The sharp drop in oil has made a significant negative impact on markets and the engineering and construction industry. Similarly, the sharp rise in the dollar has brought challenges to financial statements for many of these companies, even those that actively hedge. Some companies have made changes to hedging practices to try to tame the volatility, but hedging commodities, particularly oil or natural gas, are not typically a core competency of most treasuries.
In a recent discussion at the NeuGroup’s Engineering & Construction Treasurers’ Peer Group (E&CTPG) members heard from meeting sponsor BNP Paribas and a one of the members about approaches to hedging FX, commodities and anything else threatening stability.
One of the key focuses of the session was a question on whether companies should push FX risk – mostly embedded in projects — to clients or manage it themselves. One session leader and practitioner said that for his company, it depends on the client’s size and sophistication relative to themselves. If the client is larger and at least comparably sophisticated in mitigating risks, the company will push the risk out. If not, the company will bear it itself. They take a similar approach with suppliers.
Another observation coming from the session was that there are several options for managing project risk. The presenting practitioner outlined three types of FX and commodity risk including: (1) cash-flow and commodity price risk; (2) balance-sheet FX risk; and (3) translation in consolidating FX risk. He asserted that cash-flow and commodity price risk is the most dangerous risk.
Up until a couple of years ago FX hedging was all about smoothing out volatility, said the presenting member. More recently, however, it has been more about managing the impact of the steadily rising value of the US dollar. Among the several types of FX and commodity risk outlined, he pointed to cash-flow and commodity price risk as the most dangerous (and least visible) and detailed one strategy for mitigation:
n Hedge all to project end and unwind. This strategy calls for “entering into a single hedge out to the expected end-date of the project with a notional equal to the total project’s FX exposures and unwind a portion of the original hedge as the revenue is received or payments made.” This strategy is easy to implement, easily accommodates changes to exposure timing, and is simplified because all derivative cash settlements occur at the end of the project. The downside is that the initial hedge may be credit-intensive and could be less feasible with less liquid currencies.
For its part, BNP Paribas took an academic and analytical approach to the suggestion of offsetting FX with oil. BNPP has done research on the value correlation between currency and oil prices. In short, yes, there is definitely a direct correlation between the two assets but not enough to create a natural hedge. Therefore, the FX rate needed to obtain a natural offset is simply not feasible.
Oil is expected to remain relatively low, by recent standards, for at least a couple of years, while FX volatility is expected to remain higher than normal. A couple of members of the group have taken their own look at the correlation of oil and currency and have also concluded that the natural correlation is not sufficient to cover the risk. Consequently, anyone else considering this exercise can now be spared the time. Meanwhile, independent hedging programs for each asset will need to be maintained for business as usual.