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Risk Management at Apache

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					Apache Corporation
         Risk Management
 (Hedging Philosophy and Strategy)

            Kalin Stoyanov
            Kusuma Ketut
            Daisuke Ishida
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
Age of Fields
Mature


                 Mom &
                  Pop
                              Large
                              Independents



                                             Majors
                Wildcatters
Virgin

                Small                           Large   Size
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
   Reservoir type & technology
   Competitive concerns
   High fixed cost
   Regulations
   Contractual issues

   Apache’s general approach:
    - pumping as quickly as possible
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
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
 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
 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
      Time series data

                                                  Average Crude Oil Prices ($ per barrel)

                   60
                   50
    $ per barrel




                   40
                   30
                   20
                   10
                    0
                    70

                          72

                                74

                                      76

                                            78

                                                  80

                                                        82

                                                              84

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                                                                                                        98

                                                                                                              00

                                                                                                                    02

                                                                                                                          04
                   19

                         19

                               19

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                                                                                                             20

                                                                                                                   20

                                                                                                                         20
                                                                          Years


      Oil price now: $60.30
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.)
   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
  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.
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
   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
 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
   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
   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




▪ 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




Quantity:
1M cubic feet
  Price per 1000 cubic feet   $3      $3.30   $3.50   $4      $5.26   $6      $7.30
  No Hedge                    3,000   3,300   3,500   4,000   5,260   6,000   7,300
  Costless Collar             3,500   3,500   3,500   4,000   5,260   5,260   5,260
  Difference                  -500    -200    0       0       0       1,260   2,040
 Costless Collar for Crude Oil




            ΔP            -30%    -20%    -10%    0%      10%     20%     30%
            Price         25.9    29.6    33.3    37      40.7    44.4    48.1
Quantity:
            Rev/Hedge     3,400   3,400   3,400   3,700   4,070   4,150   4,150
100 bbl     Rev/NoHedge   2,590   2,960   3,330   3,700   4,070   4,440   4,810
            Gain / Loss   810     440     70      0       0       -290    -660
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?
   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

   Payoff under Normal View       Payoff under Bullish View




                              P                               P
                    P*                             P*
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?
   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?
   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
Cash Cost



Price




                                  Production
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
   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
   Effective Date
                     
                     
                              1, 2001
                         Jan.1, 2001
                         Jan.


   Requirement      
                      Mark-to-market all their their
                       Mark-to-market all derivative
                       positions
                       derivative positions
                      Report gains/losses on P&L without
                       reporting any offsetting on P&L
                      Report gains/losseschanges in the
                       without reporting any
                       value of the underlying asset
                         offsetting changes in the value
                         of the underlying asset
   Consequence       May actually create, rather than
                       dampen, apparent volatility in reported
                      earnings
                       May actually create, rather
                         than dampen, apparent
                         volatility in reported earnings
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?
   Conceptually      Avoid bankruptcy cost, mitigate
                       asset substitution and under
                       investment issues
                      Signaling – better information


   Practically       Apache’s Successful Acquisition
                       Strategy requires hedging


   Empirically       Stock Price shows outperformance
                       against benchmark and peers
                       (Exhibit 7)
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
   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

				
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