be the cost / benefit of hedging? • No => Proxy hedging - Do other financial instruments exist for highly correlated commodities? (Proxy hedging) - How stable is the correlation across time? - How effective is the hedge relationship? => Proxy hedging may be the only efficient solution for hedging but may create additional complexities on the accounting side. PricewaterhouseCoopers Slide 39 Where philosophy meets strategy CRM and the Treasurer • Commodity Risk Management tends to be placed under the responsibility of the Treasurer when the exposures remain acceptable. - This allows to benefit from the Expertise and the infrastructure of Treasury. • This is untrue for companies where Commodity Risk is at the core of the Business (e.g. Utilities, Metal Refining, etc) - Commodity Risk tends to be managed by a distinctive function from Treasury (need for expert skills and specific systems). • In the latter case, interaction between Commodity Risk Management and Treasury remains important in order to integrate : - The FX risk dimension (commodities are often USD denominated) - Funding of CRM activities (e.g. margin calls) - Counterparty risk generated by CRM activities (OTC derivatives) PricewaterhouseCoopers Slide 40 Section five Audience perspective A view on the markets Evolution of Commodity Markets Where philosophy meets strategy CRM related issues Wrap up and conclusion PricewaterhouseCoopers Slide 41 CRM related issues Managing CRM related issues Managing commodity risk comes along with other “side duties”: Liquidity Commodity Risk Management Counterparty Crack spread swaps Foreign Currency Brent swaps Operational Accounting PricewaterhouseCoopers Slide 42 CRM related issues Accounting for Commodity Hedges (1/2) Specificities for commodities: • Cannot isolate a component of a pricing formula: only the entire change in fair value of the hedged commodity contract can be hedged - Hedging one component of a price formula would most likely not qualify for hedge accounting Proxy hedging - Basis risk • When no exact pricing is available to hedge an exposure, a correlated pricing can be used which may lead to difference in pricing movement from the hedge item and hedge instrument Proxy hedging - Quality premium • The quality premium in a pricing formula of a physical contract may not be included in the pricing formula/index of a financial contract. Hedge accounting and effectiveness testing may be difficult to achieve but solutions do exist. PricewaterhouseCoopers Slide 43 CRM related issues Accounting for Commodity Hedges (2/2) Application of hedge accounting to stack-up strategy • De-designation and Re-designation may need to take place if various derivatives are packaged to synthetically hedge the exact exposure Synthetic jet fuel build-up 14.000 Volume (Bbl) 12.000 Diffs 10.000 8.000 6.000 Crack spread swaps 4.000 2.000 Brent swaps 0 Q1 Q2 Q3 Q4 Q5 Q6 Q7 Q8 Quarter ahead PricewaterhouseCoopers Slide 44 CRM related issues FX and Operational risks Majority of commodities are quoted in USD – FX risk • Chosen policy should incorporate a strategic analysis of interdependency of these two risks - Managed at the same time? - Manage separately (leave room to benefit from potentially favourable market movements) Type of operations – Operational risk • Need to have adequate structure to manage CRM instruments (derivatives) - FO / MO / BO segregation - Set-up risk committee to monitor CRM activities and take strategic orientations - Follow-up of physically VS financially settled transactions - Adequate systems and tools - Knowledgeable teams / training => Treasury is the adequate environment to develop this activity PricewaterhouseCoopers Slide 45 CRM related issues Liquidity and Counterparty risks High volatility implies important changes in market values – Liquidity risk • Exchange traded derivatives often require the set-up of margining arrangements - Daily exchange of the Mark-to-Market (MtM) of open contracts • Limited credit risk • Creates additional administrative burden • Creates additional liquidity requirements that may be significant (asymmetric margining between physical and financial contracts) Important market values of derivatives can increase the credit risk • Positive fair value of OTC derivatives not subject to margining create additional credit risk - Requirement for adequate follow-up of trading counterparties - Need to incorporate credit risk within the CRM policies PricewaterhouseCoopers Slide 46 Agenda Audience perspective A view on the markets Evolution of Commodity Markets Where philosophy meets strategy CRM related issues Wrap up and conclusion PricewaterhouseCoopers Slide 47 Wrap up and conclusion The best moment to fix the roof is when the sun is shining • • Is it the right time to hedge the Commodity price risks? In any case it is the right time to - Define your CRM strategy - Start managing your commodity risks 700,00 Back to the future! • Brent: Dec 2004 • Zinc: Dec 2004 • Aluminium: Oct 2002 • Copper: May 2005 Between 4 and 7 years of price rise have disappeared! 600,00 400,00 300,00 200,00 100,00 04/01/2009 04/10/2008 04/07/2008 04/04/2008 04/01/2008 04/10/2007 04/07/2007 04/04/2007 04/01/2007 04/10/2006 04/07/2006 04/04/2006 04/01/2006 04/10/2005 04/07/2005 04/04/2005 04/01/2005 04/10/2004 04/07/2004 04/04/2004 04/01/2004 04/10/2003 04/07/2003 04/04/2003 04/01/2003 04/10/2002 04/07/2002 04/04/2002 04/01/2002 04/10/2001 Source: Bloomberg data and PwC analysis 04/07/2001 0,00 04/04/2001 100 = 04/04/2001 500,00 Time ICE Brent PricewaterhouseCoopers LME Zinc Cash price LME Copper Cash price Aluminium Cash price Slide 48 Thank you! Olivier Cattoor [email protected] +32 2 710 4118 Olivier Kaczmarek [email protected] +32 2 710 9624 © 2009 PricewaterhouseCoopers. All rights reserved. “PricewaterhouseCoopers” refers to the network of member firms of PricewaterhouseCoopers International Limited, each of which is a separate and independent legal entity. *connectedthinking is a trademark of PricewaterhouseCoopers LLP (US). PwC