MARGIN SHOCK
How CFOs are learning to live with high oil prices.
By Simon Littlewood and Tom Leander

“My formula for success is to rise early, work late, and strike oil,” said legendary oilman John Paul Getty. That last approach is not so easy anymore, and the world is feeling it, not least CFOs. With oil prices at record levels and great uncertainty about when they will settle back down again, concerns about oil prices now top the list of the CFO magazine and Duke University quarterly tally of world trends that keep finance chiefs up at night. At press time, an attempted terrorist strike at a Saudi Arabian complex that handles two-thirds of the kingdom’s oil exports spiked crude prices 3.9%, and no one really agrees whether the world is headed toward US$100 a barrel or back down to a manageable US$35. This spells volatility, and every CFO has to have an opinion on how to manage it.

In Asia, as in the rest of the world, CFOs have lived with this reality since oil prices began edging up three years ago. Even those that have adjusted still toss off the odd lament. “We live in interesting times – in the Chinese sense,” says Antoine Marcos, Asia-Pacific division CFO of Nalco, a chemical company based in the US, with US$3.3 bn in global sales. “Investment is pouring into the region and expectations are high.” But, he goes on, “oil is one of our key raw materials cost drivers and price volatility has the potential to undermine growth in the most fundamental way.”

He’s not kidding. Increases in energy and material costs totaled US$166m in 2005 for Nalco worldwide, versus price increases for the year of US$150m. Yet Marcos sees higher fuel prices as a manageable problem – one that, like it or not, comes under his risk management responsibilities. In his case, he was able to vest into a company tradition, in which Nalco’s CEO, William H Joyce, gave his officers a global mandate to grapple with the complex problem of how to mitigate volatile energy and raw-material costs due to high oil prices and stay profitable. Worldwide, Nalco was actually able to increase sales – minus price increases for petroleum-related costs – by 2.2%, driving down costs – with savings of US$89m – due to hard thinking and tough choices in the new environment.

In the Asia Pacific, Nalco’s fastest growing region, this made for a difficult but ultimately rewarding year. “As soon as we realized just how devastating the rise might be,” says Marcos, “we recognized that, though all customers would be affected, we would need to be pragmatic and selective about what we communicated and to whom.”

Here to Stay

Learning how to absorb the high price of fuel seems to be on the agenda of every CFO these days. Despite a recent drop in prices from a peak of US$72 a barrel in October to US$50 a barrel at press time, there’s no doubt that high oil will be with us for some time. In the US, Hurricanes Katrina and Rita proved that a single, surprise event can affect world prices. Iran’s position on nuclear development has added an ‘Iran premium’. Terrorist attacks and political upheavals promise to be part of the global risk profile of companies.

CFOs know this no matter what industry they’re in. Most obviously, higher fuel costs hit any business that relies on moving things from place to place. The impact is most keenly felt in airlines, where CFOs can deploy surcharges and intensified hedging can ease the strain on margins – but not all the costs. In the air cargo industry, some players like Federal Express have been able to retain pricing power, passing along costs to consumers. Outside of transport, cyclical industries like semiconductor manufacturing have been clobbered, as pricing power collapses while fuel costs remain high. For Korean manufacturers, DRAM computer chip prices have fallen by more than half since 2003, while the price of oil per barrel has soared 300% in the same period.

In China, where over-capacity in many industries is on the horizon, higher oil costs can add an incendiary element to industries on the verge of consolidation. The tire industry, for one, is grappling with a particularly inopportune surge in fuel-related input costs. “Adding higher fuel costs to the picture has posed a direct threat to future profits,” says Xue Jianmin, CFO of Shanghai Tire & Rubber, “perhaps even the company’s survival.”

For other manufacturing companies in the Asia Pacific, the negative impact of oil prices “depends on where you are in the supply chain,” says Brian Cahill, head corporate credit analyst for the Asia Pacific region at Moody’s. Packaging companies’ ability to mitigate costs by boosting prices is tempered by a fear of destroying relations with global customers like Wal-Mart that wield tremendous pricing power over their vendors. It isn’t all bad. Japan’s car manufacturers – including Toyota, which recently passed General Motors of the US as the world’s biggest carmaker – have ridden higher US sales of more fuel-efficient automobiles to greater profitability. But US carmakers are losing sales fast.

Hedging Their Bets

The airlines industry has been hit hardest. Despite a 4.1% gain in seat capacity this year, in Asia’s airlines, profit margins, or net income divided by sales, have been tightening. “It’s only going to get worse,” says Cahill. Fuel costs based on the price of oil have pushed industry costs up more than 40% on average, says Ian Thomas, an analyst for Asia Pacific Aviation, based in Sydney. Because of a worldwide shortage of jet fuel refiners, jet fuel typically adds another 10 to 15 US cents on the dollar, says Thomas. The double whammy has hit margins hard. Cathay Pacific’s profit margin is expected to drop to 6.7% this year from an estimated 7.4% in 2005, projects Kevin O’Connor, Hong Kong-based analyst at CLSA, an investment bank. The margin at Singapore Airlines could drop to 8.9% in the year ending in March 2006 from 11.6% a year earlier, O’Connor estimates.

Airlines’ high fixed costs mean that finding new avenues of cost-cutting can be difficult. One option has been to purchase more fuel-efficient jets. Cathay, Singapore Airlines, and Qantas have put in new jet orders this year – a worldwide trend, reflected by Boeing’s record year for jet orders. Cathay has long eked out whatever costs it could squeeze out of the system. So the primary alternatives are surcharges and hedging. Surcharges, says Martin Cubbon, CFO of Swire Pacific, which owns Cathay, “nowhere near cover the full cost – that’s true of all airlines.”

The fallback is the imperfect option of hedging. The airline’s view of fuel price comes from a model that “is not magical in any shape or form,” says Cubbon. “We are looking to have 30% of any one year’s needs covered,” says the CFO. “This predicts to the marketplace broadly what the hedging strategy is.” He adds that it can vary more significantly, depending upon market conditions.

“We might use derivatives in a spike,” he says, “but we have underlying simple cover. We look at it over a long duration, of baskets over four or five years, but we can’t go out too far.”

“It’s necessary to communicate to investors that we will have some element of insurance [against fuel price volatility],” Cubbon continues. But, for the purpose of investor relations, the company “tries to make sure we’re not, for whatever reason, seen to be radical.” Too much hedging, he notes, exposes the Swire group to charges of speculation. Too little, to accusations of inadequate cover.

A glance at the hedging strategies for 2006 of Asia’s and Australia’s major carriers shows that there’s no gospel approach. While Cathay favors hedging of 30%, Qantas has gone a different route. The boost in fuel prices increased costs at the carrier by US$509m in the second half of 2005 on revenues of US$5 bn. It earned US$158m in hedging benefits. Qantas is seeking a 100% hedge for 2006. Thomas cautions that no hedging strategy is perfect. With a 100% hedge, Qantas is “in a position where there is little they can do to counter the effects,” if market conditions deviate from expectations. “It leaves you at risk of not getting full value in the event of a downturn in prices,” he says.

Larger carriers, because of their volume and credit quality, have a natural hedging advantage over the budget airlines, because they can get better fee rates on hedging from the banks. Moreover, the capital structure of smaller start-up airlines has been threatened by uncertainty over fuel price. They are dependent on revenue returns over the first three years, and higher costs put a great deal of pressure on debt levels. “In some markets it’s causing some investors to think twice about investing in airlines,” says Thomas.

Cubbon agrees. “A profit model that relies on high volume and low margin is at a greater risk,” he says. “High fuel prices play to the hands of the premium products.”
Cubbon can leverage industry advantage because of Cathay’s size. But in different arenas, particularly in maturing industries in China, such as textiles or automotive, there are few silver linings. Xue of Shanghai Tire & Rubber has to vie in a market contested by virtually all of the major international tire manufacturers, along with about 500 domestic tire makers. Exports present one avenue of relief, but the government’s controlled appreciation of the yuan against the dollar may shut the door. Xue cites the prediction by the China International Capital Corporation, an investment bank, that the dollar/yuan rate will reach 7.8 in 2006 and 7.5 in 2007. If that happens, Xue says his company will lose up to 10m renminbi in export revenue each year over the next two years.

Despite the home currency appreciation, Xue says his company will increase exports in 2006 to avoid competition in the domestic market. Exports accounted for 42% of the company’s sales in 2005. Xue expected to raise the figure to 52% in 2006. In order to mitigate the impact of the renminbi’s appreciation, he will reorganize the company’s loan structure by taking on more foreign-currency loans and reducing the size of local-currency ones. He is also in talks with banks on the use of currency forward contracts to hedge the exchange rate risks.

The Art of Forethought

Xue’s solution so far is market-based – exporting overcapacity and reducing currency liability. But CFOs in other industries have begun taking a more internal approach, aware that fuel price volatility may never vanish. This is true of the chemical sector, where companies have differentiated themselves by their ability to mitigate oil price increases and ease tightening margins.

“Many of them are beginning to look at the planning and execution methods necessary to [squeeze] the highest possible margin out of their products,” says Allan Ziirsen, senior executive and chemical industry lead, Asia Pacific, at Accenture. “But many still don’t have sufficient techniques and tools to understand the margins that are driving their products.”

Ziirsen notes that there are four key levers to mitigating fuel price volatility: price optimization, reduction of the cost of goods sold, increasing volume, and reduction of other costs. He says that a recent case study revealed that success in price optimization will deliver the biggest benefits, creating a boost in earnings before interest and tax (EBIT) of 12%. In contrast, success in reduction of the cost of goods delivers an 8% improvement. Increasing volume and cutting other costs yield 3% and 2%, respectively.

For Nalco’s Marcos, planning ahead on fuel costs is part of the company mantra. “When we first recognized the likelihood of a period of price volatility – and potentially record highs – we started to model potential scenarios and to begin discussing the impact of input price rises with our customers.”

“Whether you are wearing your planning hat or merely trying to respond to near-term questions from your sales director,” says Marcos “you are faced with trying to make sense of a mass of conflicting data.”

He points out that, despite actual oil prices of around US$50 (having peaked at US$72), contacts in the upstream still insist on using price estimates in the low 30s for long-term investment decisions.

“I don’t have a crystal ball and frankly people who know a lot more than I do keep getting it wrong,” says Mike Grundy, founder and CFO of Amazon Papyrus in Hong Kong, “so our planning is very hard.” Grundy started the privately-held specialty chemicals company in 2000. He doesn’t release revenue figures, but says that growth since 2000 has topped 50% per annum, based largely on China demand.

“On the one hand reserve replacement ratios are a concern – in general we are using far more oil than we are finding,” Grundy says. “On the other hand, there are constant improvements in technology that ensure improvements in well-recovery performance.”
Marcos echoes the degree of challenge. In mid 2004 Nalco began a campaign to make both its own staff – especially in the sales and marketing area – and key account customers more aware that oil price increases were coming.

“We were in the very fortunate position of having enough granularity (level of detail) in our reporting to be able to see the impact of rising purchasing costs versus standard costs,” says Marcos with relief, “so we were able to model prices to increase margin to cover variable costs as required.”

But doing the modeling – valuable though it may be – is a good deal less then half the battle. Marcos points out that while the CFO has a vital role in alerting the organization to the economic impact of input price rises, the more challenging part – by far – comes when a company tries to execute those increases.

“Before we engaged any customers we instituted a cross-functional strategy driven jointly by finance and marketing in each region, to assess how receptive each region would be to price increases.”

By planning in this way, and with the active support of the division president, Nalco was able to arrange for division heads to meet the key customers in selected markets to pass on the message. The campaign’s early start translated into pragmatic support and achievable targets.

Granularity – the extent to which components of a system are broken down – at market and product level is key, explains Marcos. At a country level in Nalco, granularity cascades down through annual budgets, with raw material costs planned and specific margin objectives prescribed by division and market. This is backed up by effective reporting – and this needs to be short-term and responsive – on price increase achievement versus plan by country and business unit.

Focusing on Price

“For a while we worried a lot,” says Marcos. “But due to early action and an emphasis on execution, we more than covered raw material price increases.” He adds: “For those nimble enough to move fast, price volatility can be an opportunity.”

Kimo Esplin, CFO of US$13-bn-a-year Huntsman Chemicals – with US$1.5 bn in sales in greater China – points out that, although increasing prices is a must, it presents very different challenges depending on the business. “For differentiated businesses (or performance promise chemicals, as they are sometimes known), it’s about maintaining the perception of value,” he says. “For commodity products it’s easier – the market understands price volatility and prices can be increased every 30 days or so. For specialty items it’s harder. Customers are not used to seeing prices fluctuate – in the past it has taken up to nine months to mediate price increases.”

“In these cases, or when all else fails, we go back to the customer on a one-to-one basis to explain face-to-face why we need to increase prices and to try and manage this. We also work with the customer to find alternative technologies or we suggest ways in which by giving us other products they can enable us to keep down prices.” Concludes Esplin: “Anyone who tries to be a shock absorber will go out of business.”

For some, awareness of price pressure creates opportunities, both internal and external. “I got the team together and made it clear that we were facing significant challenges which could damage us a lot,” says Grundy of Amazon Papyrus. “By raising the level of concern internally, we were able to breathe new life into initiatives to sharpen our model that had been on the drawing board for a while.”

Amazon set up a cost reduction team to put under the microscope key aspects of their operations, well beyond the immediate questions raised by prices. “We looked at working capital, especially inventory, which in addition to funding costs uses up expensive warehouse space. We took a very granular look at all internal costs to drive other savings.”

Marcos is in no doubt about the importance of the CFO in this situation. Why? Because only the CFO can provide the necessary transparency around the detailed impacts of input price increases, he says. Second, because what’s needed for effective action is to translate the big picture into a specific set of pricing imperatives at a market and customer level, which requires precision. And because of the unprecedented rapidity of the changes, the CFO has the ability – and the imperative – to provide effective early warning.

Translation: when the price of oil increases, so too does the responsibility of the CFO.