Business Activity and Financial Risks Faced by Caltex
Caltex Australia Limited (Caltex) is one of the leading companies in Australia having business operations in the petroleum industry. Caltex is also regarded as a proud and iconic business entity in the petroleum industry of Australia. Over the years, Caltex has become Australia’s leading transport suppler for fuel and the company has an approximately 1900 affiliated fuel sites. In the presence of a complex supply chain system, Caltex has become able in safely as well as reliable delivery of fuel along with an evolving range of other products and services to their customers. In this context, it needs to be minion that Caltex serves three million customers each week (Caltex.com.au, 2018).
It can be seen from the 2017 Annual Report of Caltex that the business activities of Caltex are exposed to some specific financial risks; they are Foreign Exchange risk, Interest Rate risk, Commodity risks, Credit risks and Liquidity risks. The following discussion shows the discussion about these financial risks of the company:
Foreign Exchange Risk: It is considered as the most important financial risk for the business operations of Caltex as the business activities of Caltex are exposed to the impacts of changes in the rate in foreign exchange (Mancini, Ranaldo & Wrampelmeyer, 2013). Caltex buys crude and other products in USD and sells them in AUD in the presence of pricing formula that reflects changes in the exchange in AUD/USD. As a result of difference between the purchase and sales related payment, a change in the rate of foreign exchange creates negative impact on the earnings of Caltex.
Interest Rate Risk: This rate is also considered as a major risk for the financial activities of Caltex. It needs to be mentioned that Caltex has to face a major risks due to the fluctuations in the rate of interest. For this reason, it largely depends on the price sensitivity of the commodities (English, Van den Heuvel & Zakrajšek, 2018).
Commodity Risk: The business activities of Caltex are exposed to this type of risk due to the movement in the price in both the crude as well as finished products through the transactions of purchase and sales. This risk creates huge impact on the earnings of the company along with the cash flows (Etula, 2013).
Credit Risk: Credit risk is another major financial risk of Caltex that the company takes seriously. Credit risk is considered as the loss that the company recognizes in case any counterparty fails in performing as contracted. Thus, this risk is largely related to the trade receivables of the business of Caltex (Bielecki & Rutkowski, 2013).
Primary Offsets Currently Relevant for Caltex
Liquidity Risk: It is needed for Caltex to maintain cash as well as adequate committed credit facilities for meeting the forecast needs of the businesses due to the nature of the business. The company has to face the liquidity risk when fails to maintain the cash and credit requirements (DeAngelo & Stulz, 2015).
The above parts discusses about the financial risks that the business operations of Caltex are exposed to. It can be observed that all the financial risks are associated with the business operations of Caltex. For example, foreign exchange risk is related to the foreign business operation of the company while commodity risk is related to the prices of the products of Caltex. Moreover, it is obvious that the company will continue their business operation in credit and they will have to maintain all the liquidity requirements. Moreover, the management of Caltex does not have any power to control the fluctuations in the interest rate (Fernandes, Lynch Jr & Netemeyer, 2014). Thus, the above discussion signifies the fact that Caltex does not have any control over the occurrence of these risks as long as they continue their business operations; they can only make strategies for managing or mitigating these risks. For these reasons, it can be said that all these above-discussed financial risks have major significance for the business operations of Caltex in the next year; and hence, the company is needed to take into consideration these risks for the next year (Caltex.com.au, 2018).
The presence of some primary offset can be seen in the financial statements of Caltex that leads to the mitigation of these risks. It can be seen that there is an increase in the total revenue of Caltex as a result of the increase in the world petroleum product prices; this reflects the world crude oil price rise and the higher refine margin impact. However, the rise in the Australian dollar offset this increase in prices (Caltex.com.au, 2018).
In 2017, there was a 3% increase in the transport fuel sales of Caltex from 4.4 billion liters to 4.8 billion liters. Due to the highest sales volume in transport fuel sales, there was an increase in the sales of Jet and Vortex Diesel; and the decline in the sales of petrol offset this aspect. In addition, there was a decrease in the net finance costs of Caltex in 2017 as compared to 2016; and it was offset by the impact of higher average daily borrowings in 2017 as compared to 2016 (Caltex.com.au, 2018).
Risk Management Approach of Caltex
Caltex has an effective risk management framework or approach for mitigating the earlier-discussed financial risks and the main focus of the overall risks management framework of Caltex is on the financial market’s unpredictability so that the effects of these risks can be reduced. As part of the risk management approach, Caltex uses a variety of derivative financial instruments for hedging the market exposures (Moles, 2013). The adopted risk management strategies of Caltex is to enter into derivative transactions, interest rate swaps, foreign exchange contracts that includes swaps, forward and options and the swap contracts for crude and finished products. The main purpose of the risk management strategy of Caltex is the management of risks arising from the operations and finance sources of the company. It is the responsibility of the Group Treasury of Caltex to manage the market risks, liquidity risks, funding and capital management risks, financial institutional credit risks and others (Caltex.com.au, 2018).
The evaluation of Caltex Australia Limited’s annual report depicted the extensive use of hedging process, which has been conducted for minimizing their foreign exchange risk. Furthermore, Caltex Australia Limited has increased their reach to United States, New Zealand and Philippines for minimizing the risk from foreign exchange. The hedge reserve has been used for minimum the risk exposure of the organization, where the organization uses forward, swaps, and options contracts. In this context, Dong, Kouvelis and Su (2014) stated that companies use the hedging measures for minimizing the exposure in the currency market and decline the losses, which can incur from currency conversion. On the other hand, Mensi, Hammoudeh and Yoon (2015) criticizes that without the exposure in hedging process the organization is not able to curb the loses, which will direct hamper their current financial performance.
Figure 1: Depicting the Foreign Exchange Rate Sensitivity Analysis
(Source: Caltex.com.au, 2018)
The above figure directly depicts the level of foreign exchange exposure, which has been maintained by the company during the fiscal year of 2016 and 2017. In addition, from the evaluation of the above figure it could be detected that 10% of the US Dollar, NZ Dollar and Philippine Peso risk has been hedged for reducing the risk the from currency conversion. The further evaluation directly indicates that the hedge reserve has been increased exponentially from 2016 to 2017 for reducing the risk from investment. The exposure of US Dollar has mainly declined from 2016 to 2017, while the increment in other currency hedge exposure has increased. The increment in hedge reserves of NZ Dollar and Philippine Peso has improved, as the operations of the company have increased in those countries. Chege and Obwogi (2018) argued that without conducting adequate research the hedge contracts should not be taken into consideration, as it will directly increase risk from investment.
Use of Hedging Measures by Caltex
Figure 2: Indicating the foreign currency value exposure of Caltex Australia Limited
(Source: Caltex.com.au, 2018)
The exposure to foreign exchange risk can be detected from the above figure, which indicates that Caltex Australia Limited has increased its exposure in NZ Dollar and Philippine Peso, as its operations has inclined. Furthermore, adequate forward exchange contract has been used by the company for minimizing the risk from investment. The values in hedging process has mainly increased exponential in 2017, as the company’s operations has grown during the fiscal year. The company has mainly increased the level of exposure in other currency trade for minimizing the risk involved in investment. However, during the fiscal year of 2017, the company has made a loss of $75 million under other section, where the loss from foreign exchange has escalated to $26 million after conducting the hedging process. The increment in losses was due to the low exposure in hedging process, which has been conducted by the company for reducing the risk from investment. Therefore, from the evaluation it can be detected that Caltex Australia Limited has mainly increased their current exposure in hedging process for reducing the risk from investment. Jurek (2014) mentioned that companies without the correct exposure to currency conversion would directly increase the level of risk involved in investments. Hence, organization needs to maintain adequate level of risk from investment, while reducing negative impact from volatile currency market.
Figure 3: Stating the Risk Management followed by Caltex Australia Limited
(Source: Caltex.com.au, 2018)
The risk management measure, which has been used by Caltex Australia Limited for reducing the risk from investment. In addition, from the evaluation it can be detected that cash flow hedges, net investment hedges and interest rate instrument are mainly used for reducing the risk, which has been presented to the organization. With the implementation of cash flow hedges and net investment hedges, Caltex Australia is able to support its hedge accounting. On the other hand, the risk portrayed from interest rate is minimized by using the interest rate instruments and interest rate sensitivity analysis, which helps in minimizing the losses from operations and maximize the value of currency conversion. The use of forward, swaps and options is used in cash flow hedges for reducing the negative impact on their current operations. The cumulative gain or loss in equity is mainly transferred to the income statement of the organization, where the hedge item effects the profit or loss of the company. The Gull NZ Assets is used for reducing the risk from New Zealand dollar, which reduces the risk from exchange differences arising during translation of net investment. Lastly, from the evaluation it could also be detected that interest rate instruments are used for reducing the risk involved in interest rate. The interest rate swap contracts are mainly conducted for three to five years, where the interest rate has declined from 3.4% in 2016 to 2.3% in 2017, which led to the loss of $1 million in 2017 and 0.566 million in 2016 in net fair value of interest rate swap contracts.
Figure 4: Portraying the risk exposure of Caltex Australia Limited
(Source: Caltex.com.au, 2018)
The figure depicts the overall derivative financial instruments, which has been used by Caltex Australia Limited for minimizing the risk from currency conversion. The hedging measures directly indicate that both derivative financial instruments and non-derivative financial instruments is used by the organization for hedging its overall exposure. However, the exposure ion derivative financial instruments mainly increased the losses from to 10,891,000 in 2017, as compared to 8,668,000 in 2016. On the other hand, the losses from non-derivative financial instruments loss declined, which directly indicates that the company’s observation on the hedging process was flawed. This mainly declined those financial arrangements from the value of 1,100,000 in 2016 to 953,664 in 2017. Hence, it could be understood that company’s overall performance in hedging process has declined, which led to the loss incurred from currency conversion. The policy of Caltex for not hedging the refiner’s margins, which led to the increment in loss incurred from operations. Furthermore, AASB 9-Finanical Instruments are mainly used for complying with the new standards.
References
Bielecki, T. R., & Rutkowski, M. (2013). Credit risk: modeling, valuation and hedging. Springer Science & Business Media.
Caltex. (2018). Annual Reports. Retrieved 29 August 2018, from https://www.caltex.com.au/our-company/investor-centre/annual-reports-and-reviews
Caporin, M., Jimenez-Martin, J. A., & Gonzalez-Serrano, L. (2014). Currency hedging strategies in strategic benchmarks and the global and Euro sovereign financial crises. Journal of International Financial Markets, Institutions and Money, 31, 159-177.
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Chege, J. M., &Obwogi, T. N. (2018). The Effect Of Currency Risk Internal Hedging Strategies On The Value Of The Firm: Evidence Of Listed Commercial Banks In Kenya. Management and Economic Journal, 315-323.
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English, W. B., Van den Heuvel, S. J., & Zakrajšek, E. (2018). Interest rate risk and bank equity valuations. Journal of Monetary Economics.
Etula, E. (2013). Broker-dealer risk appetite and commodity returns. Journal of Financial Econometrics, 11(3), 486-521.
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Jiménez, L. M., Acevedo, N. M., &Lambis, E. (2018). Portfolio of Financial Options as Currency Hedging Strategy in Colombia. International Journal of Applied Engineering Research, 13(12), 10871-10877.
Jurek, J. W. (2014). Crash-neutral currency carry trades. Journal of Financial Economics, 113(3), 325-347.
Mancini, L., Ranaldo, A., & Wrampelmeyer, J. (2013). Liquidity in the foreign exchange market: Measurement, commonality, and risk premiums. The Journal of Finance, 68(5), 1805-1841.
Mensi, W., Hammoudeh, S., & Yoon, S. M. (2015). Structural breaks, dynamic correlations, asymmetric volatility transmission, and hedging strategies for petroleum prices and USD exchange rate. Energy Economics, 48, 46-60.
Moles, P. (2013). Financial risk management. Sources of Financial Risk and Risk Assessment, UK.
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