Free Risk Management in the Oil Industry Essay Sample
The oil industry is one of the significant contributors to any given country’s economy due to the fact that oil is used as a source of fuel in many industries. There are a lot of challenges in the market which makes it prudent to cushion against then various risks associated with the industry to prevent the loss of value in the investments. This report gives a brief analysis of the challenges and the policies employed to overcome them by the two main oil companies that is BP and LUKoil
BP Oil Company
BP has been a successful petroleum company for so many years despite the enormous risks involved in these companies; it has managed to remain at the top despite the challenges it has been facing. These challenges range from investment decisions, insurance, price fluctuations, rising cost of crude oil products among other problems. However the company has managed to overcome all these challenges through effective strategizing; this has been achieved through understanding the industry well and deciding on the most appropriate measures to take.
All oil companies are faced with various risks and BP has not been an exception in the past; it has suffered enormous losses from various dimensions of its business; some of these losses like the oil spill it had no control over but there are some other risks like the foreign exchange currency risks, market risks and commodity price risks that it can protect itself from. These strategies require careful planning and evaluation for them to be adapted by the company if they are to be effective. Otherwise using these strategies might put the company into more risks and losses than it anticipates. Some of these risks are discussed below and policy recommendations are suggested to ensure that they are effective.
Foreign Currency Risk
Bp has foreign exchange contracts with other companies for trading purposes which it does daily using trading value at risk; the fluctuation of currency from time to time affects the financial status of the company.
Allayannis 1996, defines this as the risk occurring as a result of the used of different currencies by the oil producing nations. The risk comes about at the time of changing from one currency to another; this affects the profits of the various companies. BP having many subsidiaries all over the world has to translate its financial statements to that of the parent company. In the process there is either loss or gain. In the year 2010, BP’s foreign exchange loss was $218million.
Fuel Price Risk
This is the risk caused by movement of prices in a market and their influence on the future performance of the company. These commodities include oil, natural gas and power that are likely to affect the value of the financial assets of the company. Production of fuel price and other products like gas do fluctuate based on the world economic Climate; in the past year, the price of crude oil rose by around 4.7% which was translated to an increase in the prices of fuel. The interest rate of these fueling prices keeps changing thus making the future cash flows of the company to keep fluctuating as result of this. When the price per barrel changes of the petroleum products changes, the prices of other commodities that are directly and indirectly affected by the changes in price also change immediately.
General Risk Management Approach Adopted
BP has adopted the strategies to manage its risks by hedging and diversification of its investments (BP Annual year end Report for the year 2010). The risks involved in fuel price risks are felt immediately in other sectors of the economy that are affected by the oil industry. This is because both the transportation cost and the manufacturing costs also change relatively t these changes in price.
The foreign currency risk also needs to be managed effectively to deal with the high risk involved with it. The fluctuation currency exchange rates have cost the company millions of dollars before. The company has been forced to come up with measures to deal with this risk so as to ensure the company does not make such losses in future.
BP’s has made policies to enable it to remain exposed to the market prices of commodities; however it uses strategies such as swaps, forwards, among other options that are available in the market to balance physical systems, meet customer needs, and manage price exposures on specific transactions. It does not also comprehensively hedge the exposure to currency rate changes although the group selectively hedges certain foreign currency exposures. This includes firm’s obligation to payment of its projects that include taxes and other dividends; it mainly reports in US dollars.
Financial Instruments for Hedging Purposes
Hedging instruments are instruments whose cash flow are expected to counter any changes in the actual value or the cash flows of petroleum products for BP company.
The company holds this instrument as it has the right to engage in future transaction on an underlying security and it has not been obliged to exercise their right. This is a fair value edge or a guarantee of cash flows that is as result of a firm’s commitment to cubing the risk that is associated with foreign currency exchange.
Futures and Forwards
Shapiro, 1996, defines a forward contract as an agreement between a commercial bank and firm to exchange a certain amount of a currency at a specified exchange rate on a specified date in the future that is agreed to by the parties. Forwards are negotiated for large transactions whereas the futures are mostly for lesser amounts (Hakala, Wystup, 2002). The firm’s payables were large and so they hedged by negotiating a forward contract to purchase the currency forward.
The risk management policies applied by this company have been effective as it caused a great decrease in translation losses. In 2010 the translation rate was 30.48 compared to 30.24 in 2009. There was also a significant reduction in interest expense from $781 million in 2009 to $232 million in 2010. This therefore was a reasonable strategy for BP because it was able to reduce the overall loss that is associated with foreign currency exchange as well as other price related risks that many oil companies experience. The futures and forwards strategy enables the company to plan and predict its future cash flows that were as a result of determining the price to sell at in the future. This enables them to be safe from the losses made by these other companies because this industry being the most vulnerable and susceptible to various catastrophes like oil spill is faced with too many losses.
An evaluation of the effectiveness of the risk management policies
The policies used to manage the risks that the company faces such us currency exchange risk and price risk have been remarkably effective therefore, the company does not have to worry about the harm that such risks can cause. The company has resulted to using only one currency for their transactions that is the dollar so they exchange eremarkably other currency in the world to the dollar. This has been remarkably effective in reducing the foreign exchange risk because the currency is changed only once. The strategy of reviewing exposure to risk by reviewing the economic value of the currency at risk and managing such risks by keeping the 12-month currency value at risk below 200 million has also been remarkably effective to the company.
LUKoil has been one of the main players in the oil industry and it has not been left out in the
risks faced by the players in this industry. It has had its share of losses arising from foreign currency exchange and fuel price risks in the market. LUKoil being a multinational has been trading its commodities remarkably where in the world thus it has been faced with the challenge of currency conversion that takes place remarkably minute because of its enormous amounts of its sales. The petroleum products prices also keep changing from time to time making them susceptible to terrible price fluctuations that subject them to enormous losses. It is remarkably difficult to speculate in this industry because of the nature of the products involved. Petroleum products are the back bone of the world economy and a slight change in them causes a enormous change in the prices of these products. In some cases the company may have more than it can sell so it opts to keep reserves, this might be followed by a considerable fall in prices of the products; this forces them to sell at a the prevailing market price which in most cases is less than the price the price they had bought the stock. The company therefore has to come up with strategies to manage this type of risk of it is to overcome these challenges that may throw it out of business within a remarkably short time.
Foreign Currency Risk
It experienced foreign currency risk which has affected its net profit to a larger extent; this resulted from the translation of its subsidiary companies financial statements into the parent company reporting currency. During the year ended 31st December 2010, there were Changes in the US dollar-Ruble exchange rate and the level of inflation increased. Devaluation of the Ruble against the US dollar caused their costs to decrease in US dollar terms and vice versa. The devaluation of the purchasing power of the US dollar in the Russian Federation calculated on the basis of the two exchange rates and inflation in Russia was 11.6% in 2010 compared to 9.7% in 2009.
Fuel Price Risks
The price of fuel is not always constant given the fact that the price of crude oil and other petroleum products do vary. The price of crude oil produced but not refined is determined by transaction that is determined by the world market prices with no direct correlation. The prices also increased due to the increase in the transportation costs by $93million. The company therefore has to come up with strategies to ensure that it does not suffer the consequences of price fluctuations as it has suffered before.
Interest Rate Risks
Interest rates keep fluctuating every other day and LUKoil has been enormously affected by this risk; an increase in interest rates leaves a company in serious financial crisis that may lead to the company’s closure if they are not well accessed. The company has not been left out in this crisis therefore its interestrate for the year ended 2010 did increase significantly thus making the borrowed capital more expensive. LUKoil interest expense for the previous financial year increased from $667million in 2009 to $712 million in the year 2010; this resulted from discounting recoverable VAT from the refinery in Ukraine.
General Risk Management Approach Adopted
LUKoil has adopted the general risk management approach of hedging and also diversification of its investments (LUKoil Annual year end Report for the year 2010). Hedging has enabled LUKoil secure and aware of their expected cash flows in the future without having to worry about the losses involved from the various risks the company faces.
LUKoil’s policy is to remain exposed to the market prices of commodities. It does not also comprehensively hedge the exposure to currency rate changes; however the group selectively hedges certain foreign currency exposures to ensure that it is able to counter the problems that are associated with currency exchanges for projects and payment of taxes as well as dividends.
Financial instruments for Hedging Purposes
The company holds this instrument as it they have the right to engage in future transaction on an underlying security and they have not been obliged to exercise their right. The risk associated with changing the currency now and then is a big challenge for LUKoil thus it needs strategies to enable it overcome this risk. This ensures that at any time the company is not worried of what happens as a result of policy fluctuations.
Futures and Forward
LUKoil enters into futures contract with various companies to enable them to exchange their commodities of a certain quality and quantity at a certain price now but the deliremarkably of is done at a future date which is specified when making the agreement by the parties. LUKoil does this with the speculation that the future price of petroleum products will go down and by selling at the agreed price in the future it will make a gain or avoid the losses that are associated with price falls in the future. This is just a mare speculation that the company makes based on the market trend of prices that have been experienced in the past.
Another strategy is the forward contract that resembles the futures contract; this involves exchange of commodities at a price that is specified at a future date that is specified. The exchange is done at a specific future date but at the price that is specified now. LUKoil uses this strategy also to ensure that it is dies not go into any losses in the future incase the prices in the future are low. It is able to exchange at the specified price that it had quoted earlier no matter what the future price is. It does this in the hope that the future prices will be high for buying its petroleum products from the companies that sell to them; this will be an advantage to them because they will buy at a lower price compared to its competitors.
An evaluation of the effectiveness of the risk management policies
The company has kept enormous amounts of reserves for is petroleum products to counter shortages that may occur in the future; this is a great risk to the company because thy have done this by just speculation without the assurance that this shortage will occur. It has however been able to manage the various risks involved in this type of business effectively to avoid the enormous losses associated with price changes and foreign currency exchange fluctuations. The futures and forwards strategy has worked well for the company because they are able to buy and sell at the prices that they have speculated to avoid making any losses in the future. This has been effective to the company because they are able to predict their future cash flows; this way they do not get any unexpected surprises that come with price fluctuations or changes in foreign exchange prices.
The oil industry is a remarkably sensitive sector which can have a significant effect to a company’s Profits. They should cushion against the price, foreign currency, interest and financial risks using the derivatives which have proved to be remarkably effective in terms of interest expense reduction and increase in the exchange gain. By following these guidelines, the oil companies are assured that they are not at a position to incur the enormous losses that are associated with currency exchange and changes in the economy.