Risk Management At Apache

Risk Management at Apache

Case Study - Team 6

4/5/2012

TSU EMBA Energy Trading

Table of Contents

Introduction 2

Major Risks 2

How is Apache managing risk now? 3

Should Apache manage risk? Is risk management valuable to Apache? 4

How could Apache manage risk? 5

What is the goal of hedging? 5

Conclusion 6

Introduction

The Apache Corporation is an independent oil a gas exploration production company. Towards the late nineteen nineties and early twenty first century, Apache had completed several acquisitions. They included the following: Repsol which is in Egypt's Western desert, Shell Overseas Holdings a partner of Repsol and Fletcher Challenge Energy. They combined for a total cost of $1billion. In an effort to minimize the volatility of the price of gas, Apache began a limited hedging program. The management team was aware of the underlying risks associated with hedging and they ultimately had to determine if they should continue hedging long term. If so, should they extend their current program beyond hedging the revenues from acquisitions. Within this case study, we will discuss major risks, how Apache Corporation is managing risks and whether or not they should be. We will also discuss how Apache could manage their risk as well as define what is the goal of hedging.

Major Risks

The biggest risk within this industry is the price of oil and gas. History has proven how volatile prices can be. Exhibit 9 indicated approximately a 70% range of price fluctuation between 1996 and 2000. The equation is relatively straight forward. When the prices are up, the industry is making money and is traditionally eager to hire new employees. When the prices are down, the industry is losing money and there is a strong likelihood that layoffs will follow.

Apache, along with other independent oil and gas companies had become quite efficient at capitalizing on the leftover wells that became uneconomical for the larger companies to manage. However, because oil exploration and production in the U.S. and Canada had gone longer than most areas of the world, their maturity had caused many large companies to focus more on natural gas exploration and production. There was great opportunity with respect to natural gas and the existing pipeline within the U.S. and Canada, but it had not yet developed to an international market. This is due to inability to efficiently change the state of gas to a liquid so that it can be transported via ship.

How is Apache managing risk now?

The price of natural gas during this time on the futures market had been rather high compared to historical levels. Traditional philosophy suggested that "buying high and selling low was a less optimal strategy." However, Apache's management believed that this was a great opportunity for them to negotiate lower prices for great properties. This was possible because many of their competitors were avoiding acquisitions during this time. Apache's management was able leverage their hedging practices to secure these high gas prices which typically lasted for two to three years.

Thomas Mitchell, Apache's controller believed that "any hedging strategy must be grounded in a market view. We believe that oil prices reflect renewed discipline by the OPEC nations that have successfully reduced inventories in the world system during a period of strong demand... We also believe that the North American natural gas market is in a period of supply shortfall, which is the result of the collapse in the industry's gas well drilling activity during 1998 and early 1999." When you consider the market view, as indicated by Mitchell, the facts indicate that the price will remain high for a long period of time. OPEC had reduced inventories and the production of gas in North America had collapsed. This meant that the demand would remain high and as a result, so will the price.

An example of how hedging worked for Apache was when they purchased Occidental Petroleum's reserves within the Gulf of Mexico for $365 MM. The price of gas per thousand cubic feet was approximately $1.12. They used "costless collars" (i.e. selling a call, buying a put with the proceeds from the call used to pay for the put) to solidify a price floor of $3.50 up to $5.26 per thousand cubic feet.

Should Apache manage risk? Is risk management valuable to Apache?

There will always be risk associated with oil and gas as indicated by the historical volatility in price. There