Alcoa 1999 Annual Report Download - page 37

Other Income/Foreign Currency — Other income totaled $124
in 1999, down $25 from 1998. The decline was due to a $57 decline
in interest income, a negative swing in foreign exchange and lower
gains from asset sales. Offsetting a portion of these negative factors
were gains from marking to market certain aluminum commodity
contracts versus losses in 1998. In 1998 from 1997, other income fell
9% to $149. The majority of the change was due to increased losses
from marking to market aluminum commodity contracts and lower
interest income. Offsetting a portion of these negative factors were
increased gains related to asset sales, higher equity income and a
positive swing in foreign exchange.
Exchange gains (losses) included in other income were $(18.7)
in 1999, $(3.7) in 1998 and $(9.8) in 1997. The total impact on net
income, after taxes and minority interests, was $(8.3) in 1999,
$(8.0) in 1998 and $6.9 in 1997.
In July 1999, the Brazilian real became the functional currency
for translating the financial statements of Alcoa’s 59%-owned
Brazilian subsidiary, Alcoa Aluminio (Aluminio). Economic factors
and circumstances related to Aluminio’s operations had changed
significantly since the devaluation of the real in the 1999 first quarter.
Under
SFAS 52, ‘‘Foreign Currency Translation,’’ the change in these
facts and circumstances required a change to Aluminio’s functional
currency.Asaresult,atJuly1,1999,Alcoa’sshareholders’equity
(cumulative translation adjustment) and minority interests were
reduced by $156 and $108, respectively. These amounts were driven
principally by a reduction in fixed assets. This reduction resulted
in a $15 decrease in Aluminio’s depreciation expense for 1999.
Minority Interests — Minority interests’ share of income from
operations rose 2% from 1998 to $242. The increase was due to
higher earnings at Alcoa of Australia (AofA) and
AFL , partly offset
by lower earnings from Alcoa World Alumina L.L.C. For 1998,
minority interest fell 11% to $238, as lower earnings at Aluminio
and AofA were partly offset by improvements at
AFL .
Risk Factors
In addition to the risks inherent in its operations, Alcoa is exposed
to financial, market, political and economic risks. The following
discussion, which provides additional detail regarding Alcoa’s expo-
sure to the risks of changing commodity prices, foreign exchange
rates and interest rates, includes forward-looking statements that
involve risk and uncertainties. Actual results could differ materially
from those projected in these forward-looking statements.
Commodity Price Risks — Alcoa is a leading global producer of
aluminum ingot and aluminum fabricated products. As a condition
of sale, customers often require Alcoa to commit to fixed-price
contracts that sometimes extend a number of years into the future.
Customers will likely require Alcoa to enter into similar arrangements
in the future. These contracts expose Alcoa to the risk of fluctuating
aluminum prices between the time the order is accepted and the
time that the order ships.
In the U.S., Alcoa is net metal short and is subject to the risk of
higher aluminum prices for the anticipated metal purchases required
to fulfill the long-term customer contracts noted above. To hedge
this risk, Alcoa enters into long positions, principally using futures
and options. Alcoa follows a stable pattern of purchasing metal;
therefore, it is highly likely that anticipated metal requirements will
be met. At December 31, 1999 and 1998, these contracts totaled
approximately 465,000 mt and 933,000 mt, respectively. These
contracts act to fix the purchase price for these metal purchase
requirements, thereby reducing Alcoa’s risk to rising metal prices.
A hypothetical 10% change from the 1999 year-end, three-month
LME aluminum ingot price of $1,650 per mt would result in a pretax
gain or loss to future earnings of $77 related to all of the futures
and options contracts noted above. However, it should be noted
that any change in the value of these contracts, real or hypothetical,
would be significantly offset by an inverse change in the value of
the underlying metal purchase transactions.
Earnings were selected as the measure of sensitivity due to the
historical relationship between aluminum ingot prices and Alcoa’s
earnings. The hypothetical change of 10% was calculated using a
parallel shift in the existing December 31, 1999 forward price curve
for aluminum ingot. The price curve takes into account the time
value of money, as well as future expectations regarding the price
of aluminum ingot.
The futures and options contracts noted above are with credit-
worthy counterparties and are further supported by cash, treasury
bills or irrevocable letters of credit issued by carefully chosen banks.
The expiration dates of the options and the delivery dates of the
futures contracts noted above do not always coincide exactly with
the dates on which Alcoa is required to purchase metal to meet its
contractual commitments with customers. Accordingly, some of
the futures and options positions will be rolled forward. This may
result in significant cash inflows if the hedging contracts are ‘‘in-the-
money’’ at the time they are rolled forward. Conversely, there could
be significant cash outflows if metal prices fall below the price of
contracts being rolled forward.
Alcoaalsohad21,000mtand29,000mtoffuturesandoptions
contracts outstanding at year-end 1999 and 1998, respectively,
that cover long-term, fixed-price commitments to supply customers
with metal from internal sources. Accounting convention requires
that these contracts be marked to market, which resulted in after-
tax gains of $12 in 1999 and charges of $45 in 1998 and $13 in 1997.
A hypothetical 10% change in aluminum ingot prices from the
year-end 1999 level of $1,650 per mt would result in a pretax gain or
loss of $3 related to these positions. The hypothetical gain or loss
was calculated using the same model and assumptions noted earlier.
Alcoa sells products to various third parties at prices that are
influenced by changes in
LME aluminum prices. From time to time,
the company may elect to hedge a portion of these exposures to
reduce the risk of fluctuating market prices on these sales. Towards
this end, Alcoa may enter into short positions using futures and
options contracts. At December 31, 1999, these contracts totaled
244,000 mt. These contracts act to fix a portion of the sales price
relatedtothesesalescontracts.Ahypothetical10%changeinalumi-
num ingot prices from the year-end 1999 level of $1,650 per mt would
result in a pretax gain or loss of $29 related to these positions. The
hypothetical gain or loss was calculated using the same model and
assumptions noted earlier.
Alcoa also purchases certain other commodities, such as fuel oil,
natural gas and copper, for its operations and enters into futures and
options contracts to eliminate volatility in the prices of such products.