Perspectives

Question Answered: Treasury’s supportive role as the energy crisis bites

Published: Nov 2022

“How can treasury support through the energy crisis, and what are the potential impacts of the energy crisis on corporate health?”

Piggy bank surrounded by euro notes, energy crisis concept
Portrait of Oliver Stratmann, Head of Treasury and Investor Relations, LANXESS

Oliver Stratmann

Head of Treasury and Investor Relations
LANXESS

We are a leading speciality chemicals company based in Cologne. With around 13,200 employees in 33 countries, we are an established company on the global market. Our core business is the development, manufacturing and marketing of chemical intermediates, additives and consumer protection products with annual sales of €6.1bn (2021). Our energy sourcing differs from country to country. At some sites, we even produce our own energy. Despite the war in Ukraine, the sourcing at our major sites in the Lower Rhine region in Germany is secure. Here chemical park operator Currenta provides LANXESS with electricity and steam produced in the park’s own power plants. Our energy supply is based on long-term contracts.

Energy prices have risen substantially since the start of the war – and we expect our energy costs to double in 2022 compared to 2021. So far, we have been able to pass on increased raw material and energy prices fully, albeit with a time lag of around a quarter to our customers.

Treasury is in close collaboration with our procurement department in order to assess the situation and decide whether physical hedging or hedging via financial derivatives makes any sense, but we don’t currently hedge energy.

LANXESS is committed to becoming climate neutral by 2040. This includes a switch to green energy. We are constantly evaluating the potential to switch energy sources and use alternative ways to operationally run plants. Technical possibilities here are however limited. Importantly, we have substantially increased exposure to US based production, and this helps us.

We are passing on higher energy costs to our customers and thereby ensuring that absolute profits remain protected. However, inflation in the top line of our sales arithmetically leads to lower margins. Massive inflation could also lead to a decline in demand which fuels the broadly discussed fears of a recessionary environment.

Our liquidity reserves have been ample and have been diligently prepared since the beginning of the year. Passing on raw material and energy costs ensures that we are being compensated for the higher costs. Nevertheless, our inventory levels and hence tied-up cash, are higher as disruptions in global value chains and higher prices drive up values and volumes of goods in transit and inventories. It is key to be prepared to finance rising cash needs in working capital. Fortunately, we anticipated the current situation early and have been preparing since the beginning of the year.

Portrait of Gerben Hieminga, Senior Economist, ING

Gerben Hieminga

Senior Economist
ING

Companies are focused on forecasting and budgeting their energy costs for the year ahead. But in these markets of high uncertainty, a different approach incorporating scenario risk analysis is better suited to assessing the impact of energy prices on financials. Risk analysis will help companies secure their costs for a period ahead so they can start planning in a more stable environment.

Scenario risk analysis allows companies to measure what risk they can take and what type of volatility they can support before it damages the company. Companies should be aware of these calculations and act accordingly – for example, to what extent is halting production a risk to avoid?

We would also warn companies that although energy prices are coming down, they may not drop further – scenario planning should include the risk of gas prices rising and returning to €300 per megawatt (MWH) hour in the winter months.

In December 2021, the gas price peaked at €140 MWH. It subsided, but in February 2022 we had another peak of €200 MWH. Summer 2022 it peaked again at almost €350 PMW. Prices ahead will depend on how severe the winter is and how much gas Europe has managed to store. We believe that if it is a mild winter, prices will stay below €200 MWH, but if it’s a severe winter prices could reach €300 MWH. At this price, manufacturers like aluminium or glass makers may be forced to save energy and stop production.

Energy intensive industries like chemicals, plastics, base metals, steel and cement will feel a direct impact. The impact will then filter down to food and beverage groups, and agriculture. These businesses will see their costs increase although it will depend on the type of energy contracts they have. In a second order of impact, high prices will trickle down to the real economy to travel agencies, hospitality and construction. This is where the full economy and every supply chain will start to feel the impact.

Corporate treasury is in a better position than consumers and households to weather the impact because the pricing power for companies is quite high. We hear from energy companies that a lot of contracts will expire by the end of the year as contracts are signed from year to year. It could be that the full impact is felt when companies need to start negotiating their energy contracts. In this way the energy crisis for corporations is like a peat fire, burning underground and not visible from the surface. Renegotiating contracts could mean the energy crisis suddenly becomes a full forest fire.

Positively, companies are in better shape now than after the GFC. Many have cash on their balance sheet because interest rates have been low for so long. In the past, energy has only been a small portion of typical costs and companies outsourced their procurement strategy to energy service providers. Because costs have increased, many companies now want a one-on-one relationship with their energy provider. Procurement departments are working much more closely with their energy provider to secure energy for the year ahead and energy procurement strategies have become more interactive and time consuming as a result.

Portrait of Gareth Williams, Head of Corporate Credit Research, S&P Global Ratings

Gareth Williams

Head of Corporate Credit Research
S&P Global Ratings

We are seeing companies reconsider their investment plans and they may now be more inclined to preserve cash. Cash balances rose through COVID, and companies may now slow deploying that cash because of economic uncertainty. Higher interest rates offer some benefit from keeping cash too.

We have two areas of concern regarding the effect of high energy prices on corporate credit ratings. First is the potential impact from higher costs on profitability and demand. This might weaken the ability to service debt. For now, this effect has been modest as many companies appear to have been able to pass costs on to customers. Ultimately this is all adding to inflation and broader cost of living challenges, but this is more likely to be felt next year as economies slow.

At some point companies won’t be able to pass cost pressures on as easily and we will pay close attention to corporate results in this results season. It may be that companies have been able to pass this cost on in the first part of the year but that their profit margins are coming under pressure as wage pressures rise and the days of easy cost pass through start to fade.

The second impact is the effect on funding costs, with energy prices a key part of the equation pushing borrowing costs higher. Market confidence is an additional element here, with corporate debt issuance slumping this year. Again, this remains a slow burning pressure for now. Companies refinanced at attractive rates during the pandemic and refinancing needs are modest for now.

On a positive tack, we are seeing signs that the supply side shock that has fed inflation is starting to ease. For example, container shipping costs have fallen dramatically. Once inflation comes under control, the medium-term picture might be more positive.

The financing environment remains a concern, both in terms of market sentiment but also in relation to possible systemic risk in the financial system. The sharp fall in UK government bonds in October exposed unexpected risks in the pension system from Liability Driven Investment strategies and could be a sign that other risks might have built up from a prolonged period of very low interest rates. Sharp moves in asset prices can reveal these hidden risks and a financial crisis would make a cyclical downturn more pronounced.

A final concern is that the cost of servicing dollar debt has gone up significantly given the surging dollar and higher US interest rates. Our analysis shows that 51% of the debt of UK companies we rate is dollar denominated. Even though treasury teams carefully manage this exposure, often via natural hedging in terms of where companies’ revenues are coming from as well as forwards and swaps, this could be an unwelcome pressure for companies reliant on US debt funding but without matching US revenues.

Next question:

“How prepared are companies and countries for new IFRS rules designed to tackle greenwashing and create a single set of corporate climate reporting standards to meet investors’ information needs?”

Please send your comments and responses to qa@treasurytoday.com

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