Alcoa 2006 Annual Report Download - page 36

Market Risks and Derivative Activities
In addition to the risks inherent in its operations, Alcoa is
exposed to financial, market, political, and economic risks.
The following discussion provides information regarding
Alcoa’s exposure to the risks of changing commodity prices,
foreign exchange rates, and interest rates.
Alcoa’s commodity and derivative activities are subject to
the management, direction, and control of the Strategic Risk
Management Committee (SRMC). The SRMC is composed
of the chief executive officer, the chief financial officer, and
other officers and employees that the chief executive officer
selects. The SRMC reports to the Board of Directors on the
scope of its activities.
The interest rate, foreign currency, aluminum and other
commodity contracts are held for purposes other than trad-
ing. They are used primarily to mitigate uncertainty and
volatility, and to cover underlying exposures. The company
is not involved in energy-trading activities, weather
derivatives, or other nonexchange commodity trading activ-
ities.
Commodity Price Risks—Alcoa is a leading global
producer of primary aluminum and aluminum fabricated
products. As a condition of sale, customers often require
Alcoa to enter into long-term, fixed-price commitments.
These commitments expose Alcoa to the risk of higher
aluminum prices between the time the order is committed
and the time that the order is shipped. Alcoa also sells
aluminum products to third parties at then-current market
prices and is exposed to the risk of lower market prices at
the time of shipment. Alcoa uses futures and options con-
tracts, totaling approximately 595 kmt at December 31,
2006, to reduce the aluminum price risk associated with a
portion of these fixed-price firm commitments. The effects
of this hedging activity will be recognized in earnings over
the designated hedge periods, generally within three years.
Alcoa has also entered into futures and options contracts,
totaling approximately 767 kmt at December 31, 2006, to
hedge a portion of future production. The effect of this
hedging activity will be recognized in earnings over the
designated hedge periods in 2007 to 2011.
Alcoa has also entered into futures contracts to minimize
its price risk related to other customer sales and pricing
arrangements. Alcoa has not qualified these contracts for
hedge accounting treatment, and therefore, the fair value
gains and losses on these contracts are recorded in earnings.
These contracts totaled 206 kmt at December 31, 2006. In
addition, Alcoa has power supply and other contracts that
contain pricing provisions related to the LME aluminum
price. The LME-linked pricing features are considered
embedded derivatives. A majority of these embedded
derivatives have been designated as hedges of future sales of
aluminum. Gains and losses on the remainder of these
embedded derivatives are recognized in earnings.
The net mark-to-market earnings impact from aluminum
derivative and hedging activities was a gain of $9 in 2006.
Alcoa purchases natural gas, fuel oil, and electricity to
meet its production requirements and believes it is highly
likely that such purchases will continue in the future. These
purchases expose the company to the risk of higher prices.
To hedge a portion of these risks, Alcoa uses futures and
forward contracts. The effects of this hedging activity will
be recognized in earnings over the designated hedge periods,
generally within five years.
Financial Risk
Interest Rates—Alcoa uses interest rate swaps to help
maintain a strategic balance between fixed- and floating-rate
debt and to manage overall financing costs. For a portion of
its fixed-rate debt, the company has entered into pay float-
ing, receive fixed interest rate swaps to effectively change the
fixed interest rates to floating interest rates.
Currencies—Alcoa is subject to exposure from fluctua-
tions in foreign currency exchange rates. Foreign currency
exchange contracts may be used from time to time to hedge
the variability in cash flows from the forecasted payment or
receipt of currencies other than the functional currency.
These contracts cover periods consistent with known or
expected exposures, generally not exceeding three years.
Fair Values and Sensitivity Analysis—The following
table shows the fair values of outstanding derivative con-
tracts at December 31, 2006 and the effect on fair values of
a hypothetical change (increase or decrease of 10%) in the
market prices or rates that existed at December 31, 2006:
Fair value
gain/(loss) Index change of + / - 10%
Aluminum $(453) $146
Interest rates (111) 57
Other commodities,
principally energy related (134) 62
Currencies 91 4
Aluminum consists of hedge contracts with gains of
$105. This is mostly offset by losses on embedded
derivatives in power contracts in Iceland and Brazil and our
share of losses on hedge contracts of Norwegian smelters
that are accounted for under the equity method.
Material Limitations—The disclosures with respect to
commodity prices, interest rates, and foreign exchange risk
do not take into account the underlying commitments or
anticipated transactions. If the underlying items were
included in the analysis, the gains or losses on the futures
contracts may be offset. Actual results will be determined by
a number of factors that are not under Alcoa’s control and
could vary significantly from those factors disclosed.
Alcoa is exposed to credit loss in the event of non-
performance by counterparties on the above instruments, as
well as credit or performance risk with respect to its hedged
customers’ commitments. Although nonperformance is
possible, Alcoa does not anticipate nonperformance by any
of these parties. Contracts are with creditworthy counter-
parties and are further supported by cash, treasury bills, or
irrevocable letters of credit issued by carefully chosen banks.
In addition, various master netting arrangements are in
place with counterparties to facilitate settlement of gains
and losses on these contracts.
See Notes A, K, and X to the Consolidated Financial
Statements for additional information on derivative instru-
ments.
34