Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Our activities expose us to a variety of market risks. Our primary market risk exposures relate to foreign exchange, interest rate and commodity risks. To manage these risks and our exposure to the unpredictability of financial markets, we seek to mitigate their impact on our financial performance and capital. Where appropriate, we use derivative financial instruments solely for the purpose of hedging the foreign exchange, interest and commodity risks arising from our operations and sources of finance. For this purpose, a systematic financial and risk management system has been established. We do not enter into derivative financial instruments for speculative purposes.
The following discussion and analysis only addresses our market risk and does not address other financial risks that we face in the normal course of business, including credit risk and liquidity risk.
Interest Rate Risk
Interest rate risk management aims to protect consolidated net income from negative effects from market interest rate fluctuations. Orion is exposed to interest rate risk which might arise from incurring new liabilities due to higher interest rates. We also have Term Loans which are variable interest rate instruments, that exposes us to market risk arising from changes in the yield curve. Appropriate hedging instruments are in place to mitigate the exposure arising from increasing interest rates.
The table below shows the sensitivity of the interest expense to changes in the interest rate, after the impact of hedge accounting. It shows the change resulting from a hypothetical fluctuation in the three-month LIBOR of 50 basis points (0.50%) as of December 31, 2021 assuming that all other variables remain unchanged. For example, changes in USD/EUR currency rate would have an impact on our interest exposure and vice versa. Changes in interest rates would also have a related impact on our foreign currency (USD) exposure. The sensitivity analysis assumes that the hypothetical interest rate was valid and that the Revolving Credit Facility was utilized in the full amount over the course of the entire year.
The effect of this hypothetical change in the interest rate of the variable rate loan on our consolidated Income before earnings in affiliated companies and income taxes ("income before taxes" in this section) for the year ended December 31, 2021 is as follows:
December 31, 2021
Increase by 0.50% Decrease by 0.50%
In millions
(Increase) decrease in interest expense $ (5.6) $ 1.5
Increase (decrease) in equity (cash flow hedge reserve) 1.9 (1.1)
Increase (decrease) in total comprehensive income before taxes 7.5 (5.8)
The above table does not include the impact of hedges.
Foreign Currency Risk
A significant portion of our reporting entities use the euro as their functional currency. Our reporting currency is the U.S. dollar. The translation gains or losses that result from the process of translating the euro denominated financial statements to U.S. dollars are deferred in Accumulated other comprehensive income until such time as those entities may be substantially liquidated or sold. Changes in the value of the U.S. dollar relative to the euro can therefore have a significant impact on Comprehensive income.
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Orion Engineered Carbons S.A
The table below shows the sensitivity with regard to the effect of a change in the Euro/U.S. Dollar exchange rate using the outstanding amount and the interest for the U.S. Dollar-denominated Term Loan issued by a 100% wholly owned subsidiary whose functional currency is Euro. A fluctuation of the Euro/U.S. Dollar exchange rate of 10% as of December 31, 2021 with other conditions remaining unchanged, would have the following effect on our Income before earnings in affiliated companies and income taxes:
December 31, 2021
Value of the U.S. Dollar in relation to the Euro (1)
Increase by 10% Decrease by 10%
In thousands
FX gain (loss) in financial result $ 9.3 $ (11.4)
(1) U.S. Dollar/Euro exchange rate as of December 31, 2021: 1.1326.
The above table does not include the impact of hedges.
Some of our operations enter into transactions that are not denominated in their functional currency. This results in an exposure to foreign currency risk, including, but not limited to, third party and intercompany receivables and payables and intercompany loans.
Our policy is to maintain a balanced position in foreign currencies to minimize exchange gains and losses arising from changes in exchange rates. To minimize the effects of our net currency exchange exposures, we enter into foreign exchange contracts and cross-currency swaps. Our net position in foreign currencies is monitored daily.
We maintain risk management control practices to monitor foreign currency risk attributable to our inter-company and third party outstanding foreign currency balances. These practices involve the centralization of our exposure to underlying currencies that are not subject to central bank and/or country specific restrictions. By centralizing most of our foreign currency exposure into one subsidiary, we are able to take advantage of any natural offsets thereby reducing the overall impact of changes in foreign currency rates on our earnings. At December 31, 2021, 2020, and 2019, a 10% fluctuation compared to the U.S. dollar in the underlying currencies that have no central bank or other currency restrictions related to non-hedged monetary assets, net would have resulted in an additional impact to earnings of approximately $8.3 million, $4.2 million, and $11.2 million, respectively.
Interest and other financial expense, net, in the Consolidated Statements of Operations reflected net exchange rate foreign currency losses of $6.4 million, $15.2 million and $3.6 million in 2021, 2020, and 2019, respectively.
Commodity Risk
Commodity risk results from changes in market prices for raw materials, mainly carbon black oil. Raw materials are primarily purchased to meet our production requirements. Pricing and procurement risks are reduced through worldwide procurement and optimized processes to ensure immediate sourcing of additional raw material requirements. Costs for raw materials and energy have fluctuated significantly in past years and may continue to fluctuate in the future. We endeavor to reduce purchasing risks on the procurement markets through worldwide purchasing activities and optimized processes for the purchase of additional raw materials. Raw materials are purchased exclusively to cover our own requirements.
A significant portion of our volume of approximately 70% is sold based on formula-driven price adjustment mechanisms for changes in costs of raw materials. Sales prices under non-indexed contracts are reviewed on a quarterly basis to reflect raw material and market fluctuation. We believe that our contracts enable us to generally maintain our Segment Adjusted EBITDA Margins.
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Orion Engineered Carbons S.A