Chevron's Australian Currency Hedge May be Looking Like Sheer Brilliance

Chevron Corp. (CVX) may end up getting a better deal Down Under than it bargained for.

Chevron owns a 47% stake in Australia’s 43 billion Australian dollar (US$45 billion) Gorgon liquefied-natural-gas project, set to begin production in 2014.

A strengthening Aussie inflates Chevron‘s costs, and the currency has risen by a fifth against the dollar since Gorgon’s construction began in 2009.

But Chevron‘s chief executive said he didn’t expect to hedge this currency exposure. Chevron reasons that the Australian economy, and by extension its currency, relies heavily on commodity prices.

So even if costs rise because of the currency, the concomitant increase in the price of energy offsets this by bolstering Chevron‘s revenue.

This makes sense. Looked at on a quarterly basis over the past decade, moves in the Australian currency’s value against its U.S. counterpart have displayed a 71% correlation with moves in the Dow Jones-UBS Commodity Index.

In fact, Chevron may actually fare better should the Australian dollar weaken and energy prices remain strong. That could happen, because not all commodity prices affect the Aussie dollar in the same way.

Resources accounted for 60.8% of Australia’s exports in 2011 and the Aussie has strengthened in recent years along with China’s appetite for the country’s raw materials.

Commodity exports, however, are weighted toward metals and minerals, rather than energy.

Last year, steel-ingredient iron ore and coal accounted for just over 35% of all Australian exports.

Crude oil and natural gas together accounted for just 7.2%. And while the currency’s correlation with the DJ-UBS Industrial Metals subindex has increased steadily since early 2006, it displays little correlation with crude oil.

That is unlikely to change until LNG exports from Gorgon and other projects increase beyond 2015, making energy a bigger factor in exports.

In the near term, while Gorgon is still being built, Australia’s biggest export items look more vulnerable than energy to price corrections.

Iron-ore prices have fallen this year as supply and demand have parted ways. Worse, Axiom Capital estimates new iron-ore capacity being added globally between 2012 and 2014 equates to 27% of global steel demand last year. More than half of this will be in Australia.

Energy prices are much less dependent on China; the world’s second-largest economy accounts for less than 10% of global oil and gas demand as opposed to more than half for iron ore. Demand for LNG is tied more closely to a shift toward natural gas globally.

One support for the Aussie dollar is recent evidence of it becoming a haven currency. Australia’s 10-year government bond yields have dropped from 5.5% in February 2011 to about 3.4% today.

Investors like the country’s low level of sovereign debt compared with much of the industrialized world.

But this has the makings of a crowded trade as investors chase yield in a relatively small market. Already, that yield has snapped back to 3.4% from 2.7% in less than a month. Ultimately, a slowdown in mining would bring Australia’s risks back into focus.

The stronger dollar is hurting manufacturing, tourism and retail, where employment has largely stagnated even as mining has sucked in workers and capital. And while Australia ranks low on public debt, household debt is comparatively high.

Chevron‘s sanguine approach to hedging ultimately reflects justified optimism on the prospects for global energy markets. That doesn’t necessarily make it a vote of confidence in the near-term outlook for Australia’s economy.