Risk management report

Risk management does not seek to entirely remove all of the possible sources of losses to our business. Indeed, conducting any business requires that the company bear a certain level of risk. Our goal is to achieve an acceptable balance between the potential risks to our business and the potential gains by taking on these risks. Risks must be analysed, and employees must be equipped with the tools needed to manage these risks. In this context, the key aspect of risk management is analysing possible sources of profit with a view to whether or not the risk involved is justified and, most importantly, manageable.

2009 achievements

We recognise the importance of a systemic approach to risk management in our business; our aim is to identify and analyse risks, understand the connections between different risks and provide the tools necessary to manage risks organisation-wide.

In 2009 EuroChem began to systematize its risk management. This began with structural changes and the creation of a risk management desk in our Finance Department. The risk officer is responsible for developing a methodological platform for systematic risk management, facilitating cooperation between participants in the process, identifying and classifying risks and creating a reporting process to measure the success of our risk management.

Plans for 2010

The year ahead will focus on implementing several important elements of risk management:

• Development of effective methods for quantitative evaluation of financial risks. Traditional approaches using historical data (VAR, correlation analysis) are not adequate to correctly evaluate potential risks. An alternative method for analysing financial risks involves stress-testing and developing appropriate hedging strategies to eliminate financial threats to our business.
• Implementation of risk reporting by business segment as dictated by our corporate risk management standards. The process of managing ongoing and key risks is discussed below.
• Optimization of business processes that involve unnecessary risk. In 2010 we will focus on creating a map of the Company’s business processes, paying special attention to areas where different processes interact, which is frequently a source of information gaps, incompatibilities and other sources of risk.

Our approach to risks

We classify risks into three key categories: strategic, financial and operational risks. A fourth class of risks is reputational risks, which do not arise on a stand-alone basis but may result from any of the three main risk categories. Reputational risks are viewed as a separate category due to their potential influence on the business and the tools available to manage them.

Below we discuss the key business risks that EuroChem faces, along with mitigation strategies, in accordance with the system of qualification described above. A more detailed discussion of some of our financial and operating risks is also included in Notes 30 and 31 to the audited IFRS financial statements, which are part of this annual report.

Our strategic risks

• New capacity additions. New fertilizer production capacities in regions with low natural gas costs (Middle East) could lead to increased competition in the nitrogen segment; in phosphates, significant new capacity additions (Ma’adden, Bayovar) could have negative impacts on the supply/demand balance in the segment; new players in potash, from global mining conglomerates to the governments of major potash-importing countries, could have a similar effect on the potash market. Our risk management in this area focuses on securing access to low-cost raw materials, lowering our own production costs, installing energy-saving technologies and optimization of logistics.
• Unfavourable industry structure. Fragmented supply and large-scale wholesale distributors reduce the margins of fertilizer producers and increase fertilizer price volatility. Consolidation of competitors in the sector will possibly move EuroChem further up the global cost curve. Such risks are addressed by implementing various measures that reduce our production and delivery costs.
• Decrease/stagnation in demand. While fertilizers are vital for feeding the world’s population, there are some factors that may cause global fertilizer demand to stagnate or even decrease. These may include factors such as global climate change, expansion of genetically modified crops, less resourceintensive diets, less spending on biofuels, and changes in fertilizer subsidy programmes. Such factors could lead to a long-term decrease in the global demand for fertilizers. We seek to mitigate this risk through product flexibility and by entering new markets with high fertilizer consumption potential, which allow us to adapt our product mix to changing needs across different markets.
• Declining feedstock disparity. Reduced price disparity for natural gas and phosphate rock between EuroChem and the rest of the world reduces some of our competitive advantages. We manage this risk through seeking to apply a vertically integrated business model wherever possible and diversifying our production portfolio.
• Unfavourable other costs disparity. Faster growth of other domestic costs such as rail tariffs, electricity, labour, RUR/US$ exchange rate, export duties etc. relative to the rest of the world reduces our competitiveness. We mitigate this risk by reducing production costs, developing more optimal logistics and diversifying market outlets. We also evaluate various hedging strategies which may help us reduce this risk.
• Results of investment decisions. Misguided investment decisions could lead to incorrect allocation of resources and eventual losses. We mitigate this risk by implementing a robust project investment decision process, which carefully evaluates market trends and all available alternatives.
• CAPEX financing. We have a sizeable capital expenditure programme of over US$ 4.5bn over the next five years. This programme may not be fully financed out of the company’s expected operating cash flows, hence it may require sources of financing other than our own cash flows. Our inability to secure such sources of financing at a competitive cost might have a negative effect on our investment programme. This risk is mitigated by ensuring that the company’s creditworthiness remains robust and that we have at our disposal as many financing alternatives as possible over the next five years.
• Other strategic risks that are continuously evaluated by us include regulatory risks and the risk of trade barriers.

Our financial risks

• Product price risks. Declines in fertilizer prices due to a wide array of factors leads to a decline in sales. We mitigate these risks by seeking to reduce production costs, and are considering raw materials derivatives for natural gas and chemical fertilizers.
• Financial investments. As the largest shareholder in K+S AG, we are potentially exposed to declines in the value of K+S AG shares. At this stage, EuroChem has chosen not to hedge this risk through derivatives given that the objective of the investment was to gain economic exposure to potash.
• Foreign currency risk. A significant portion of EuroChem’s revenues come from export sales denominated in US dollars. The company’s expenses, other than servicing its dollardenominated debt, are almost entirely in roubles. Changes in dollar/rouble rates may have positive or negative effects on our profitability and debt burden. Our objective in managing this risk is to minimize the volatility of EuroChem’s cash flows arising from fluctuations in foreign exchange rates. To do so we have access to a variety of derivative instruments such as forward currency contracts and option strategies. We perform regular evaluation of the cash flow at risk. As of now we have opted for a “natural hedge” which matches the dominant currency of our revenues with that of our borrowings (the US dollar).
• Interest rate risk. EuroChem is exposed to interest rate risk due to the fact that the majority of its loans have floating interest rates tied to Libor. The company constantly evaluates its exposure to variable interest rates and the use of interest rate swaps. As of the year-end we chose to leave the bulk of our borrowings at a floating rate given the outlook for US dollar interest rates.
• Liquidity risk. Short-term liquidity risks could arise in the event of a sudden drop in sales. We have both committed and uncommitted credit lines with banks to offset liquidity shortfalls if need be. A sharp liquidity gap, if not covered by such credit lines or other alternatives, could be compensated through a sale of liquid investments. We constantly monitor working capital levels to ensure we maintain a comfortable level of liquid assets.
• Financial covenants. Documentation for loan agreements, including our Eurobonds and pre-trade finance syndicated loan facility, contain certain covenants that dictate we maintain certain ratios, such as net debt/ EBITDA. The company mitigates the risk by ensuring that an internal process is in place for monitoring covenant compliance, including an early warning system.
• Other financial risks that we continuously monitor include credit risk, material costs and material tax risks.

Our operational risks

• Business interruption. Equipment failure or breakdowns at one of our plants or mines could lead to a significant decrease in production. We seek to mitigate this category of risks through a programme of maintenance and capital repairs, and a long-term programme of capital investments and renovations. In addition to maintenance and renovations, we conduct regular personnel training to develop the skills and knowledge necessary to operate plant equipment. Business interruption insurance is also available if necessary.
• Health, safety and environment. We regularly review our HSE procedures, including those which apply to emergency situations. Our ISO certifications for quality management, environmental management and health & safety management demonstrate the robust systems we have in place to mitigate such risks.
• Fraud. EuroChem seeks to build its business processes in such a way that fraud risks are minimized. Additionally, the company’s internal audit service regularly monitors the activities of its operating units. Purchases are conducted through a tender process, which includes a series of strict requirements for potential suppliers of goods and services.
• Sub-optimal purchases. The major risk factors include redundant or insufficient purchases due to a lack of process control, inadequate planning, and poor quality data on existing inventories. Our risk management is aimed at regular quality evaluation of purchase planning, improvements of counterparty compliance procedures and implementation of a software solution that minimizes the risk of human error.
• Sub-optimal sales. Losses due to exposure to a limited group of customers, short-term nature of contracts etc. We mitigate this risk by diversifying our customer base and expanding our finished goods storage capacity.
• Other operational risks. We monitor and manage other risks, which include possible losses of physical assets, risks of investment project management (construction/installation works risk), non-optimal logistics, lack of insurance coverage, legal (including license) risks.

Our reputational risks

Our reputation is one of our most valuable assets, which enables us to increase profits and which must be carefully protected. Mass media and communications mean that any company is highly exposed to the influence of reputational risks. Reputational risks arise from any one or any combination of the other risks listed above. Damage to our reputation is seen as the inability to adequately manage risks by the company. While every individual risk may affect certain processes or certain business units, there is always an element of reputational risk involved. Moreover, the reputational aspects of numerous risks may be more of a threat to the company than the initial risks involved. Timely and accurate communications are important mitigants to reputational risk, and in addition to existing public relations and government relations functions, we added a new investor relations desk in 2009.

We fully understand the importance of maintaining our reputation, and seek to monitor and mitigate the risks discussed above to minimize the risk of reputational risks arising.