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Risk Management in Apache Risk Management in Apache Raam Gururajan 2008 Raam Gururajan 1 Risk Management in Apache Introduction This is a paper analyzing the key risks of Apache Corporation (an multi mullion dollar Oil exploration and extraction company) and how the financial risk management techniques (like CFAR) can be applied to this non-financial firm. The content of this document has been produced in reference with Harvard Business Schools 2001 document - Risk Management in Apache by Lisa MeulBroek. This document has a total of 14 Pages. Raam Gururajan 2 Risk Management in Apache Section 1 The Major risks faced by Apache Corporation. 1. Price Volatility Risk: Apache has exposure to Price Volatility in many different directions. They include: a. The value of Apaches acquisitions in large part depends on the future prices of oil and gas. b. If the price of oil was low, production tended to shift away from the US, due to high cost of producing oil. Apache had 80% of its proved reserves in the US. c. Within US, deep-water drilling in the Gulf of Mexico had major interests, but this had large fixed costs and the risks were considerably high. d. The oil prices also affected the costs and the availability of drilling rigs. When prices were low, the oil companies cut their capital expenditures, leaving many rigs tied up at docs, rusting. e. The Reservoir engineers and geologists, who had the institutional knowledge about particular reservoirs could be lost due to the layoff programs that need to be executed under low-oil price scenarios. f. Under high-oil price scenarios, the increased cash flows could be misused by being invested under low NPV projects and acquisitions. (The oil & gas producers had a reputation for this) g. Oil price volatility also had the potential to disrupt acquisitions and development of current assets. h. The companys asset/liability situation can see unpredictable moves, as seen in Anadarkos case where the companys leverage had become too high and were forced to sell millions of assets to put the company back on track. Considering this being a price risk, most of the above factors can be measured in quantitative terms. 2. Acquisition & Strategy Risk: Apache has a pretty unique acquisition and acquisition-hedging strategy. They have shown (both in March 2001 and also subsequently) relatively high-risk tolerance when it comes to acquiring other firms based on their own estimates. The reason for us to believe they are high risk tolerance is because there is clear evidence that the oil industry on a whole was fairly risk averse and held back on their acquisitions during these indecisive oil price periods. The biggest risk that Apache faces from these acquisition comes in two forms - the acquisition-value risk (which Apache hedges) and the intellectual risk of the know-how of the operation of the acquired firm in the loss of key personnel (that Apache cannot hedge directly). Raam Gururajan 3 Risk Management in Apache Apaches strategy in 2001 was geared towards $1 billion acquisition of property and another $1billion in capital expenditure for exploration activity. It also financed $3.7 billion worth of acquisitions while maintaining a debt ratio of 40% and interest coverage of over 6 times. The short summary of this story is - Apache has taken a substantial initiative of investment/financing with its own view at the market. Measuring this risk would be difficult since not everything can be termed into quantitative terms, although specific investment/financing on the properties and acquisitions can be measured clearly. 3. Field Risk: This is caused again due to Apaches strategy and size as a firm. Apache had 80% of its proved reserves in the US. Oil exploration and production in the US and Canada had gone on longer than in most areas of the world, making oil fields in the US the most mature fields in the world. As the field matured, the cost of oil extraction exponentially grew and the individual/smaller firms like Apache, which bought these fields from major oil exploration firms, had to use their lower production costs (which are inherent due to their size) and also technological advancements to extract the oils. The risk with this kind of setup is that - when the fields are being bought from the major oil producers, there is an expectation on the future production capacity of the fields and the amount of oil that would be extracted from them. Under the circumstances that Apache is not hedging its oil output (since it currently only hedges the acquisitions oil value), it can meet with substantial losses in not being able to catch-up with is expected output targets (which are growing higher and higher considering the 40% debt on the balance sheet) Measuring and hedging the newly bought fields risks is definitely possible, but could be expensive and depends on the age & work done on these fields. 4. Hedging Risk: Apache is well aware that hedging itself brings inherent risks. The main risks bought by hedging are: a. Inability to find perfect hedges that are liquid and at reasonable prices. b. Cost of
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hedging over a longer period could be expensive (since it needs continuous rebalancing of the portfolio) and not clearly known at the start if the products being hedged are not vanilla. c. The hedge mostly does not cover jumps in the market and thus despite the hedges being in place, there is still risk with price movements. Raam Gururajan 4 Risk Management in Apache d. The hedge could become illiquid and not able to hold its promise at times of need. (As seen with Long term capital and other firms) e. Basis Risk on the standardized contracts and also that these contracts are priced for delivery at specific points. And Apaches exposure to risk had proved costly in the past when it found itself unable to ship gas to the delivery location to settle contracts. f. Hedge does not cover the full front to back flow of the contract. That is, in this case, Apaches exposure to transaction & storage cost for the delivery and settlement of the contract is not covered via standard contracts. 5. Other Risks: Apache is only hedging the most visible risk - i.e. the price volatility risk. But there are a few others that are still unmanaged via those collar hedges and it includes: a. FX Risk: Although the reference document did not explicitly state about the consumer base and currency risks, for a oil producer like Apache, the FX rate between USD and other currencies (i.e. the buyers of oil like Europe and Asia) would play a key role because of the following: - Apaches operations outside US. World wide consumer base - Apaches heavy reliance on US properties and fields in the US b. Economic Risk: This is the risk caused due to the overall economy and its operation on a whole. Firms with strong reliance on one or two economies tend to have risk derived based on the state of the economy. Geo-political risk could also be clubbed into this category. c. Operational Risks: Apache is running a multi million-dollar business with investments in fields/oil wells and extraction processes. And for a oil producer of this kind the operational risks are high. Raam Gururajan 5 Risk Management in Apache Section 2 Apaches approach to risk management strategy. Apaches primary tool in the risk management was - hedging. There are quite a few variations to the application and also belief system that can be observed and they are: Apache had begun the practice of hedging the expected production from its new acquisitions. Apaches view was that the current environment offered the company the opportunity to negotiate the purchase of excellent properties, at potentially attractive prices. Through hedging, Apaches managers locked in these high gas prices. The hedges concentrated on the expected production over the next 2 to 3 years, while the markets showed liquidity to up to 5 years or even more sometimes. Apaches risk managers had strongly believed that their hedging strategy aligns and is well grounded with the markets view. And Apaches near term view was quoted as bullish. I.e. the prices would go up due to strong demand and shortage of supply. Apache used collar strategy and as per the CFO, it provided good protection against a potential downturn, but they left upside potential consistent with Apaches view on the market. The CFO also believed that after the cost of extraction, the acquisition in combination with its hedging strategy assured Apache a double digit return. Apache believed that they were able to buy high-quality properties at low cash flow multiples. Also, that the hedging had benefited the firm in a subtle way by increasing the firms credibility in the acquisition process. The other approaches that Apache could use one or more of a combination of the following: No hedging: Like many other oil & gas producers, Apache could deliberately avoid hedging. This would depend on whether they are confident with their view on the tight market (similar to EOG Resources, which avoided hedging all together). The biggest benefit is that the company can keep the upside and if its view is correct. Can use companys size, liquidity, credibility (with its upgrade in investment rating by S&P from BBB+ to A-), Apache can diversify its risks. These risks might not be necessarily market risks (since not all market risks can be diversified without hedges), but can be other risks like technology risks, operational risks, etc. This was one of the approaches taken by Talisman Energy, the largest Canadian-based oil & gas producer. Investment in cost reduction programs and technology (to improve production capacity, reduce manual tasks, eliminate unnecessary roles) can also help stabilize costs within the firm and can be used as way to manage risk exposure. Raam Gururajan 6 Risk Management in Apache Choosing projects near existing infrastructures and also choosing sites that are fairly less mature are ways the management could reduce startup time, extraction costs and also increase the success of the exploration rates. Learning & implementing the new upcoming technology on pumping oil and replace the older styles could be a very effective way to further increase success rate. For example - Vastar Resources viewed better and more experienced interpretation of
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3D-seismics as a way to lower drilling risks. Raam Gururajan 7 Risk Management in Apache Section 3 Theoretical argument to support risk management activity at Apache 1998 Price levels/volatility: The oil price had hit pernicious levels in 1998 when it bottomed out at $11 per barrel. And in 2001, the prices had come up to $27 a barrel (which at that point in time was treated as relatively high). Through out the reference document, there is evidence to prove that the industry on a whole wasnt very clear on the future price direction of oil & gas. Each and every firm had their own view (like Apaches bullish view) and constructed risk management strategies in handling the exposures. The biggest risk that the industry players faced during low prices included: Going out of business Shutting down of wells/fields Heavy prices to restart previously shutdown fields Closing the fields permanently or reselling at poor prices Retrenchment of its intellectual labor forces and thus losing people with the institutional knowledge on its fields Therefore, theoretically, there is enough evidence to prove the exposure due to price volatility and that Apache needs a risk management strategy for handling the downside. The Collar Option for hedging - Option Pricing Theory: Apache being a smart new generation company had setup its company policies (like remuneration, salary, acquisition plans) in a direction so that it can operate on its areas where it had direct influence. And it had found ways to either to share or eliminate the exposures caused due to forces that were out of its influence. One such risk management strategy was using the Collar spreads to hedge exposure created by new acquisitions. A Collar spread has a long call and short put with different strikes. A good example of a payoff from cost-less collar is shown in below example. From the given information, we are not clear if Apache uses cost-less collar, but even if its not the case, we can tentatively guestimate that the puts strike is somewhere in the lower 10s(i.e. out of money), while the calls strike is more in the money. Raam Gururajan 8 Risk Management in Apache Payoff of a cost-less collar With this payoff structure, Apache would keep the benefits of the price gains (which it anticipates since it has a bullish view) and can still eliminate the downside. A Protective put might be a better strategy that Apache could use, but it would be slightly more expensive than the collar. The payoff of a protective put is like below: Apache and Basis Risk: The standardized contracts (like futures, options) were more suitable than the forwards & one-offs due to the reduced counter party risk and the liquidity offered by the exchanges. But, they came with a disadvantage of exposing the participants to the basis risk. The standardized contracts were priced for delivery at specific point; in the case of gas, this meant the Henry Hub in Louisiana. The company entering the contract was responsible for getting the Raam Gururajan 9 Risk Management in Apache gas to the Henry Hub, meaning that this portion of the cost would be un- hedged even after entering into hedging contracts. Apaches exposure to this basis risk had proved costly in the past when it found itself unable to ship gas to the Henry Hub to settle contracts, but basis risk at least in theory could be minimized through OTC contracts with dealers. With this in mind, the best suited Collars for Apache would be OTC collars with enough spread between the strike of the Put and strike of the Call, therefore covering the potential downside prices. The OTCs in this case give Apache flexibility in following factors: o These OTC collars could either be on physical underlying or on futures contracts. o And by theory, the basis price risks would be eliminated. o The spread between the strike prices can be customized to Apaches vision/view at the market. o The delivery location/settlement would also be customized to Apaches preferred location, thereby hedging away even the transportation risks that would otherwise arise on standard contracts. Raam Gururajan 10 Risk Management in Apache Question 4 Implementing Cash Flow At Risk (CFAR) for Apache The below diagram illustrates the major steps involved in CFAR analysis for a fictitious scenario of Apache taking over Oil-Producer-A. And that Apache is trying to find a CFAR for this new acquisition so that it can plan on its finances for the year ahead. There are a few key assumptions involved in the diagram: - The Cash flow into the firm has direct 1:1 correlation with the price of the oil. This is done for simplicity of the illustration. In reality, we would need to build a multi-variate distribution with a matrix of correlation before deriving the CFAR. - Apaches take over doesnt impact production or production/cost expectation of Oil-Producer-A. (That the historic costs incurred by OilProducer-A is a good estimate for the cost-simulation analysis). The Key steps for this case are: - Derive the Cost structure and run simulation to derive the distribution (whether lognormal or normal) of costs for 100G of oil production by Producer-A. This is typically based on their past history, but more manual forecasts and
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inputs could also be involved if they are legitimate. This manual input also allows for adjusting any particular factors that might undergo changes with Apaches acquisition. - Once the Cost structure is there, you have the probabilities, the mean, and variance of the key items that needs to be factored in during the income statement analysis. - Have other cash flow statement items ready (like deprecation, amortization, taxes, etc). We dont need to run simulation for them and good projections based on current records are good to start. Put all this together for deriving the income statement for various simulations. This would involve input of the price for computing the income side of things. So, we need to run simulations for it. - The end result of this exercise is that we have a distribution of various cash-flow values with their respective probabilities, mean and variance. - Now compute the 95% CFAR (i.e. 1.65 * std dev) and record the amount. - Also, record the worst case 5%. If the firm had targets (which it generally would), put them together for analysis. - The end result being that one can clearly know how much cash flows are at risk, the potential deviation that could be faced at end of year for which more financing is required. Raam Gururajan 11 Risk Management in Apache Raam Gururajan 12 Risk Management in Apache The above exercise was done for one particular scenario/risk (price risk on value of newly acquired firm) and can be repeated for the various other risks that need to be factored. The biggest benefits of this program are: Via Monte Carlo simulation, the accuracy of forecasts on the CFAR would be increased with the increase in simulation (or by using other techniques like anti-tetic or near-value approximation techniques). It factors in a majority of cases, that otherwise isnt doable with us scenario analysis. The firm with this value can also proceed to derive other metrics like Earnings at risk. The firm can better plan on its cash flow requirements and the need for any new facility arrangements (if it sees a deficit) It provides a good approximation on where the hedges should be. I.e. the prices at which Apache should build its collars to avoid the 5% downside risks. The difficulties of implementing this program are: In Apaches case, not all the exposures are cleanly measurable. i.e deriving the quantitative value for some of them can be challenging. (More details on this was provided in response to question 1) The multi variate distributions can get very complex. I.e. as the factors involved increases, so does the computation power and math complexity for accommodating them. Implementation of such a program has to come from the top management for it to be effective, and for this to be successful in the longer run, some cultural changes throughout the firm would be required. Raam Gururajan 13 Risk Management in Apache Reference Document Raam Gururajan 14

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