The last few years have been unpredictable for the oil and gas industry. The coronavirus pandemic saw oil demand suddenly slump before rebounding at a break-neck pace as economies reopened. Meanwhile, the business environment became increasingly hostile for fossil fuel companies amid activist investors and legal challenges, and with tighter regulations on the horizon.
Hedging isn’t the right strategy for all businesses, but for businesses exposed to currency market volatility, it can help you manage risk and make the most of opportunity when you’re making international payments.
By hedging all your currency exposure you could miss out on positive exchange rate movements. But if you don’t hedge at all, you could lose out if the market suddenly moves negatively.
Deciding whether to hedge is a serious consideration for your business, and it’s important to think about why hedging may, or may not, be right for your business’ strategy and future.
Understand currency exposureFirst thing’s first, your business needs to understand what’s on the table when considering currency risk.
When you’re facing market volatility, visibility is key to understanding what exactly the exposure is, and when it falls due to make better informed FX hedging decisions. Because once your business is aware of the exposure, you can assess what you’re facing and how material the risk is.
Some businesses will find that they can naturally reduce their overall exposure by netting a currency payable, for example USD, with a USD receivable.
This can create a natural hedge. For instance, if you owe $50,000 to an overseas client, but the client owes you $75,000, you have a natural hedge of $50,000, with $25,000 above the hedge.
Certainty is also important for future requirements; if a USD exposure is certain, then you know you have to pay USD in the future and therefore you can look at placing an appropriate hedging product to mitigate.
However, if the exposure is uncertain you need to be careful entering into a hedge that you may not need.
Alternatively, you should look at hedging a proportion of the expected exposure, or pivot to a hedging product that allows you to protect against unfavourable movements, but has the flexibility to let you walk away if the exposure is no longer needed.
Protect your profit marginsThere are various factors that can impact your business’ overall profit margin, and currency market movement is an especially significant one at the moment.
Against the backdrop of global economic conditions amplifying pricing pressures, shipping costs hitting all-time highs, rising commodity costs, and Covid and Brexit headwinds, businesses face significant challenges to protect their profit margins.
When dealing with different currencies to your host currency, unexpected negative volatility can have sharp and painful consequences on the bottom line, before factoring in any other costs.
During Brexit and Covid driven volatility, we’ve seen movements of 10% and more on major currency pairs in a short space of time.
For instance, GBP/USD traded at $1.42 at the start of June 2021, giving a £200,000 transfer a return of $284,000. But at the start of October 2021 the pairing was 7 cents lower at $1.34, meaning the same transfer had a discrepancy of $16,000.
Using an FX hedging plan can mitigate this potential risk, helping you to protect your profit margin, and giving you extra time and resource to concentrate on other operating costs.
Achieve consistent pricing and provide a stable serviceA great advantage to putting a hedging plan in place over a financial period, or periods, is that it can allow your business to price with a longer horizon and build in more consistency, rather than reacting to erratic exchange rate movements.
Having a hedging plan and pricing consistency makes it easier for your business to plan, manage and meet budgets. At the same time, your customers benefit from stable service and consistent pricing.
A well thought out hedging plan can help smooth financial statements on a longer term basis and demonstrate effective financial management.
Stay ahead of your competitionIt’s useful to understand what your competition is doing when it comes to currency hedging.
The likelihood is that your competitor’s exposure will mirror your exposure and understanding the strategy of a peer can help to formulate your own hedging plan.
You may be able to see a competitor’s hedging approach in their financial reports, as larger companies may need to document it.
Companies that operate in a global market should also be aware that adverse currency market movements could in fact divert business away.
For example, if a good or product becomes cheaper through sourcing from Europe instead of the UK due to unfavourable shifts in the market, a buyer may source a new supplier.
Keeping prices predictable through FX hedging can retain clients and help your business stay ahead of your competitors by maintaining predictable pricing.
There are different currency hedge strategies and products, and the nuances of each business are different, even if they may be in the same sector.
Therefore, it’s useful to get a steer from peers within the industry but to create a plan that best suits your own business objectives. What might work for one company may not always be suitable for another.
Identify balance sheet exposureSome businesses may seek to mitigate a firm’s accounting or reporting exposure on financial statements. A business may be aware of increased risk associated with future accounting measurement.
As such, there’s a requirement to quantify the expected change, and if warranted to do something to reduce it.
An example of this would be if a UK reporting company has a material overseas asset or liability, such as in USD, which will require it to be translated back to GBP for financial reporting.
Company specific reasons may necessitate hedging here. For example, to protect against a lending covenant being triggered on net worth.
However, it’s also important to weigh up whether implementing a hedge to mitigate reporting exposure could create unintended cashflows from the hedge or for rolling the hedge.
So, the result and hedging plan implemented would need to meet a clear objective that is beneficial to the company overall.
A hedging plan is a strategy of reducing or eliminating risk to provide a business with more certainty in its outlook.
Moreover, hedging can reduce the chance losses, and the examples we’ve looked at are key considerations why your business may hedge currency.
It’s important to note that we’re not advocating removing risk altogether, but rather reduce it as much as possible within the parameters acceptable to the particular business.
Businesses may want to consider adopting a hedging plan that can protect their income from dramatic swings in currency fluctuations. Amid the many risks businesses face in the current global landscape, currency risk can be reduced.
Currencies Direct is one of Europe's leading non-bank providers of currency exchange and international payment services. Since we were formed in 1996, we've maintained our focus on providing innovative foreign exchange and international currency transfer services to corporations of all sizes, online sellers and private individuals. We have also expanded our services to provide dynamic and pioneering "business to business" solutions to help companies, tier 2/3 banks and other non-bank financial institutions to process their international payments. Our headquarters are in the City of London (United Kingdom) and we have operations in continental Europe, Africa, Asia, and the United States. Currencies Direct is jointly owned by private equity firms Palamon Capital Partners and Corsair Capital.