Risk Management at Apache-Finance Case Solution Sample

QUESTION

 

 

ANSWER

 

Cash Flows

For the purpose of getting the cash flows of Apache first the data from the case was used to see the amount of production that has been hedged. An exhibit also shows the volatility of the production which was then used to calculate the 95% confidence limits of the price taking the given price of oil and gas as the mean price.  The data for the same is shown below. In case of gas the volatility is exceptionally high and hence the lower limit is takes at 20% of the actual price which is the minimum volatility of the exhibit.

Hedging Data			NGL
Oil and NGL	Rate		Volatility	60%
17%	21.75		Unhedged Reserve	76%
7%	18.8		Mean Price	19.19
Gas			Upper Limit	41.6423
7%	3.35		Lower Limit	3.2623
Gas			Oil
Volatility	110%		Volatility	60%
Unhedged Reserve	93%		Unhedged Reserve	76%
Mean Price	3.59		Mean Price	27.37
Upper Limit	11.29055		Upper Limit	59.3929
Lower Limit	0.718		Lower Limit	4.6529

After calculation of the limits of the market price the mean, upper and lower limits were calculated accounting for the portion of production that has already been hedged. The results of price range are given below.

	Oil	NGL	Gas
Mean Price	25.8147	19.5979	3.5732
Upper Limit	50.152104	36.661648	10.734712
Lower Limit	8.549704	7.492848	0.90224

The increase in production from 2000 has been calculated at 25% overall increase in production. This is takes same for all three products to reduce the complexity in the calculations and keep the results at a reasonable levels of certainty. The following table shows the production for each category and the average price the company will get for each product. This accounts for both the market price and the hedged prices and production.

		PRODUCTION				AVERAGE SALES PRICE
				AVERAGE
	OIL	NGL	GAS	PRODUCTION	OIL	NGL	GAS
YEAR ENDED DECEMBER 31,	(MBBLS)	(MBBLS)	(MMCF)	COST PER BOE	(PER BBL)	(PER BBL)	(PER MCF)
2001 mean	52,400	3,310	3,79,975	2.70	25.81	19.60	3.57
2001 upper	52,400	3,310	3,79,975	2.70	50.15	36.66	10.73
2001 lower	52,400	3,310	3,79,975	2.70	8.55	7.49	0.90

The average prices were multiplied with the production to calculate the cash flows of the company and set the limits of the cash flows. The following table shows the results of the calculated limits of the cash flows:

Cash Flows
Mean	27,75,286.00
Upper Limit	68,28,242.31
Lower Limit	8,15,634.46

Impact

We can see that against the cash flows of 2000 which are at $2.2 billion the mean cash flows for 2001 are reasonable high. The upper limit of cash flows is very high an there is very less chance that the cash flows will be in any vicinity of the results for the upper limit. The lower limit is far too low and such low cash flows can drive the company in need of cash for which it might need to raise more debt or raise equity.

The current level of long term debt with the company is $2.1 billion. The interest payment last year was $168 million which is more than 20% of the total revenues for the company’s lower limit of earnings. Thus, there is a real possibility for the company to need extra finances if the oil prices fall in the international market. The situation looks further worse when we account for the fact that in case of revenues of $2.2 billion the net income was $693 million.

Same Strategy for all production

The current level of hedge is for less than 20% of the company’s production. If the same strategy is implemented for the whole production is could nearly confirm about $2.5 billion in revenues. But there would not be any upside that will remain in the market for Apache. This strategy will limit the ability of the company to grow if the market oil prices rise. Further data has shown that a very high level of hedging is not desirable by the investors.

It should also be noted that if the company hedges the complete production that it is expecting for the next year then it will be bound to produce that amount next year. A lower production will mean the company has to buy oil from the market if futures are used and the use of option will lead to very high premiums on the hedges.

Optimal strategy

As a member of the board, my first priority will be to establish the operations of the company and ascertain that all the debt obligations are met. Thus the level of hedging will be enough that the company is able to gain at least $1.5 billion in revenues which would have led to zero profit (tax adjusted) this year. For that purpose about 50% of the production needs to be hedged. The remaining 50% of the production can be left in the market to be capitalised on any rise in the oil prices.

The ratio of 50% is not a ratio set in stone. The market conditions and the international level of production will also be a relevant factor. The stability of oil prices has increased in the last year and the prices themselves have shown an upward trend. Thus, we can reduce the amount of hedging by some amount. The amount of hedging reduced depends in the increase in certainty. The latest data from the case would suggest that hedging even 40% of the production should be sufficient.