A Year in Risk Management
by Ashish Advani, Director, Derivatives, Royal Caribbean International
About Royal Caribbean International
Royal Caribbean International (RCL) was founded in 1969 and now has a fleet of 39 ships with a capacity of 78,650 passengers. The cruise schedule includes Alaska, Asia, Australia/New Zealand, Bahamas, Bermuda, Canada/New England, Caribbean, Europe, Hawaii, Mexico, Panama Canal and South America, appealing to a wide range of customers of all ages. RCL is quoted on the New York Stock Exchange and Oslo Stock Exchange and achieved 2007 revenues of $6.1bn, an increase of $900m on the previous year.
In February 2008, I wrote an article for the TMI Hedge Accounting Guide 2008, published in association with Reval, on risk management and hedge accounting at RCL. One year on, while some issues have remained the same, such as our use of technology, managing risk in a new environment is very different. In the first part of this article, I have transcribed most of the article from last year, and in the second, illustrated the differences in the way that we hedge our risks today.
Part One: Hedging and Hedge Accounting in 2008
Hedging at RCL
Royal Caribbean has three areas of hedging activity:
With 39 cruise ships and a number of auxiliary vessels, the company’s consumption of fuel is enormous. Given the market uncertainty, treasury needs to hedge fuel costs actively to stay within budget guidelines. Cruise schedules are published several months or more ahead, so annual fuel plans can be calculated for each ship, and each November, treasury has a full fuel consumption guide for the following year. This can be analysed by ship, port and engine and consolidated into a total fuel demand.
Given the market uncertainty, treasury needs to hedge fuel costs actively to stay within budget guidelines.
It is the company’s policy to hedge 2 years out divided into two time buckets. The 1-12 month period is hedged 40-60% and the 13-24 month period hedged 10-50%. For example, full year hedging for 2008 was 45%. Typically, treasury conducts monthly contracts for each fuel type to satisfy FAS 133 hedge accounting requirements. By doing it this way, if one contract becomes ineffective, it does not affect the whole hedging programme. Approximately 10-15 contracts mature each month which we replace with a similar number as a way of averaging out fuel prices across the year.
Each ship uses a specific fuel type which is then delivered all over the world in accordance with each ship’s cruise schedule. Some of these fuel types are not commonly traded, making it difficult at times both to source and hedge the relevant fuel type. The largest fuel purchases are in US Gulf Coast which is not typically benchmarked against WTI (West Texas Intermediate, or Texas Light Sweet, used as a crude oil price benchmark) which can create problems. At some ports, such as in South America and Australia, there is no market in this fuel and therefore, as it is not universally traded, there is no standard source for future prices. This is an issue specific to shipping companies and cruise lines as other fuel-intensive industries use more commonly traded fuel types, such as airlines which use jet fuel. So while RCL aims to hedge as far out as possible, this is not always easy to achieve.
ii) Foreign Exchange
RCL has two kinds of FX exposure. Firstly, an exposure is created when buying a new ship, which can typically cost $800m - $1.2bn. Although much of RCL’s business is in the US, ships are usually purchased in €. The existing ship hedging programme of 7 ships amounts to $4.5bn. As soon as the purchase has been approved, the exposure is created, so once the contract has been signed, the hedge can be put in place. The policy is to hedge 85%- 95% of the purchase price, usually using FX forwards. FX forwards are the most FAS-friendly and "cost effective" means of hedging. As ship purchases are known exposures, there is no mismatch, and long-dated contracts are used based on a 4 or 4 1/2 year ship delivery timescale. The challenge is trying to see where €/$ rates will be over that time!
The second type of FX exposure relates to foreign currency cashflow. RCL has subsidiaries in the UK, Spain and Canada and is therefore exposed to FX fluctuations derived from cashflows for customer deposits, salaries etc. in the relevant currencies. While the foreign currency exposure might be equivalent to $0.5bn, the company took the decision to move away from hedging cashflow as most of foreign currency flows are more or less offset over a period. Treasury runs an annual Value at Risk (VaR) analysis and on the basis of the last VaR report, the decision was made that the total exposure was not significant enough to justify hedging activities.