Risk Management - Apache Case

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Apache Corporation:

Apache Corporation Risk Management (Hedging Philosophy and Strategy)

The Oil and Gas Industry:

The Oil and Gas Industry Mom and pop companies Wildcatters Large independent (Apache, Ocean Energy, Burlington Resources) Characteristics of large independent - relatively large size - managing virgin and mature fields

The Oil and Gas Industry:

The Oil and Gas Industry

The Nature of Mature Oil Fields:

The Nature of Mature Oil Fields Decline of production High production cost Typical sold to secondary oil companies with lower cost structure Sold with work on the fields In US, oil fields are matured but gas fields are still explored.

Factors Affecting Speed of Producing Oil:

Factors Affecting Speed of Producing Oil Reservoir type & technology Competitive concerns High fixed cost Regulations Contractual issues Apache’s general approach: - pumping as quickly as possible

Company Overview (March 2001):

Company Overview (March 2001) Independent oil & gas exploration and production company founded in 1954 Countries of Operation: United States, Canada, Australia, Egypt Growth Strategy: Combination of - Exploratory drilling - Development of existing projects - Select property acquisitions

Apache Operation:

Apache Operation

Operational Characteristics:

Operational Characteristics Focused on development of more mature properties (80% of the company’s proved reserves are located in North America) International operation is more exploration-oriented. Larger than many independent oil companies Reputation of being technically advanced

Financial Information:

Financial Information Recent upgrade of Apache’s credit rating from BBB+ to A- Financial Statements: Revenues: $2,290 M Net Income: $713 M Total Assets: $7,481 M Diluted EPS: $5.67 Debt/Assets Ratio: 29.3% Share Price: ~$30

Recent Acquisitions:

Recent Acquisitions Over the past two years Apache had financed $3.7 B worth of acquisitions Unusual number of acquisitions in 2000: Properties from Repsol for $149 M Properties form Collins & Ware for $321 M Properties in the Gulf of Mexico form Occidental Petrolium for $321 M Canadian properties from Philips Petroleum for $490 M Misc. regional acquisitions for $104 M

Oil Price:

Oil Price Time series data Oil price now: $60.30

Consequences of Price Volatility:

Consequences of Price Volatility When oil prices are low: Production shifts away form the US due to its relatively high costs of producing oil Oil companies cut their CAPEX, leaving many rigs tied up at docks, rusting Firms have to decide whether to “shut in” a well. Closing a well is a one-way option Fire many workers losing in this way “specific knowledge” about oil fields

Consequences of Price Volatility (Contd.):

Consequences of Price Volatility ( Contd .) When oil prices are high: Rigs are booked up to 18 months in advance Misuse of the increased cash flows: Spending too much money drilling wells Paying too much for properties Hiring many new workers Price volatility disrupts development plans The low oil prices could disrupt acquisitions and development plans Anadarko Petroleum Case: low oil prices; increased leverage; selling assets and issuing equity

Energy Derivatives:

Energy Derivatives heating oil future crude oil future over-the-counter derivatives a long term fixed price contract Enron’s VPP - “Volumetric production payments” receive funding upfront, deliver product in the future

Expansion of Energy Derivative Mkt.:

Expansion of Energy Derivative Mkt. Standardized contract Advantages - Low trading cost (High Search Cost of non-standardized contract) Disadvantages - Basis Risk: - Difference of spot and future price - Imperfect substitution

Effect of Hedge in Oil Industry:

Effect of Hedge in Oil Industry Reduce amount of necessary equity Reduce cost of capital – improve terms of debt Increase access to outside capital (Avoid credit crunch) Enable companies to focus on managing risks where they have a comparative advantage Facilitate better performance evaluation

Skepticism against Hedging:

Skepticism against Hedging Costly: consume management time and resources Forgoing the upside Paying a premium up front Counter-productive to stockholders’ intention Reputation Risk

Apache’s Acquisition Strategy:

Apache’s Acquisition Strategy Increase production through acquisitions at time of high oil price Key points: - Hedging - Financial Flexibility (Credit line, Relatively low debt ratio) - Less competitive acquisition market

Apache’s Hedging Practices:

Apache’s Hedging Practices Strategy: Hedging the expected production from its new acquisitions Implementation: “Costless collars” Selling a call and buying a put Proceeds form the call used to pay for the put Lock in a price floor of $3.50 Preserve the upside up to $5.26 (per 1000 cubic feet) Through hedging Apache is able to purchase high quality properties at low cash flow multiples Hedging contributed to the firm’s credibility in the acquisition process

Payoff Diagram of a Costless Collar:

Payoff Diagram of a Costless Collar ▪ A costless collar comprises a short call and a long put. ▪ Both are out-of-the-money and are for the same expiration. ▪ Strike prices are chosen so that the cost of purchasing the put is offset by the income from selling the call.

Costless Collar : Acquisition of Occidental Petroleum:

Costless Collar : Acquisition of Occidental Petroleum Quantity: 1M cubic feet

Costless Collar for Crude Oil:

Costless Collar for Crude Oil Quantity: 100 bbl

Financial Flexibility:

Financial Flexibility Apache’s financial strategy, including hedging, has a positive effect. - hedging in acquisition - $1.5B line of credit - acceptable debt to equity ratio(40-45%) and interest coverage ratio(6 times) Credit rating upgrade – S&P comment “even if prices were to revert to very depressed levels, the company is likely to maintain adequate coverage of fixed charge and capital expenditures needed to replace production.”


Signaling Economic and Accounting information consists of “signal” and “noise”. Oil price is not under control of management. Apache’s financial information is more useful to investors or creditors.

Should Mgmt Bet on Their View?:

Should Mgmt Bet on Their View? Mgmt should use their view, but limit it for fine tuning of hedging. Pros: -utilize their industrial knowledge -mitigate the effect of forgoing the upside Cons: -may miss their tip (little but adverse effect) -may weaken signaling effect

Hybrid Approach: Betting & Hedging:

Hybrid Approach: Betting & Hedging

Apache’s Problem Recognition:

Apache’s Problem Recognition Avoid “shut in” - if re-drill, Apache needs $20M - $100M per each field (Net income in 2000 = $713M) Avoid “hiring and firing cycle” - if layoff, Apache loses layoff cost and a great deal of institutional knowledge. - specific knowledge is critical for efficient operation

Should Mgmt Extend Hedging?:

Should Mgmt Extend Hedging? To avoid “shutting in wells” and “firing”, Apache takes advantage of hedging. Pros: Reduce “shutting in” probability Signaling – reduce cost of capital Cons: Cost – on industrial average, 1% production hedging leads to 0.4% drop of cash flow

Should Mgmt Extend Hedging? :

Should Mgmt Extend Hedging? Rough calculation Shutting in occurs once in four years. Re-drilling cost per field is $60M. 1% production hedging leads to 0.4% drop of cash flow. - If hedging, the company recover $15M shut in cost per year. $15M is about 2% of net income. Breakeven point of hedge ratio is about 5%. If we hedge less than 5% of production and can avoid one field shutting in, we should extend hedging.

Hedge to Protect Most Expensive Fields:

Hedge to Protect Most Expensive Fields Cash Cost Production Price

Other Risk Management Strategies:

Other Risk Management Strategies Bet on the view (no hedge) Increase company size De-levering Technology development; Cost cut Insurance Property & Casualty Business Interruption

Management Compensation Plan:

Management Compensation Plan Incentive bonuses based upon growing both reserves and production while keeping costs low In 2000 executives were eligible for a bonus above the target of 50% of their base salaries if: The company acquired or brought under its management assets valued in excess of $1B, and Maintain Debt-to-Capitalization Ratio of 45% All employees receive additional compensation if the company achieve target stock price levels of $100, $120, and $180 by year-end 2004 If production per share doubled to projected levels, additional compensation would be granted

New Accounting Rule: FAS 133:

New Accounting Rule: FAS 133 Effective Date Jan. 1, 2001 Mark-to-market all their derivative positions Report gains/losses on P&L without reporting any offsetting changes in the value of the underlying asset May actually create, rather than dampen, apparent volatility in reported earnings Requirement Consequence Jan. 1, 2001 Mark-to-market all their derivative positions Report gains/losses on P&L without reporting any offsetting changes in the value of the underlying asset May actually create, rather than dampen, apparent volatility in reported earnings

Example: Impact of Hedging on Financial Reporting:

Example: Impact of Hedging on Financial Reporting Lock the price at $10 for 100% production using future contract. If expects 100,000 barrel of production per quarter, then short 400,000 barrel worth oil contract at $10 per barrel. A quarter of the contracts expire every three months. Quarter 1 Quarter 2 Quarter 3 Quarter 4 Production 100 100 100 100 Price 10 12 8 6 Revenue 1,000 1,200 800 600 Hedging Gain (Loss) [100*(10-10)]= 0 [100*(10-12)]= -200 [100*(10-8)]= 200 [100*(10-6)]= 400 Profit 1,000 1,000 1,000 1,000 Hedging Gain (Loss) [400*(10-10)]= 0 [300*(10-12)]= -600 [200*(12-8)]= 800 [100*(8-6)]= 200 Profit 1,000 600 1,600 800

Did Hedging Add Value?:

Did Hedging Add Value? Conceptually Practically Empirically Avoid bankruptcy cost, mitigate asset substitution and under investment issues Signaling – better information Stock Price shows outperformance against benchmark and peers (Exhibit 7) Apache’s Successful Acquisition Strategy requires hedging


Summary Acquisition strategy Hedge against oil price volatility to protect investment in newly acquired oil fields Tend to acquire when oil price is high (buyer’s market) Hedge Lower production cost (avoid cyclicality) Apply other risk management tools (like insurance etc.)

Apache, thereafter:

Apache, thereafter Still believe being not “clairvoyant” – don’t speculate Major risk management strategy for acquisition: hedge to protect from forecasting risk for drilling: manage risk by underforecast Other risk management strategy Insurance: Property & Casualty (incl. Business Interruption) Stock price now: $68