FACTOR VIII: (ANTIHEMOFILICO O GLOBULINA ANTIHEMOFILICA)

The major elements affecting oil refineries’ profit margins are the demand for and prices of petroleum products in relation to the supply and cost of crude oil and other feedstock. Also refinery’s configuration, capacity and utilization rates affect to the profitability of refineries. Oil refining is primarily a margins-based business, in which both feedstock and petroleum products are commodities. Since operating expenses (when raw material costs aren’t taken into account) are relatively fixed, Neste Oil’s profit is very critically under an exposure to changes in commodity prices. As Neste Oil states in its annual report it aims to hedge its exposure to oil price volatilities. This is done by commodity price risk hedging, which is divided into refining margin hedging and refining inventory hedging. (Neste Oil Annual Report, 2010)

Margin hedging in Neste Oil

As discussed earlier it’s very characteristic in oil industry that both input products and output products are subject to significant market price fluctuations. As Neste Oil’s profit highly depends on the demand for and prices of refined oil products compared to the price level and supply of crude oil and other feedstock, price volatilities have great impact to its profits. Principally refining margin decreases if crude oil price increases or product prices decrease. Margin hedging is used in order to ensure a certain level of margin in this uncertain environment where price level can change significantly between the period that the crude oil is purchased and refined products are sold to customers. The aim of margin hedging is to ensure a certain profit of its production that is highly exposed to international market price fluctuations. (Neste Oil Annual Report, 2010)

Refining margin means the value that oil refining company gets when the costs of raw – material and production are reduced from the selling price of refined products. Refining margin indicates very well the profitability and cash flow of an oil refiner. As refining margin is an important determinant of Neste Oil’s profits, its fluctuations (i.e. fluctuating price difference between selling and buying oil prices) generate a significant risk. Therefore Neste Oil aims to secure its margin per barrel and uses financial derivatives to hedge part of its refining margin. However Neste Oil only hedges a part if any of its refining margin whereas inventory price and foreign exchange risks are hedged entirely.

Inventory hedging

Inventory price risk means a risk that the value of products in the inventory fluctuates as the market prices changes. Managing inventory price risk is highly important to oil refiners as due to the nature of business, inventory levels tend to substantial but also fluctuate a lot due to volatile demand and demanding logistics. In practice as oil purchases and sales are always done to the market price level, there’s a risk that in a case of decreased price levels, a refiner is in a situation in which it has inventories full of crude oil bought during a high price level and is now supposed to sell refined products at lower price. This could mean crucial losses to an unhedged refiner. Consequently, inventory hedging aims to reduce an exposure to price fluctuations. In practice in order to hedge this exposure oil companies seek to buy financial oil derivatives contracts when inventory decreases (and contracts are sold when in a reverse

situation). The idea behind this is that if the value of inventory decreases the value of futures increases and thus the physical and paper position offset each other.

Neste Oil’s refining inventory, to which is referred as ‘base inventory’, consists of two components. The first component is the compulsory inventory which is a minimum inventory level that Neste Oil is required to maintain constantly by Finnish laws and regulations. The other component is the operational inventory which is a minimum level of products and feedstock which refinery requires to its operations without going below compulsory inventory level. The components are illustrated also in the Figure 8 below. In practice Neste Oil’s inventory level fluctuates below and above base inventory level but is not allowed by law to go below compulsory inventory level. In practice the fluctuations below and above the base inventory level expose Neste Oil to price risk. Therefore Neste Oil’s risk management policy is that hedging operations target only to those levels that excess or fall below of the ’base inventory’. If the whole inventory would be hedged the fluctuations in market prices would mean enormous fluctuations to the paper position’s value (if inventory level were one million tons would 1 U.S. dollar/bbl increase in crude oil price mean over 7.5 Million U.S. dollar effect to the position’s value (1bbl = 159litres)). And in this volatile price situation daily price movements of 5 U.S. dollars aren’t uncommon. However, not hedging the entire inventory (both the compulsory and the operational inventories) is well justified as a big part of inventory remains stable (due to the law issues) and only fluctuating parts of these stocks create cash flow. (Neste Oil Annual Report, 2010)

Figure 9: Neste Oil's refining inventory

Practically the refining inventory level depends on the relationships between feedstock purchases, refinery production and product sales which is a reason why refining inventory

price risk is also known as transaction risk. In addition it’s worthwhile to notice inventory fluctuations expose Neste Oil’s income statement and balance sheet to price risk too.