Liam Denning at the Wall Street Journal has a nice piece today on why Chevron has chosen not to hedge its apparent exposure to fluctuations in the value of the Australian dollar.
The apparent exposure arises from its Gorgon liquefied-natural-gas project. Sales of natural gas are denominated in US dollars, but a large fraction of Chevron’s costs at Gorgon are denominated in Australian dollars. Let’s look at the project’s value measured in US dollars. How are they exposed to fluctuations in the exchange rate between the Australian dollar and the US dollar? A mechanical sensitivity analysis will show the US dollar costs fluctuating as the exchange rate fluctuates, while the US dollar revenues will be constant. That creates the apparent exposure.
But this mechanical calculation treats the US dollar revenues as if they are fixed when the exchange rate changes. There is an implicit assumption of zero correlation between the exchange rate and the US dollar denominated selling price.
Chevron thinks that implicit assumption is wrong, as Denning reports:
Chevron reasons that the Australian economy, and by extension its currency, relies heavily on commodity prices. So even if costs rise because of the currency, the concomitant increase in the price of energy offsets this by bolstering Chevron’s revenue.
And Denning goes on to present some statistical evidence in support of that.
Chevron’s reasoning here is a good example of thinking through the full economic exposure. Many valuation models take as inputs multiple variables which may be tied together by some underlying economic forces. A sensitivity analysis in which the variables are changed, one-by-one, as if they are independent of one another, can be useful, but can also be misleading if the analyst is not conscious about the implicit assumption.
Australian resource projects and companies have always been a good source of case studies for this type of deeper analysis of economic exposure, precisely because the apparent exposure from selling raw materials into a global commodity market denominated in US dollars vanishes as soon as one thinks about the underlying determinants of the exchange rate. The classic case study is “Managing Currency Exposure: The Case of Western Mining”, Journal of Applied Corporate Finance, 1990. Western Mining was an Australian mining company that was subsequently taken over by BHP Billiton.