Published: June 15, 2009
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.
Royal Caribbean has three areas of hedging activity:
i) Fuel
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 $0.5bn, the company took the decision to move away from hedging cashflow as most of foreign currency flows are more or less offset over a period. Treasury runs an annual Value at Risk (VaR) analysis and on the basis of the last VaR report, the decision was made that the total exposure was not significant enough to justify hedging activities. [[[PAGE]]]
iii) Interest Rate Risk
As a capital-intensive business, RCL has extensive borrowings and therefore has significant exposure to interest rates. Most of the company’s borrowings are in US$ and therefore the primary exposure is to US Libor, but RCL issued a €1bn bond in 2007 and bought a Spanish subsidiary last year together with its € debt, so there is an exposure to both Euribor and exchange rates. In general, the firm holds around 50% of the portfolio in fixed rate debt and 50% floating rate; the interest rate policy stipulates a fixed rate portion of 40-60% in fixed rate debt so treasury aims to stay within this guideline. With the floating rate debt, there is always the challenge of deciding the period for which to fix rates and with $400m in interest rate expense, treasury needs to make the right decisions to maintain predictability of outgoings.
Before acquiring Reval®, treasury was largely dependent on its banking counterparties to provide mark-to-market valuations. For interest rate risk, bonds were valued using Bloomberg rates and swaps using counterparty curves, creating very large mismatches. The decision to acquire a system for hedge accounting was driven by the CFO with the consistent management of interest rate risk being the primary driver. FX and fuel created fewer problems - treasury used an in-house system for FX which worked well enough although it was not being used for hedge accounting. We started using Reval for interest rate risk in October 2007, followed by FX, which went live in January 2008 and fuel in March 2008. We experienced considerable benefits from implementing Reval, such as reducing the month end closing process substantially.
As a web-based solution, Reval has proved very convenient, as people based in different locations can produce reporting when required, which is also very useful when travelling. It is delivered on an ASP basis so updates to the system are applied automatically rather than having to schedule upgrades. Producing enhanced hedge accounting reports has been a significant step forward. Treasury can now compare valuations of the underlying debt and the associated hedge using a constant methodology so the results are far more reliable.
Since this time last year, the risks in the market have changed completely. Risks that were considerable before, are now extremely significant, with sharp, unpredictable swings in FX rates, commodity prices and interest rates. Consequently, while identifying and hedging our risks has always been a very important part of RCL’s treasury activities, risk management has become an extreme task with breathtaking uncertainty.
Using the example of interest rates, which of course have dropped sharply to unprecedented levels, RCL’s fixed to floating interest rate swaps are now significantly in the money. While in theory this is advantageous, with the liquidity crisis it has become very difficult to capitalise on in-the-money swap values and banks are charging high funding costs. Consequently, the current crisis has a number of different manifestations: not simply the difficulties of obtaining credit or smoothing market volatility, but even taking hold of a company’s own cash.
The challenge for us in managing risk is the constant change in requirements, which makes it difficult to hedge our commodities and establish a clear view into whether commodity purchases are viable. This problem is unique to the shipping industry and certain other industries heavily reliant on fuel, but it has changed the way in which we forecast and hedge our exposures.
Like many firms, we have found it difficult to respond in time to the new market conditions. We have analysed our hedging position extensively, and we are being forced to take unconventional approaches to solving unfamiliar problems. Looking at our commodity requirements for example, we are trying to move to more standardised commodity products. For example, as I described in my article last year, we used to hedge US Gulf Coast as far as possible. One of the problems with this was the lack of a liquid benchmark, so now we are considering proxy hedging using heating oil, which is a highly liquid benchmark. While we will have to take on basis risk, we will be less liable to uncertainties of US Gulf Coast oil pricing. [[[PAGE]]]
In the past, changes in FX rates have generally been based on factors within the financial markets. Today, the sharp volatility in FX movements is based on geopolitical factors - such as €/$ and £/$ currency pairs, relating to issues such as the sub-prime mortgage crisis, so rates become even more difficult to predict. Furthermore, traditional ways of looking at rates, namely purchasing power parity (PPP) has to be dispensed with, as rates can now shift dramatically according to the mood of the day - for example, sometimes a country’s trade deficit will matter, sometimes not.
Risks that were considerable before, are now extremely significant, with sharp, unpredictable swings in FX rates, commodity prices and interest rates.
The unprecedented strengthening of the US$ has resulted in problems for many corporates. It is not just the level which is so striking, but the speed with which this has occurred. Few corporates, including RCL, have had time to make the necessary changes to treasury policies and even then, it is difficult to tell how long the current situation will last. There are currently moves afoot by the Subcommittee of Agriculture in US Congress to regulate over-the-counter (OTC) derivatives. If these plans are approved and take effect, the resulting tremors in the derivative markets will be seismic in proportions. Participants will be forced to go through a clearing house and may be required to collateralise every trade, which will be almost impossible bearing in mind the risks run by the corporation and the increased liquidity requirement. Rather than hedging according to our needs, OTC instruments are, by their nature, non-specific, and therefore will not be designed to hedge our risks directly. If these measures go through, we envisage significant risk management challenges.
As a US business, RCL needs to report under FAS 157 and 161 which have created an additional and more complex reporting burden, although not to the extent of stretching our processes to breaking point. However, we would question the value of some of these additional disclosure requirements. For example, RCL’s credit rating was recently downgraded, which actually resulted in a pick-up in our P&L under FAS 157. Therefore, what this requirement is meant to do, namely include counterparty risk in mark-to-market calculations, has unintended consequences.
To date, the planned revision to FAS 133 to bring it more in line with comparable standard IAS 39 has not taken place and we are hoping that this will be delayed as long as possible. Given the considerable challenges with which corporations are currently faced, both in the financial markets and more widely, this would add another significant overhead in treasury, although we are in the fortunate position of having the technology to handle it.
The next twelve months will undoubtedly be challenging, as the previous year has been. What will be important for treasurers is to continue to be responsive to changing market conditions, and be able to flex risk management policies in line with these. The situation we find ourselves in is unfamiliar and unprecedented, which will call for new and innovative solutions.
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