PETRONAS GAS BERHAD

1. Background
Petronas Gas Berhad (PETGAS) was founded in 1983 as a wholly-owned subsidiary of
PETRONAS based in Kuala Lumpur, Malaysia and went public on the Bursa Malaysia primary
market on 4 September 1995. PETRONAS owns 60.66% of the company, with the balance
shares held by institutional investors and regular investors. PGB is a Malaysian company that
specializes in extracting energy resources into its constituent parts, as well as storing, shipping,
and exporting those parts. Plant Operations Division (POD), Transmission Operations Division
(TOD), Centralized Utility Facilities Division (CUF), and Technical and Facilities
Development Division are the divisions that make up PGB (Petronas Gas Berhad 2016).

In Malaysia, the company has various natural gas processing units capable of processing
roughly 2000 million standard cubic feet of natural gas per day. Natural gas will be absorbed
from offshore structures outside of Malaysia and processed into lucrative natural gas products
such as gas, ethane, propane, and butane. Products are delivered to clients via the parent
company's network. It also contains Peninsular Malaysia's largest natural gas pipeline network,
with a total length of around 2551 kilometers. Miri and Bintulu are two countries with well-
developed distribution networks. Then it converts customers to natural gas transit between
Malaysia and Singapore (Petronas Gas Berhad 2016).

Customers are charged a transportation cost for supplying gas throughout Malaysia. This part's
revenue in 2016 was 1.3 billion ringgits, with a gross profit of RM975.3 million. In addition,
the corporation has a number of factories that supply power and other commodities. Pumping
station, nitrogen generation unit, air separation unit, and cogeneration plant are the four
factories in Kertih, Pahang, Terengganu, and Gerbang. This division's revenue in 2016 was
RM1.07 billion, with a gross profit of RM155.9 million. Finally, the corporation owns an LNG
Regasification Terminal with a capacity of 530mmscfd for regasification. In 2016, this part's
revenue was RM631 million, with a gross profit of RM286.3 million (I3 LLC 2022).

2. All of the risk exposure of your company with supporting facts and logical estimation.

2.1 Credit Risk

First risk exposure to Petronas Gas is credit risk. Credit risk is the uncertainty of loss from the
failure of any party to follow the terms and conditions of the financial contract such as failure
to make the payments on loans (GDSLink 2021). The company exposure to credit risk arises
from their operating activities especially from their receivables from customers and fund
investments.

Usually the maximum exposure to credit risk in this company is arising from trade receivables
that are represented by the amounts in the statement of financial position. At the end of the
reporting period, the company can determine whether the financial assets carried at amortized
cost are credit-impaired. This company had recognised and measured the impairment loss by
using PETRONAS Credit Risk Rating system to measure Expected Credit Loss (ECLs) of trade
receivables.

ECLs for trade receivables in the company are categorized in 3 credit risk ratings which are
low, medium and high risk rating. At 31 December 2020, medium risk rating is having the
highest carrying amount, RM479,150,000 which contains ⅔ of the total on trade receivables
(Appendix 1). The representation of trade receivable in this company are holding company,
joint ventures, related company and related parties while related company is the largest trade
receivable in this company at the end of 31 December 2020. However, in 2020 there is still no
bad debt which means all of the trade receivable still does not exist the due date for the
repayment (Appendix 2).

Secondly, Petronas Gas is also exposed to counterparty credit risk from financial institutions
through fund investments activities. Since financial instruments have low risk of default, the
borrower can have strong capacity to meet its contractual cash flow obligation but it will not
necessarily. It has the probability to reduce the ability of the borrower to fulfill the cash flow
obligation. Although the credit risk on financial instruments is considered low, the company
assumes there is a significant rise in credit risk when it is past due.

This shows that Petronas Gas had been exposed to credit risk due to the receivables and fund
investment activities. Credit risk might bring a negative impact to the company such as
reducing the company’s profitability. This is because receivable is the amount that should be
received by the company but if the party refused to pay this amount at the specified date, the
company is considered to lose money which reduces the profitability.
2.2 Interest rate risk

Interest rate risk is an uncertainty that arises due to the fluctuations in interest rate (Moorad
2001). The value of Petronas Gas’s liabilities, financial assets or expected future cash flow
could be adversely affected by the fluctuations of interest rate.

The investments of Petronas Gas in fixed rate debt instruments are exposed to a risk of change
in their fair value due to the movements in interest rates. About RM257.1 million of fixed rate
financial assets are subject to the interest rate risk in 2020 (Appendix 3). The interest rate risk
will directly affect the value of Petronas Gas’s fixed-rate assets. The value of the fixed rate
assets has an inverse relationship with the interest rate (Joshua 2022). Therefore, the value of
Petronas Gas’s fixed rate assets will decline when the interest rate increases as the opportunity
cost of holding these assets increases. The cost of missing out on a better investment is higher.

Besides that, the fixed rate liabilities of Petronas Gas are also exposed to a risk of higher
borrowing costs due to the fluctuation in interest rate. There is about RM3.28 billion of fixed
rate financial liabilities exposed to the interest rate risk in 2020 (Appendix 3). The interest rate
risk is not expected to have any material impacts on profit or loss of Petronas Gas.However,
the cost of borrowing on fixed rate liabilities seems more expensive compared to variable rate
of liabilities when the interest rate is reduced. According to the annual report of Petronas Gas
in 2020, it mentioned that Petronas Gas is required to pay a fixed profit rate from 2.03% to
3.74% for Sukuk Murabahah which is a fixed rate financing facility obtained by Petronas Gas
(Appendix 4). Furthermore, Petronas Gas was also required to pay interest at rates ranging
from 7.2% to 9.1% per annum for lease liabilities which were included in fixed rate liabilities
(Appendix 5). In 2020, OPR rate was reduced to 1.75% which is the lowest on record and
therefore the interest rate of floating rate borrowing is much lower compared to the interest rate
for fixed rate borrowings which bears up to 9.1%. As a result, Petronas Gas is obliged to pay a
fixed interest payment which is more expensive compared to the variable interest payment
which is cheaper when there is a decrease in interest rate.

Moreover, the floating rate financial assets of Petronas Gas are also exposed to a risk of change
in their interest income from the investments due to the fluctuation in interest rate. There is
about RM3.14 billion of floating rate financial assets exposed to the interest rate risk in 2020
(Appendix 1). The interest rate risk will directly affect the interest income of Petronas Gas and
hence affect their investment return. Therefore, when the interest rate is reduced which is
unfavorable to Petronas Gas’s floating rate financial assets will reduce the interest income of
Petronas Gas. Starting from July 2020, the OPR rate has been reduced to 1.75% which is the
lowest on record (Appendix 6). Based on Petronas Gas’s annual report in 2020, the interest
income in 2020 was reduced to RM106.2 million from RM140.4 million in 2019 (Appendix
7). As a result, the interest income of Petronas Gas in 2020 is lower compared to interest income
in 2019 due to the decrease in OPR rate.

In addition, Petronas Gas’s variable rate borrowings are subject to the risk of cash flow change
due to interest rate fluctuations. There is no floating rate borrowing in 2020 which is exposed
to interest rate risk and therefore we use floating rate borrowing in 2018 to explain this interest
rate risk. Approximately RM1.79 billion of floating rate borrowing in 2018 are subject to
interest rate risk (Appendix 8). The interest rate risk will directly affect the cost of borrowing
of Petronas Gas and hence affect the profit. The borrowing cost of variable rate borrowing will
increase when the interest rate increases. This will increase the cost of Petronas Gas and hence
reduce the profit. In November 2017, the OPR was increased from 3% to 3.25% and has
maintained this rate until 2019 (Appendix 9). Due to the increase in OPR in the end of 2017,
the financing cost of variable rate borrowings has been increased from about RM12 million to
RM78 million although the amount of floating rate borrowing in 2017 and 2018 does not differ
much (Appendix 8 and Appendix 10). Moreover, the profit of Petronas Gas has also been
adversely affected which reduced from RM1.7 billion in 2017 to RM1.6 billion in 2018
(Appendix 11). Part of the reasons for profit reduction in 2018 is due to the increase in
borrowing cost of floating rate borrowing.

2.3 Foreign exchange risk

Third risk exposure to Petronas Gas is foreign exchange risk. Foreign exchange risk is the
uncertainty that international financial transactions or investment may lose money owing to
currency movements involved (Harpreet 2020). This risk can arise when there are any
economic conditions such as inflation or recovery of the economy. For example, when there is
an increase in interest rate in the US, the value of USD strengthens which leads people to spend
more home currency to buy 1 USD.
Usually the maximum exposure to foreign exchange risk arises when they enter into the
transactions that are not denominated in their respective functional currencies, or when foreign
currency monetary assets and liabilities are converted at the reporting date. At the end of the
reporting period, the company can determine whether the residual net positions are actively
managed and monitored against prescribed policies and control procedures of the company.
The company will only enter into derivative financial instruments to hedge and minimize its
exposures when the foreign currency movements deemed necessary and appropriate (Petronas
2020).

As of 31 December 2020, we can see that the USD net exposure asset is RM262,056 meanwhile
the liability denominated in USD exposed to foreign exchange risk is RM1,599,738 (Appendix
12). This shows that the exposure risk of foreign exchange risk in liability is much higher than
the asset as the exposure of liability is almost 6 times of the assets. Although there are no USD
term loan which has been subsequently on-lent to a subsidiary and a joint venture in FY2020
which lead a lower foreign currency monetary liabilities compared to the amount of
RM2,806,222,000 in FY2019, but the USD currency risk exposure still arises for Petronas Gas.

On the other hand, the net exposure of MYR currency is lower compared with the USD
currency risk exposure. From Appendix 13, we can even see there is no exposure risk to
exchange MYR for Petronas Gas in FY2020. This is happening due to Petronas operating
predominantly in Malaysia and transact mainly in MYR, thus they no need to exchange to USD
with the sales or purchases within Malaysia.

This shows that Petronas Gas had been exposed to foreign exchange risk due to the financial
asset and financial liabilities investment activities that were denominated in USD. Foreign
exchange risk might bring a negative impact to the company such as reducing the company’s
revenue. This is because receivables that are denominated in USD may lose value if there is
depreciation in US dollar or appreciation in MYR. While in terms of liabilities, the company
needs to use more MYR to exchange USD to pay the liabilities if the USD appreciates or MYR
depreciates.

3. ONE (1) of the risk exposure that you are able to hedge by using a listed derivative with
appropriate justification.
3.1 Foreign exchange futures contracts
We are going to choose foreign exchange futures contracts to hedge the foreign currency
risk. Foreign exchange futures contracts is also known as currency futures contracts which is
a type of futures contract to exchange a currency for another at the fixed exchange rate on the
specific future date. Since the contract’s value is based on the underlying currency exchange
rate, the currency futures are considered financial derivatives which are cash-settled or
physically delivered when they expire on set dates. While, cash settled methods are settled
daily on a mark to market basis (CMI n.d.).

Foreign exchange futures contracts also contain currency futures margin which refers to how
much the trader must have in their account to open a one-contract trade. This is the money that
is held by the broker to offset any losses that might incur on a trade. Once the trade is closed,
traders will be able to use those funds again (Adam 2021).

Moreover, foreign exchange futures have the same features as other futures that can be used
for hedging purposes. A party who knows they need to foreign currency at the futures for
business purposes or other, but does not want to purchase the foreign currency now, will choose
to buy a foreign exchange futures contract (FX futures). This is because FX futures can help to
hedge the position against the volatility of the exchange rate. At the expiration date, the party
will be guaranteed by the FX futures contract’s exchange rate, and vice versa (CMI n.d.).
3.2 SGX MYR/USD FX Futures

We decided to hedge foreign exchange risk by using SGX MYR/USD FX Futures. It is a

oreign exchange futures contract that is listed in the Singapore exchange limited called “SGX
MYR/USD FX Futures”. This futures is able to hedge most of Petronas Gas’s foreign currency
risk, especially when they have a lot of borrowing which denominated USD in FY2020 and
FY2019. Therefore, Petronas Gas can short SGX MYR/USD FX Futures in order to protect
them from depreciating MYR which causes them to use more MYR to pay the borrowing which
is denominated in MYR. Meanwhile, the contract size is standardized for 500,000 MYR with
the minimum price fluctuation of USD 0.00001 per MYR (Appendix 14). In addition, the
negotiated large trade must be a minimum of 10 lots.

For the final settlement, cash settlement will be made as of the Business Day which is the day
on which trading has ceased in accordance with these specifications, with such update being
made on the following Business Day, subject in all cases to any relevant term in the SGX's
Finance Procedures and its Rules that may affect the timing of such payment. The settlement
basis will be in USD. Furthermore, the final settlement price will be the reciprocal of the Kuala
Lumpur USD/MYR reference rate reported by Bank Negara Malaysia (BNM) and the Financial
Markets Association of Malaysia (FMA) at approximately 3:30pm Kuala Lumpur time on the
last trading day and the result will rounded to 5 decimal places.

3.3 How SGX MYR/USD FX Futures eliminate the foreign currency risk

Based on Petronas Gas annual report, their exposure in foreign currency risk is mainly on
financial liabilities that are denominated in USD. There is RM1,599,738,000 of financial
liabilities denominated in USD are exposed to foreign currency risk which is higher than the
assets in 2020. Meanwhile,when there is a 10% appreciation in USD, Petronas Gas will face a
loss of RM133,768,000 based on the currency risk sensitivity analysis (Appendix 15). Hence,
in this situation Petronas Gas should short SGX MYR/USD FX Futures to eliminate the foreign
currency risk.

The financial liabilities denominated in USD can be hedged by shorting 3,199 contracts of
SGX MYR/USD FX Futures and this will be explained further in the next question. Petronas
Gas is the party to make delivery of USD to pay the financial liabilities which are denominated
in USD. Therefore, Petronas Gas (short position) will hope the USD depreciates, so that
Petronas Gas can use less MYR to exchange USD to pay for the liabilities. Hence, Petronas
Gas will be afraid the USD appreciates or MYR depreciates. Therefore, Petronas Gas should
place a short position in SGX MYR/USD FX Futures. Thus, when MYR depreciates, Petronas
Gas which already shorted the SGX MYR/USD FX Futures has already locked their price at a
higher MYR/USD rate. This means Petronas Gas used lesser MYR to exchange USD compared
to the market.

As a result, if the USD appreciates or MYR depreciates, the profit in SGX MYR/USD FX
Futures can offset the losses in paying financial liabilities when they use more MYR to
exchange USD to pay financial liabilities that are denominated in USD. In contrast, if the USD
depreciates or MYR appreciates, the losses in the SGX MYR/USD FX Futures can be offset
by the profit in paying financial liabilities when they use lesser MYR to exchange USD to pay
the financial liabilities.
Meanwhile, Petronas Gas just wants to hedge their position and hence they will not mind facing
losses in hedging the foreign exchange risk as the losses after hedging is typically smaller than
the losses without hedging. With a hedge position, the profit or losses faced by Petronas Gas
when entering SGX MYR/USD FX Futures will be the same no matter how the MYR or USD
moves (Ahamed Kameel Mydin Meera 2018). Hence, Petronas Gas would not need to worry
about the fluctuation in USD or MYR as the foreign exchange risk will be mitigated by shorting
SGX MYR/USD FX Futures.

4. Discuss how you can mitigate the risk by hedging the derivatives contract with
appropriate illustration and payoff.

Based on Petronas Gas’s 2020 annual report and also as mentioned in the previous part, a total
of RM 1,599,738,000 of “Financial liabilities” is denominated in USD. On 29 March 2022, the
spot rate of MYR/USD was 0.2374 as shown in Appendix 16.

As mentioned, depreciation of MYR or appreciation of USD will lead to a loss to Petronas Gas.
Hence, it is recommended for Petronas Gas to enter into a MYR/USD June 2022 Future
contract to hedge against its position for 3 months, till June 2022. The June future contract for
MYR/USD that recommends Petronas Gas to enter is listed on Singapore exchange (SGX). As
shown in Appendix 17, the MYR/USD June future contract is 23.63800 as it is multiplied by
100. Thus, in simplified form, the MYR/USD June 2022 future contract is MYR/USD 0.23638
(23.63800/100).

Since the contract size is RM500,000 per contract, thus, the number of contracts that will be
entered is 3,199 of MYR/USD June 2022 future contracts. Which means, we will hedge
RM1,599,500,000 of financial liabilities instead of the full exposure of RM1,599,738,000. A
brief table on calculation is shown below.

Total foreign exchange rate exposure RM 1,599,738,000

Contract entered 1,599,738,000 / 500,000 = 3,199.476

*Contract size = RM 500,000 *Enter into 3,199 contracts
 Under Hedged value [(1,599,738,000 - (3,199 x 500,000)]
= RM238,000

Total Hedge 1,599,500,000

Table 1: Calculation for number of contracts entered and total hedge amount

This means that Petronas Gas will be underhedge by RM238,000. With underhedge, it means
the RM238,000 is exposed to the fluctuation in foreign exchange market. We choose to
underhedge instead of overhedge as from Appendix 16, we see there’s potential for
appreciation in MYR which is beneficial for Petronas Gas. Moreover, we had hedged 99.985%
of the total exposure, hence, Petronas Gas is considered safe from fluctuation in MYR/USD in
these 3 months while the RM 238,000 will not cause a severe loss in Petronas Gas.

Payoff diagram

MYR/USD Spot rate as at 29 March 2022 MYR/USD 0.2374

MYR/USD June 2022 Future Contract rate MYR/USD 0.23638

Amount of exposure that will be hedged RM 1,599,500,000

Number of contract entered 3,199

Contract Size RM 500,000

Table 2: Summary of numbers that will be used in calculation

Scenario 1: If the spot rate is MYR/USD 0.26, where MYR appreciate

Action Today Value Maturity Profit/Loss

1. Value of MYR 1,599,500,000 ($379,721,300) $415,870,000 $36,148,700

2. Short 3,199 of MYR/USD futures $378,089,810 ($415,870,000) ($37,780,190)

 ($1,631,490)

Table 3: Effect on Hedging when MYR appreciate

Today Value
1,599,500,000 x 0.2374 = $379,721,300
3,199 x 500,000 x 0.23638 = $378,089,810

Maturity
1,599,500,000 x 0.26 = $415,870,000

Scenario 2: If the spot rate is MYR/USD 0.20, where MYR depreciate

Action Today Value Maturity Profit/Loss

1. Value of MYR 1,599,500,000 ($379,721,300) $319,900,000 ($59,821,300)

2. Short 3199 MYR/USD futures $378,089,810 ($319,900,000) $58,189,810

($1,631,490)

Table 4: Effect on Hedging when MYR depreciate

Today Value
1,599,500,000 x 0.2374 = $379,721,300
3,199 x 500,000 x 0.23638 = $378,089,810

Maturity
1,599,500,000 x 0.20 = $319,900,000

Explanation
Before a detailed explanation, we have to be clear that the purpose of hedging is not to make
profit, but to reduce the volatility in financial statements by taking an opposite position, making
the profit or loss certain. Hence, it is possible to incur a loss in hedging.

In both scenarios shown in the previous part, where after Petronas Gas hedged its foreign
exchange risk exposure of RM1,599,500,000 by entering into a MYR/USD June 2022 futures
contract, the loss is fixed at $1,631,490 regardless of the foreign exchange market movement,
appreciation or depreciation in MYR. The detailed discussion of both scenarios will be
provided below.

As from scenario 1, MYR appreciates from a spot rate of MYR/USD 0.2374 to MYR/USD
0.26 in June 2022, Petronas Gas will gain profit of $36,148,700 from its current position. As 1
MYR can now exchange for $0.26, which is more. However, since Petronas Gas is in a short
position in future contracts, the appreciation in MYR/USD will make it incurred a loss of
$37,780,190 from the future. Not to worry that, the loss will be reduced to $1,631,490 due to
the gain in Petronas Gas’s existing position.

In scenario 1, although Petronas Gas was unable to enjoy the gain when MYR appreciated due
to hedging; however, hedging has also successfully helped Petronas Gas to avoid further huge
losses as shown in scenario 2 when MYR depreciates.

For scenario 2, when MYR depreciates to $0.20 per MYR, Petronas Gas will incur a loss from
its existing position. As 1 MYR can only be exchanged for $0.20, thus, more MYR is needed
to settle the financial liabilities. However, the loss of $59,821,300 can be reduced by the gain
from the June 2022 MYR/USD future contract. As with short positions in future contracts,
when MYR depreciates, PETGAS will earn a profit of $58,189,810. Therefore, at the end of
the day, the loss is fixed at $1,631,490 which is the same as scenario 1, regardless of the
fluctuation of MYR/USD. Important to note that, the loss had been reduced by around 97.2%,
from -$58,189,810 to -$1,631,490 due to hedging.

As a result, hedging can successfully protect Petronas Gas from further loss derived from the
fluctuation of foreign markets. Hedging can avoid Petronas Gas from taking out more MYR to
exchange for USD to pay the financial liabilities when MYR depreciates as shown in scenario
2. Hence, when the loss is fixed at $1,631,490, it is certain Petronas Gas does not need to worry
about the movement in MYR/USD that will cause a huge shrink in its profit.

Nevertheless, since Petronas Gas had underhedge RM238,000, which means this amount will
be exposed to the current fluctuations in the market without the presence of hedging to offset
the position. Without hedging, if in scenario 1, when MYR appreciates, Petronas Gas will gain
profit. While when MYR depreciates, the RM238,000 will incur a loss as it is worth less.
However, for the amount that is hedged (RM1,599,500,000), it will not be exposed to the
foreign exchange market fluctuation as in June 2022, the loss is fixed at $1,631,490. Thus,
hedging can help Petronas Gas to add certainty as the expenses are locked and able to avoid
high fluctuations in foreign exchange market that might lead to a severe loss that affects its
revenue (Hedge trackers 2019).