Hedging Against Risk Takes Spotlight in Volatile Times

23 July 2001 00:00  [Source: ICB Americas]

In today's global market environment, where profitability is often at the mercy of volatile swings in external factors, hedging against risk is getting more attention than ever. Over the past year, the US chemicals industry has been besieged by sky high oil and gas-based raw material costs, diminished pricing power, the persistent strength of the US dollar hampering export and overseas profitability and adverse weather conditions in the form of flooding in the Gulf Coast.

While all these events could have been at least partially offset by hedging instruments, hedging comes with its own risks as well.

"Investors will pay a higher multiple for companies with more predictable earnings, so to the extent some volatility can be removed by hedging, we think that's an expense that has a good return," says Merrill Lynch analyst John Roberts. "In 2001, most companies have significantly increased their hedging of raw materials, energy and currencies."

"In the investment community, there is a groundswell of concern about the volatility of prices, costs and profits," says Argus Research analyst David Kerans. "We do prefer to see a leveling of costs and profits that can come with hedging."

Dow Chemical Company is a leader in feedstock management. In the fourth quarter of 2000, the dramatic spike in natural gas prices drove Dow's hydrocarbon and energy costs up by over $500 million. However, operating earnings only fell by $136 million, partly because of its proactive hedging activities. Hedging also helped offset higher feedstock costs in the first quarter.

With the acquisition of Union Carbide, which did not materially hedge, Dow has likely boosted its overall hedging activities. Other companies that have increased hedging activities this year include DuPont, Rohm and Haas and Solutia, notes Merrill Lynch's Mr. Roberts.

Hedging against risk is an old game. Precious metals producers hedge their production through liquid standardized futures contracts, guaranteeing a certain price for their product over a specified period of time. Many fertilizer companies significantly hedge their natural gas feedstock requirements.

However, the chemical industry has lagged other industries in the hedging department, partly because of the lack of appropriate tools. "The chemical industry doesn't have as many direct tools," notes Mr. Roberts. "You've always been able to hedge natural gas, but it wasn't until a few years ago that you could hedge things like propylene and further downstream into derivative chemicals."

Firms offering chemical hedging instruments include Enron, Shell Chemical Risk Management (SCRiM), Koch and Louis Dreyfus. These entities can help companies manage price risk for chemicals such as ethylene, propylene, styrene and their derivatives as well as a host of other products through the use of contracts.

"We've seen a noticeable increase in the number and scope of the counterparties that have an interest in developing a hedging/risk management program," says John Nowlan, vice- president, Enron Global Markets.

The spike in natural gas prices earlier this year has had a ripple effect on hedging activities. "When feedstocks spiked up, companies started to look very seriously at hedging their input exposure. The next question they asked was: How do we hedge our output?," Mr. Nowlan says. "The industry has come to the decision that they need some ability to hedge their output, and since we've really been the market maker in this category for the last couple of years, we've seen a sizeable increase in activity."

Enron's trading platform Enron-Online, which was introduced in late 1999, offers trading in standardized forward contracts in the form of swaps and options on a wide range of chemicals. "This is really becoming the industry's forward curve, especially for aromatics," says Mr. Nowlan. "It gives the industry the ability to see a live, transactable number on these contracts that people are willing to buy and sell at. It is a quantum step for the industry."

An active, liquid forward market is of paramount importance for a chemical company to determine if it is able to effectively lock in margins through hedging.

"People are becoming more cognizant about taking a look at what is actually available [for hedging] on the forward market, and taking into account their operating plans and margins, are trying to lock some of that in," notes Mr. Nowlan.

Companies can also trade standardized futures contracts on the Chicago Mercantile Exchange (CME), although the number of chemical products is limited. The CME along with Che-Match.com created the first standardized benzene futures contract available for trading on the CME back in March.

In 1997, Enron started offering contracts to help companies manage their exposure to weather conditions. For the chemical industry, weather can impact sales of fertilizers and agricultural chemicals, as well as interfere with production in extreme cases (hurricanes, flooding).

While companies can offset adverse market conditions through the use of hedging instruments, hedging itself can present risks.

"Solutia has hedged 40 percent of its natural gas requirements for the summer and winter months in 2001 at an above market $5 per mmbtu price and thus may not retain much of the benefit from the recent decline in natural gas costs," notes JP Morgan analyst Donald Carson.

One of the most notable high profile hedging disasters involved Air Pro-ducts and Air Liquide's joint £7.2 billion ($11.2 billion) bid to acquire UK-based BOC Group in July 1999. Air Products & Chemicals Inc. was to contribute $5.9 billion in cash to the deal and hedged its exposure by buying futures contracts on the British pound.

If the pound happened to rise against the US dollar while the transaction was in the process of being completed, Air Products would have been protected because the value of its financial instruments would rise, offsetting the higher amount it would have to pay in dollars. If the pound fell versus the dollar, the value of the futures would fall, but be offset by the fact that Air Products would pay less in US dollars for the acquisition.

The problem was that the acquisition of BOC fell through in May 2000 because of issues with the FTC. By that time, the pound fell significantly against the US dollar, leaving Air Products with a hefty loss of $595 million ($372 million after taxes) on its currency hedge position.

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