The Foreign Exchange and Risk Management Policy of Chevron - Research Paper Example

?CORPORATE RESEARCH PAPER Table of Contents Introduction 3 The Foreign Exchange (FX) and Risk Management Policy of Chevron 6 Chevron’s utilization ofderivatives for funding, investing, and other price risks 11 Extent of the Chevron’s offshore and Euro market funding and investing activities 13 Conclusion 15 Works Cited 16 Appendices 17 2.Geographical Breakdown of Assets 18 3.Geographical Breakdown of Income 18 4. Chevron’s “Other Comprehensive Income” 19 5.Investments and Advances of Chevron across the world 20 Introduction Chevron Corporation is one of the biggest integrated organization of the United States with reference to the energy sector. On the basis of market capitalization, Chevron can be considered as one of the leading companies in the world. As of the financial year 2011, Chevron generated a sales value worth $244 billion and the net income attributable to the company during the same period was $27 billion. The profitability of the company can be gauged from the fact that the net income per share of the company during 2011 was $13.44, while the company also paid cash dividends worth $3.09 per share. The return on capital and the return on equity of Chevron during as of 2011 were 21.6% and 23.8% respectively (Chevron, 2012). Though the company is instituted in California, in the United States, Chevron has business activities throughout the world in over 120 countries. The following figure represents the geographic reach of Chevron across the world, by means of onshore operations, offshore operations, pipelines or refineries. Figure 1: Global Reach of Chevron Corporation (Juhasz, 2009) In 2011, the average net production of Chevron was 2.673 million oil barrels for every day, of which around 75% of the volume was produced from countries other than the United States (Chevron, 2012). This can be lucidly illustrated from the following figure: Figure 2: Geographic Segmentation of Chevron’s Production (Chevron, 2011) Chevron is present in various countries, such as the USA, the UK, Canada, Malaysia, Indonesia, Bangladesh, Vietnam, Nigeria, Singapore and Australia to name a few. Chevron Corporation has a number of subsidiaries and associates for managing and operating its worldwide operations. Some of them are Chevron U.S.A. Inc. (CUSA), Chevron Phillips Chemical Company LLC, Chevron Transport Corporation Ltd. (CTC), and Tengizchevroil LLP (TCO) among others. Even though every subsidiary of Chevron is accountable for its individual affairs, Chevron Corporation handles its investments in its subsidiaries in addition to their affiliates. The operations and business activities of Chevron are categorised into two business divisions, namely, Upstream and Downstream. The upstream business segment comprises of sale of crude oil and natural gas produced by the company itself, in addition to the sale of natural gas produced by other companies. On the other hand, the downstream segment comprises of activities related to the processing and marketing of various forms of petroleum products. The United States of America is the principal country of operation of Chevron Corporation. Hence, in its annual reports, the company presents its geographic breakdown of performance in terms of two categories, i.e., the United States, Chevron’s domicile nation while other countries where the company operates reported as ‘International’ (outside the United States). The following table represents the breakdown of sales, assets and income of Chevron Corporation for the year 2011, in terms of the above discussed segments: Year 2011 Sales Assets Earnings Upstream United States 27,738 37,108 6,512 International 55,098 98,540 18,274 Downstream United States 91,078 22,182 1,506 International 123,221 20,517 2,085 All others United States 1,598 8,824 - International 46 17,661 - Total United States 120,414 68,114 8018 International 178,365 136,718 20,359 (All values in millions of US dollars) (Chevron Corporation, 2011) In this context, it is should be noted that excluding the United States, no other nation contributed individually contributed for more than 10% of the total sales of Chevron in 2011. The Foreign Exchange (FX) and Risk Management Policy of Chevron The structure of Chevron Corporation is decentralised in nature. Though the company is primarily instituted in California, which is its head office, Chevron has operations all over the world. Thus, the company has regional offices and operating subsidiaries in many countries. Chevron operates in the oil and natural gas sector, which has been generating record profits. However, this industry entails a lot of intrinsic risk ranging from adverse climatic exposure, operational exposures, translational risk and other economic exposures. Moreover, the operations of the company are spread across the world with 28% of the company’s net established reserves are located in the Organization of the Petroleum Exporting Countries like Angola, Nigeria, Indonesia and Venezuela. These countries are impacted by regional unrest, acts of violence, and tension in relations with the government. Thus, the company’s operations and business outcomes are exposed to elevated uncertainty. In order to deal with these risk exposures, Chevron uses certain risk strategies. Chevron exercises ‘derivative commodity instruments’ to deal with its exposures to the instability of crude oil prices, as well as the prices of refined oils and natural gas. The internal risk control group observes and handles the exposures of the company in the market on an everyday basis (Reynolds, n.d.). In addition to all the operational risk, the major risk that Chevron is exposed to owing to its globally spread business is the foreign exchange risk. The currency of each nation is valued in relation to the currencies of other nations by means of the exchange rates. International trade and transaction require currencies to be exchanged. The values of majority of the currencies vary over a period of time owing to the forces pertaining to the market and the government policies. When the value of the currency of a particular nation rises in comparison to other currencies, then its current account balance declines. This is because as the value of the currency appreciates, the products sold by that nation to other overseas nations would become more costly to the importing nations. As a result, the demand of the products of that nation will decline leading to reduced balance in its current account. For instance, during the end of 2008, the currency exchange rates of the Euro currencies fell considerably in comparison to that of dollar. Since, the head office of Chevron Corporation is instituted in California, United States; its home currency is the ‘Dollar’. Nevertheless, as the company has operations in various other countries spread across the globe, it would have to deal with other currencies as well. Thus, Chevron would be exposed to the foreign exchange exposure, which is actually the risk associated with exchange rate movements. Owing to its overseas business operation the assets and liabilities of Chevron as well as their cash flows are expected to be maintained in different currencies. The variations in the exchange rates of US Dollar and the other currencies that Chevron is associated with, might unfavourably impact the reported earnings and the supposed net worth of Chevron. As a result of foreign exchange exposure, the cash inflows as well as outflows from the overseas business operations around the world can be unfavourably affected when valued at US dollar, which is the domestic currency for Chevron. Again, the settlement value of Euro dominated contracts, for instance loans in Euro, when valued in US dollars can be detrimental to Chevron owing to the exchange rate fluctuations. The sources of foreign exchange exposure for Chevron in its business operations are overseas production facilities, outsourced facilities or support, overseas sales operations, and supplier relationships among others. In general there are three different kinds of foreign exchange exposures, namely transaction exposure, economic exposure and the translation exposure (Ajami & et al, 2006). Translation Exposure: This is also known as accounting risk, which a firm faces when it has subsidiary operations in other countries. When the foreign exchange movements adversely affect the translated values of assets and liabilities of the subsidiaries, it becomes an unwanted exposure for the parent company’s consolidated financial statements. This risk can be hedged by using currency futures, currency swaps etc. Translation exposure comes into play as an effect of the fact that Chevron, which is the parent company in this case, has to merge all of the operations of its subsidiaries and their affiliates into its own accounting statements. Since the assets of the production units in the overseas nations would be carried on their accounting books in terms of their respective domestic currencies, it is essential to translate those currency values of the assets into Dollar values for merging with the Chevron Corporation’s assets. The varying currency exchange rates lead to the occurrence of gains or losses for the period of the translation process. In view of the fact that this exposure is associated with the assets and liabilities of the company as mentioned in the balance sheet, it is frequently termed as accounting exposure. Transaction Exposure: This exposure is related to the future payments and receipts in foreign currency. Companies many a times limit this type of exposure by requiring the cash flows to be received and made in the home currency rather than foreign currency. Another way to minimize this risk is netting out the exposure by a lot of different currencies or only in one currency (Jacque, 1997). This is done by large corporations with significant amounts of international operations. Other techniques for alleviating short-term currency risks are currency forwards, currency futures, money market hedge, option hedge and cross hedge (Kelley, 2001). Chevron is exposed to transaction risk as it engages in current business transactions involving foreign currencies. Thus, the company would be open to transaction risk, whatever might be its choice of investment strategy. This is because the nature of business of Chevron is likely to involve it in foreign currency transactions. The transaction exposure of the company can be managed by entering into forward contracts, futures, options and other money market hedges in addition to currency swaps (Sullivan, 2009). Economic Exposure: This exposure is faced by corporations with large international presence and relates more with the net present value of future cash flows of a firm. The management of economic exposure involves the use of complex instruments and strategies besides the foreign exchange management (Ajami and Goddard, 2006). As the business of Chevron is geographically expanded and the frequency of trades in foreign currencies is also very high for the company, it is highly likely that there will be an economic exposure to the firm’s business operations. Other comprehensive income: ‘Other comprehensive income’ is equivalent to the difference amid net income of an organization and its comprehensive income. This includes definite kinds of profits and losses, which are not documented in the annual reports as ordinary profits or losses. ‘Other comprehensive income’ covers the gains or losses made by the organization from derivatives, from currency exchange and from workforce pension plans. During the past three years the Chevron Corporation had encountered ‘other comprehensive losses’. The value of ‘other comprehensive loss’ of Chevron in the year 2009 was 399 million US dollar, this loss reduced to 167 million US dollars in 2010. However, in 2011, the other comprehensive loss of the company increased to 1,581 million US dollars (Chevron Corp, 2011). Thus, the loss of the company arising due to currency translation, derivative hedge transactions, and actuarial loss on pension benefit loss accounted for $1,581 million during the financial year 2011. (Refer Appendices) Chevron’s utilization of derivatives for funding, investing, and other price risks Chevron is open to market perils associated to price instability of crude oil, developed products, natural gas liquids, natural gas, liquefied natural gas and processing plant feedstock. The organization utilises ‘derivative commodity instruments’ to deal with these risks on a segment of its operations, together with firm obligations as well as expected dealings for the procurement, sale and storing of crude oil, developed products, natural gas, liquefied natural gas and organizational refinery feedstock. Now and then, Chevron Corporation also utilises derivative commodity instruments for the purpose of limited trading (United States Securities And Exchange Commission, 2011). Chevron Corp’s derivative commodity instruments predominantly consist of futures, and forward contracts, swaps, and options on crude oil, refined product and natural gas. However, not any of Chevron’s derivative instruments is named or considered as a hedging tool, even though some of the organization’s associates make such labels. During the year 2011, Chevron’s derivatives were not material to its financial situation, outcomes of operations or solvency. The management of Chevron considers that the company has no credit threats to its business, liquidity or financial situation as a consequence of its commodity derivative investments (United States Securities And Exchange Commission, 2011). Chevron Corporation exercises “International Swaps and Derivatives Association” accords to administer derivative contracts with some of its alliances to lessen credit risk. On the basis of the nature of the derivative dealings, Chevron might also get into two-sided collateral engagements. When Chevron is affianced in excess of one derivative contract with the same alliance and also has an officially implementable netting accord with that alliance, the mark-to-market exposure results in the mitigation of the positive as well as the negative exposures with that alliance and is a rational assessment of the organization’s credit risk exposure. Chevron also utilises other netting contracts with some alliances with which it carries out considerable transactions to diminish credit perils (United States Securities And Exchange Commission, 2011). Almost all of Chevron’s engagement in derivative commodity instruments is proposed to control the financial risk caused due to the corporeal transactions. For a number of this derivative investment, normally restricted to big, distinct or occasionally happening dealings, Chevron Corporation opts to exercise ‘fair value’ or else ‘cash flow hedge accounting’. For rest of the derivative instruments, commonly owing to the interim nature of the agreements or their restricted use, Chevron does not exercise hedge accounting; instead the variations in the fair value of those agreements are revealed in the current income. For Chevron’s commodity trading actions, the profits or losses incurred from derivative instruments are accounted in the company’s current income. Once in a while, Chevron might get into interest rate swaps on account of its general approach to control the interest rate exposure on the company’s debt. The interest rate swaps associated to a part of Chevron’s fixed-rate debt is reported as fair value hedges. On the other hand, the interest rate swaps associated to the floating-rate debt, are stated on the balance sheet at fair value, where the consequent gains or losses are revealed in the income (Chevron, 2011). The derivative commodity tools utilised by Chevron for its risk management along with trading activities includes primarily of futures, swap and options contracts that are traded on the New York Mercantile Exchange , the Inter-Continental Exchange and the Chicago Mercantile Exchange. Additionally, for swap as well option contracts on natural gas, unrefined oil, and refined products, Chevron associates mainly with key financial institutions in addition to other peer oil and gas organizations in the “over-the-counter” markets (United States Securities And Exchange Commission, 2011). Chevron Corporation gets involved into foreign currency derivative deals to control a part of its foreign currency risks. These risks involve sales and expected purchase dealings, together with overseas currency capital expenses as well as lease commitments. The foreign currency derivative contracts are accounted on the balance sheet at fair value, where the consequential profits and losses are shown in income. As on December 31, 2011, Chevron Corporation had no active foreign currency derivative agreement (United States Securities And Exchange Commission, 2011). Chevron Corp also utilises interest rate swaps once in a while as a component of its overall policy to deal with the interest rate hazard on its debt. As of December 2011, Chevron had no investments in interest rate swaps. Generally, interest rate swaps are accounted at their fair value on the financial statements, while ensuing profit and losses reflected in income. Extent of the Chevron’s offshore and Euro market funding and investing activities As already discussed, Chevron Corporation is engaged in business operations that are spread throughout the world, including Europe. The investing activities of Chevron can be illustrated with the following figure: As per the international parity conditions, the percentage return produced in the equity market of a particular nation is likely to be comparable to the exchange rate adjusted return in markets of an overseas nation. This situation can be explained with the help of the following example. For instance, let us suppose that the index return in the Euro Zone market is 8 %, while the corresponding index return in the United States is 7 %. In such a situation the excess 1 % return in the Euro Zone market will be compensated by a matching extent of appreciation in the dollar value. A common characteristic among the principal international parity conditions is that associations among the domestic market returns as well as overseas-market returns go through the conduit of the foreign-exchange market. Subsequently, a shock in the currency exchange market would create an exchange rate exposure which would simultaneously impact the oil and natural gas market along with the markets of stocks and bonds. Conclusion From the study of the international financial strategy of Chevron, it can be understood that like most other Oil and Natural Gas companies, Chevron is also more focussed on its long term capital. This is the reason why, the company hedges against its long term capital commitments. Chevron is less focussed towards the immediate fluctuations that are impelled by the transactional risks the company is exposed to. However it should be noted that even if Chevron’s own dealings do not lead to a major transactional exposure, the high competition in the industry will lead to an exchange rate exposure. Moreover, oil has become scarcer and as a result, oil firms are exploring to wider and wider geographic regions. The major consequence of this is the requirement of higher oil price in order to make projects reasonable and beneficial. The international strategy of Chevron has created value for the company so far; however, the company should attempt to revise its strategy in the course of time so as to continue creating value in all its projects. Works Cited Ajami, R. A. et al. International business: theory and practice. USA: M.E. Sharpe, 2006. Ajami, R.A. & Goddard, J., International business: theory and practice. USA: M.E. Sharpe. 2006. Chevron Corporation, 2011 Annual Report, 2011. Web. 10 August 2012. Chevron, Corporate Fact Sheet. 2012. Web. 10 August 2012. Chevron. 2011 Supplement to the Annual Report, 2011. Web. 10 August 2012. Jacque, L.L., Management and Control of Foreign Exchange Risk. Springer. 1997. Juhasz, A. The True Cost of Chevron, 2009. Web. 10 August 2012. Kelley, M.P., Foreign Currency Risk: Minimizing Transaction Exposure. 2001. Web. 10 August 2012. Reynolds, D. Industry Risk Report Energy/Oil & Gas. No Date. Web. 10 August 2012. Sullivan, D. International Business. India: Pearson Education, 2009. United States Securities and Exchange Commission. Form 10-K. 2011. Web. 10 August 2012. Appendices 1.Geographical Breakdown of Sales (Source: Chevron Corp, 2011) 2.Geographical Breakdown of Assets 3.Geographical Breakdown of Income (Source: Chevron Corp, 2011) 4. Chevron’s “Other Comprehensive Income” (Source: Chevron Corp, 2011) 5.Investments and Advances of Chevron across the world (Source: Chevron Corp, 2011) Read More