Integrated Annual Report of LOTOS Capital Group 2016

28. Objectives and policies of financial risk management

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The Group is exposed to financial risks, including:

• market risk (risk related to prices of raw materials and petroleum products, risk related to prices of CO₂ allowances, currency risk, interest rate risk),
• liquidity risk,
• credit risk related to financial and trade transactions.

The Parent operates a Financial Risk Management Office, which coordinates and exercises ongoing supervision of the Group’s financial risk management processes. 

Furthermore, the Price Risk and Trading Committee, appointed by the Management Board, supervises the work on development of policies and procedures, and monitors implementation of the Group’s strategy in the area of its responsibilities. Specifically, the Committee provides opinions on or initiates key price and trading risk management projects, makes recommendations, and submits proposals for actions that require the Management Board’s approval. 

In addition, to ensure effective management of liquidity, debt structure and external finance raising by companies of the LOTOS Group, the Management Board has appointed the Liquidity Optimisation and Financing Coordination Team.

Financial risk management seeks to achieve the following key objectives:

• increase the probability of budget and strategic objectives being met,
• limit cash flow volatility,
• ensure short-term financial liquidity,
• optimise the expected level of cash flows and risk,
• support operating, investment and financial processes, and create value in the long term.

With a view to implementing the above objectives, the Group has put in place relevant tools and developed a number of documents, approved at the relevant decision-making levels, defining the framework for ensuring effectiveness and safety of the Group’s financial activities, including:

• the methodology for quantifying exposures to particular risks,
• the time horizon for hedging a given risk,
• acceptable financial instruments,
• the method of assessing financial risk management,
• limits within risk management,
• the reporting method,
• credit limits,
• documentation and operating standards,
• division of responsibilities for execution of transactions, risk analysis and control, as well as documentation of and accounting for transactions, among various corporate units.

The Parent monitors and reports all managed market risks on an ongoing basis. Grupa LOTOS S.A. uses liquid derivatives which can be measured by applying commonly used valuation models. Valuation of derivative financial instruments is performed based on market inputs provided by reliable sources. Opening positions with respect to risks which do not arise as part of the Group’s core business is prohibited.

In 2016, the Parent continued to apply the hedge accounting policies implemented in 2011 and 2012 with respect to its cash flows (i.e. foreign-currency facilities used to finance the 10+ Programme, designated as hedges of future USD-denominated petroleum product sale transactions). 
 

28.1 Risk related to raw material and petroleum product prices

The Group considers risk related to prices of raw materials and petroleum products to be particularly important.

The following risk factors are identified in this area:

• volatility of the refining margin, measured as the difference between liquid indices of a reference petroleum product basket (e.g. aviation fuel, gasoline, diesel oil, fuel oil) and a liquid index of a reference raw material (e.g. Urals crude),
• volatility of prices with respect to the raw material and product inventory volumes deviating from the required levels of emergency and operational stocks,
• volatility of differentials between the reference indices and indices used in commercial contracts (e.g. Urals-Brent differential, i.e. the difference between different types of crude oil),
• use of non-standard pricing formulae in commercial contracts.

On February 16th 2015, the Parent’s Management Board approved the “rupa LOTOS S.A.’s raw material and petroleum products price risk management policy, which introduced the classification system for transaction portfolios, defined their business functions, described how risk is understood and how portfolio exposures are set, specified permitted financial instruments, limitations on their use, and transaction execution standards, and also provided guidelines on how to evaluate risk management performance and set relevant limits. Transaction limits falling within the scope of that policy are delegated by the Management Board to lower-level decision-makers.

To support the achievement of the policy objectives, the Company uses a leading ETRM system available on the market.

Under the approved policy, the Company may continue to offer its customers petroleum products at fixed prices. The transactions executed in 2016 covered bitumen components. To preserve the original price risk profile the Group entered into commodity swaps. 

Acting within the framework of its approved policy, in order to take advantage of the contango environment on the futures market, improve the operating margin and get prepared for the maintenance shutdown in 2017, the Company entered into commodity swaps based on the ULSD 10 ppm CIF NWE index and purchased additional volumes of diesel oil (carried as inventory).

Open commodity swaps as at December 31st 2016

The above swap transactions for a total of 181,526 tonnes based on the 3.5 PCT Barges FOB Rotterdam liquid index in the period from March 2017 to November 2018 and (16,201) tonnes based on the Gasoil 0.1 pct Crg CIF NWE ARA liquid index in the period from March 2017 to November 2018 were entered into to reverse the risk profile relating to the prices of raw materials and petroleum products in connection with sales of bitumen components at fixed prices. The swap transaction for (16,050) tonnes based on the ULSD 10 ppm CIF NWE index in April 2017 was entered into to benefit from contango.

Open commodity swaps as at December 31st 2015

The above swaps for a total of 92,845 tonnes based on the 3.5 PCT Barges FOB Rotterdam liquid index in the period from March 2016 to November 2017 were entered into to reverse the risk profile relating to the prices of raw materials and petroleum products in connection with sales of bitumen components at fixed prices. The swap transactions for a total of (249,931) tonnes based on the Brent (Dtd) index in the period from March to May 2016 were entered into tp benefit from contango.

Open commodity options as at December 31st 2016

The above options for a total of 10,646 tonnes based on the 3.5 PCT Barges FOB Rotterdam liquid index in the period from March 2017 to October 2017 were entered into to reverse the risk profile relating to the prices of raw materials and petroleum products in connection with sales of bitumen components at fixed prices.

Open commodity options as at December 31st 2015

The above options for a total of 27,105 tonnes based on the 3.5 PCT Barges FOB Rotterdam liquid index in the period from March 2016 to October 2017 were entered into to reverse the risk profile relating to the prices of raw materials and petroleum products in connection with sales of bitumen components at fixed prices.

28.1.1 Sensitivity analysis: market risk related to raw material and petroleum product price movements

Below is presented an analysis of the sensitivity of the Group’s financial transactions to the risk of fluctuations in prices of raw materials and petroleum products as at December 31st 2016 and December 31st 2015, assuming price increase/decrease corresponding to the implied annual volatility of the underlying index.

28.2 Risk related to prices of carbon (CO₂) allowances

The risk related to prices of carbon dioxide emissions allowances is managed by the Parent on an ongoing basis in line with the assumptions set forth in the strategy for managing the risk related to prices of carbon dioxide (CO₂), approved by the Grupa LOTOS Management Board. The Group balances its future CO₂ emission allowance deficits and surpluses depending on the market situation and within defined limits. In line with the approved strategy and limits, the Parent executes the following transactions for emission units:

• EUA (Emission Unit Allowance) – representing an allowance to emit one tonne of CO₂, 
• CER (Certified Emission Reduction unit) – representing one tonne of CO₂ equivalent (tCO₂e) effectively reduced; CERs are obtained in connection with investment projects implemented in developing countries where no CO₂ emission limits have been defined,
• ERU (Emission Reduction Unit) – representing one tonne of CO₂ equivalent (tCO₂e) effectively reduced; ERUs are certified emission units obtained through investment projects implemented in countries where the CO₂ reduction costs are lower.

As at December 31st 2016, the Parent’s deficit of allowances in the 2013–2020 trading period (Phase III) was 1,231,057 tonnes. However, taking into account derivative transactions for a total of 1,752,000 tonnes, the Parent had surplus emission allowances for 520,943 tonnes, which were purchased in view of the market situation and the strategic nature of the emission allowances deficit expected after 2020.

As at December 31st 2015, the Parent’s deficit of allowances in the 2013–2020 trading period (Phase III) was 1,095,003 tonnes. Taking into account derivative transactions for a total of 1,715,000 tonnes, the Parent had surplus emission allowances for 619,997 tonnes, purchased in view of the market situation and the anticipated strategic deficit in emission allowances after 2020.

To manage risk related to carbon dioxide emission allowances, the Group evaluates the risk of deficit of free emission allowances allocated under the National Allocation Plan on a case-by-case basis. 

The CO₂ emission allowances for 2013-2020 presented below include allowances granted pursuant to the Regulations of the Polish Council of Ministers, as well as other free allowances allocated by the European Commission.

Number of free CO₂ emission allowances for 2013-2020 and actual CO₂ emissions:

'000 tonnes	2013	2014	2015	2016	2017	2018	2019	2020	Total
Allowances allocated under the National Allocation Plan (1)	1,766	1,688	1,652	1,613	1,576	1,540	1,505	1,461	12,801
Actual CO2 emissions (2)	1,745	1,875	1,947	1,956	-	-	-	-	7,523

As at December 31st 2016, considering the proposed amount of allowances to be allocated under the European Union Emissions Trading Scheme for 2016 and the actual volume of emissions, the Group reported a deficit of allocated CO₂ emission allowances, and therefore recognised a PLN 9,790 thousand provision as at December 31st 2016 (December 31st 2015: PLN 1,059 thousand). The PLN 8,731 thousand effect of the provision on EBIT (see Note 9.3) is presented under other expenses (2015: PLN 1,059 thousand; see Note 9.4).

If required, futures contracts to purchase carbon (CO₂) allowances open as at the last day of the reporting period are settled by the Group through physical delivery, with the intention to potentially use the allowances to offset the Group’s actual CO₂ emissions. The valuation of contracts settled through physical delivery is not disclosed under financial assets/liabilities in the financial statements. However, the Group internally monitors and performs the valuation of such contracts as part of an overall assessment of the effectiveness of its CO₂ risk management (off balance sheet).

EUA futures contracts open as at December 31st 2015 which the Group considered likely to be settled through physical delivery and used for the Group’s own purposes were not disclosed in the financial statements as at the last day of the reporting period, and their fair value was recorded only as an off-balance sheet item.

Contract position as at December 31st 2016 and 2015:

Open CO₂ allowances contracts as at December 31st 2016:

Open CO₂ allowances contracts as at December 31st 2015:

28.2.1 Sensitivity analysis: market risk related to movements in prices of carbon dioxide (CO₂) emission allowances

As at December 31st 2016 and December 31st 2015, the Group held futures for the purchase of carbon dioxide (CO₂) emission allowances.

The Group does not perform a sensitivity analysis for the fair value of futures contracts to purchase CO₂ emission allowances held by it as at the end of the reporting period if it intends to settle the contracts through physical delivery and use them to cover its own allowance deficits under the carbon emission reduction system. Therefore, no sensitivity analysis was performed with reference to the EUA futures held as at December 31st 2016 and 2015.

28.3 Currency risk

In its operations the Group is exposed to currency risks related to:

• trading in raw materials and petroleum products and other merchandise, 
• investment cash flows,
• cash flows from financing activities, including deposits and borrowings,
• valuation of derivative instruments, 

indexed to or denominated in a currency other than the Group’s functional currency.

Since August 20th 2015, currency risk has been managed in line with the assumptions stipulated in the Grupa LOTOS S.A.’s currency risk management policy. Under the new policy, exposure is understood as material positions exposed to currency risk and affecting the liquidity in the management horizon in accordance with the scheduled payment dates. The central risk metric is Cash-Flow-at-Risk (CFaR), computed based on the CorporateMetrics™ methodology, with the CFaR value limit and the maximum hedge ratio being the key limits.

The exposure management horizon is linked with the budget forecast horizon, which varies from three to five consecutive quarters depending on the time of the year.

The Group actively manages its currency exposure by optimising the expected values of cash flows and risk within applicable limits, taking into account expected market developments.

As USD is used in market price quotations for crude oil and petroleum products, it was decided that it is the most appropriate currency for contracting and repaying long-term credit facilities to finance the 10+ Programme, as this would reduce the structural long position, and consequently also the strategic currency risk.

The Group has a structural long position in USD (it benefits from a rise in the USD/PLN exchange rate) as its cash inflows dependent on the USD exchange rate (mainly revenue from sale of petroleum products) are higher than the corresponding cash outflows (e.g. on purchase of crude oil, credit facility repayments).

Under the EFRA Project, the Group concluded EUR/USD currency contracts designed to hedge EUR-denominated capital expenditure against USD as the main financing currency.

Open currency contracts as at December 31st 2016

Open currency contracts as at December 31st 2015

28.3.1 Sensitivity analysis: market risk related to currency exchange movements

Currency structure of selected financial instruments as at December 31st 2016

Currency structure of selected financial instruments as at December 31st 2015

For the purposes of sensitivity analysis, the currency structure presented above also accounts for intercompany foreign currency transactions sensitive to changes in foreign exchange rates, which affect the Group’s currency risk in accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates with respect to recognition of relevant foreign exchange gains or losses in the Group’s net profit or loss.

Apart from currency spots, forwards and swaps, the Group held foreign-currency derivatives, including commodity swaps, commodity options, interest-rate swaps and futures. Depending on the type of derivative, the Group applies the appropriate method of fair value measurement, which also determines the method of calculating the effect of changes of foreign exchange rates on the value of individual derivatives (for more detailed information on the derivative measurement methods, see Note 7.24). The tables below, presenting sensitivity of financial instruments to currency risk as at December 31st 2016 and December 31st 2015, also present the effect of currency rate movements on the carrying amounts of the derivative financial instruments.

Analysis of the sensitivity to currency risk as at December 31st 2016, showing the effect of a +/- 12.9% change in the USD/PLN exchange rate and a +/- 7.375% change in the EUR/PLN exchange rate on net profit or loss

The above deviations of carrying amounts in the złoty that are dependent on currency exchange rates were calculated on the basis of the implied annual exchange rate volatility for December 31st 2016, which was 12.9% for USD/PLN and 7.375% for EUR/PLN, as published by Reuters. The sensitivity analysis was performed with reference to the balance of instruments held as at December 31st 2016.

Analysis of the sensitivity to currency risk as at December 31st 2015, showing the effect of a +/- 10.675% change in the USD/PLN exchange rate and a +/- 6.9% change in the EUR/PLN exchange rate on net profit or loss

The above deviations of carrying amounts in the złoty that are dependent on currency exchange rates were calculated on the basis of the implied annual exchange rate volatility for December 31st 2015, which was 10.675% for USD/PLN and 6.9% for EUR/PLN), as published by Reuters. The sensitivity analysis was performed with reference to the balance of instruments held as at December 31st 2015. The purpose of taking a different approach to calculating the percentage change in exchange rates in 2015 was to better reflect the fluctuations in exchange rates on financial markets.

28.4 Interest rate risk

The Parent is exposed to the risk of changes in cash flows caused by interest rate movements as interest income and interest expense related to certain assets and liabilities accrue based on floating interest rates, including in particular investment credit facilities under the 10+ Programme and the EFRA Project, as well as the financing and refinancing credit facility where the amount of interest is computed by reference to the floating LIBOR USD rate. The Parent manages the interest rate risk within the granted limits using interest rate swaps.

In a long-term perspective, a partial risk mitigation effect was achieved through the choice of the fixed interest rate for a tranche of the term facility contracted to finance the 10+ Programme.

Open interest rate contracts as at December 31st 2016

In the table above, IRS contracts are aggregated according to the currency of the notional amount and the reference rate. The “Period” column shows the earliest start date and the latest end date of the period for contracts classified in a given group.

Open interest rate contracts as at December 31st 2015

28.4.1 Sensitivity analysis: market risk related to interest rate movements

Analysis of the sensitivity to interest rate risk as at December 31st 2016, assuming a +/- 0.35% change in interest rates

Analysis of the sensitivity to interest rate risk as at December 31st 2015, assuming a +/- 1.14% change in interest rates

The sensitivity analysis was performed for the balance of instruments held as at December 31st 2016 and December 31st 2015. The effect of the interest rate changes on the fair value was examined assuming that the currency exchange rates remain unchanged. In the case of derivative instruments held as at December 31st 2016 and December 31st 2015, for the purpose of the interest rate sensitivity analysis the interest rate curve was moved up or down by the historical annual volatility for December 31st 2016 and December 31st 2015, calculated based on historical volatility data for interest rates on interest rate swaps expiring in two years and three years, respectively, as published by Reuters.

28.5 Liquidity risk

The liquidity risk management process at the Group consists in monitoring projected cash flows and the portfolio of financial assets and liabilities, matching maturities of the assets and liabilities, analysing working capital, and optimising cash flows within the Group. This process requires that units operating in different business areas closely cooperate in activities undertaken in order to ensure safe and effective allocation of the liquidity.

The majority of the Group’s Polish subsidiaries participate in a real cash-pooling arrangement, whereby the Parent manages the structure on an on-going basis to optimise liquidity and interest balances.

In the period covered by the budget, liquidity is monitored on an ongoing basis across the Group as part of the financial risk management. In the mid- and long term, it is monitored as part of the planning process, which helps to develop a long-term financial strategy. 

In the area of financial risk, in addition to active management of market risk, the Group observes the following liquidity management rules:

• no margins in derivative financial instrument trading on the OTC market,
• limited possibility of early termination of financial transactions,
• limits for low-liquidity spot financial instruments,
• credit limits for counterparties in financial and trade transactions,
• ensuring adequate quality and diversification of available financing sources,
• internal control processes and organisational efficiency facilitating prompt contingency response.

Contractual maturities of financial liabilities as at December 31st 2016 and December 31st 2015 are presented below.

Contractual maturities of financial liabilities