Zhimeng Ye 1081890 Colin Sproat 1100503

Apache Case Study

Colin Sproat & Zhimeng Ye F ! "13 section A1 #ar$ra %amieson

Zhimeng Ye 1081890 Colin Sproat 1100503

1. Systematic Risk & nsecurity arising 'rom daily operating acti(ities) such as product deli(ery and oil drilling* as +ell as its 'inancing acti(ities) such as issuance o' $onds and shares, Price Risk & -ncertainty a$out 'uture pro'its and losses occurring 'rom selling un. hedged oil & gas in the mar/et, Hedging Risk & 0he Chance o' 'oregoing any additional pro'its i' prices +ere to increase dramatically under the collar strategy, Political Risk & -ncertainty stemming 'rom in(esting internationally and the associated 'oreign policies in di''erent countries, 2. 1hen prices are up the 'irm has a higher income there'ore +ill ha(e larger cash 'lo+s directed to+ards in(esting and operating acti(ities, 2o+e(er) +hen prices are do+n) the company tends to report lo+er 3e(en negati(e4 net income and ha(e smaller cash 'lo+s going into operating and in(esting acti(ities, Financing acti(ities +ere /ept 'airly sta$le due to the re5uired de$t.to.capital ratio to /eep good credit so cash 'lo+s had little e''ect on the 'inancing acti(ities, n addition) price 'luctuations can also a''ect the amount o' ta6es Apache has to pay, Since +hen prices are lo+) the 'irm is a$le to de'er its ta6es +hereas +hen their high) Apache has to pay up, 7perating acti(ities are a''ected +hen oil and gas prices 'luctuate, Apache +ishes to produce and sell as much as possi$le to pro'it +hen prices are high) +hich entails hiring a great deal o' employees and specialists, 2o+e(er) +hen prices are lo+) Apache lays.o'' these e6cess employees to dampen their losses,

Zhimeng Ye 1081890 Colin Sproat 1100503

8o+ prices may 'orce cut$ac/s on technology +hereas higher prices could induce more spending on technological research and de(elopment, Furthermore) certain drilling operations may $e shut in due to lo+ prices) only to $e re.drilled +hen they are $ac/ up, 9rice (olatility also has the potential to disrupt ac5uisition and de(elopment o' current assets in the 'irm, 0his can steer the 'irm:s in(estment strategy a+ry, 3. 2edging price ris/ ena$les Apache to reduce the amount o' e5uity needed to support operations, 0his arises 'rom the 'act that they can increase the amount o' le(eraging +ith more con'idence, 0here'ore) hedging price ris/ can reduce the net cost o' capital, n addition) hedging can increase a 'irm:s access to capital mar/ets and impro(e the terms on +hich they raise that capital thus creating (alue 'or the 'irm, ;educing price (olatility remo(es the noise created $y 'luctuating prices) and thus it ma/es e(aluation o' managers easier to e6ecute, 0his also creates (alue 'or the 'irm $y $eing a$le to identi'y managers +ho are per'orming poorly and those +ho are per'orming +ell, As a result) cost due to e6cess compensation is dampened, <oreo(er) this also ensures e''ecti(e $onus distri$ution $ecause incenti(es are dispersed +ere they $elong, Finally) in(estors can get a $etter idea o' the 'irm:s per'ormance and can ma/e more in'ormed decisions, 8astly) sta$ili=ing the price at +hich Apache can sell oil and gas) the 'irm can o$tain a $etter credit rating, 0his creates (alue 'or the 'irm $ecause a higher credit allo+s the 'irm to $orro+ at a lo+er interest rate, Also) a higher credit rating attracts more ris/. a(erse in(estors and allo+s the 'irm to $orro+ more cash in general, 0his creates (alue 'or the 'irm since it +ill sa(e cash on its $orro+ing and ha(e higher 'le6i$ility $y $eing a$le to $orro+ larger amounts, 4. 0here are a lot o' oil and gas producers that a(oid hedging their price ris/, 0hey do this $ecause it can $e a (ery costly endea(or, From hiring specialists to transaction

Zhimeng Ye 1081890 Colin Sproat 1100503

costs) the $ill can really add up, !ot only does it re5uire initial resources and cash to do) hedging isn:t guaranteed to sa(e you money, Some can $e tempted to loo/ at hedging as speculation rather than as insurance, 0a/e !ic/ 8eeson 'rom #arings #an/ 'or e6ample) he +as a$le to dri(e the 'irm into $an/ruptcy $y ma/ing unauthori=ed trades, 0here'ore) this re5uires monitoring the oil and gas prices (ery closely and monitoring the hedgers e(en closer, Some more reasons oil and gas producers a(oid hedging is $ecause hedging itsel' is ris/y, 9rices may not end up mo(ing do+n, 0his could mean that Apache could lose or 'orego potential pro'it i' they are +rong, 0hus hedgers should $e+are that there could $e a looming opportunity cost in their decisions, Some also argue that it is the >o$ o' the in(estors to hedge their ris/s and not that o' the 'irm, #y hedging) a 'irm could also lose a lot o' its in(estors, 5. Apache manages its ris/s in three +ays, 0he 'irst o' +hich in(ol(es ho+ they in(est, ?i(ersi'ying their in(estments geologically helps the 'irm to hedge a domestic price ris/ $y /eeping assets in 'oreign countries, n addition) Apache in(ests in di''erent pro>ects to meet there goals) +hich includes) e6ploratory drilling) de(elopment o' e6isting pro>ects and selection o' property ac5uisition, 0hey also manage (irgin 'ields in addition to the more mature properties, 0his /eeps a certain di(ersity o' holdings, Secondly) Apache is a large independent oil company, 0his means that it can use its si=e to help manage its ris/, ts $ul/ allo+s 'or $ene'its) such as li5uidity) sta$ility and di(ersity) especially +ith its technology ris/s, Apache can reap these @$ene'itsA $y using its enormity to underta/e many pro>ects at a time, 8astly) the 'irm also strategically manages its ris/ $y considering +here it +ill operate, Apache a(oids potentially unsta$le international areas) li/e 1est A'rica and territories in the 'ormer So(iet -nion, 0hese areas $ring a$out political ris/ and only +or/ to complicate the ris/ situation,

Zhimeng Ye 1081890 Colin Sproat 1100503

6. B(en i' Apache is not (ery good at 'orecasting) this does not mean they should stop hedging, 0he 'irm $ene'its 'rom more than >ust the security 'rom hedging its price ris/, As noted in the case) hedging contri$uted to their credi$ility, !ot only does this add to their credit rating) it also contri$utes to their reputation o' @al+ays closing a dealA and gi(es them ad(antages in the ac5uisition mar/et, 0his @'inancial 'le6i$ilityA increases Apache:s a$ility to e6ecute 'aster, 7. a) B6hi$it 10 re(eals that the $eta 'or C change in oil is 0,D") and the $eta 'or C change in gas is 0,"D, 0his means that Apache:s return +ill increaseEdecrease $y 0,D"C per 1C increaseEdecrease in the oil price) holding the gas price constant, n turn) this means the 'irm:s return +ill increaseEdecrease $y 0,"DC per 1C increaseEdecrease in the gas price) holding the gas price constant, B6hi$it 11 tells us a$out the price sensiti(ity o' the 'irm:s stoc/s on oil and gas, 0he $eta 'or oil stoc/ price is 0,D and that 'or the gas stoc/ price is 0,"3, For e(ery percentage point increaseEdecrease in oil stoc/ price) holding other (aria$les constant) the 'irms o(erall stoc/ return inclinesEdeclines $y 0,DC, Similarly) the 'irm:s return on stoc/ increasesEdecreases $y 0,"3C 'or one percentage point increaseEdecrease in gas stoc/ price) holding other 'actors constant, b) 0he limitation to this is that the regressions are estimated using historical data) not current data, 0here'ore they re'lect the sensiti(ity o' the return to the 'irm:s stoc/ to changes in oil and gas prices, 8. a) Apache is a conser(ati(e hedger so +ould suggest that the stri/e $e near F3,50 so +ould suggest F3,D5, b) From the #.S <odel !?9 Stoc/ Formula +e o$tain a put premium o' F0,9",

Zhimeng Ye 1081890 Colin Sproat 1100503

c) -sing the #.S <odel !?9 Stoc/ Formula +e o$tain a stri/e 'or the call o' F5,31 to get a costless collar,

d)
Conditions 9ut 7ption 9ayo'' 38ong4 Call 7ption 9ayo'' 3Short4 !atural Gas 9ayo'' 38ong4 0otal 9ayo''

S0 H 3,50 3,50 I S0 I 5,31 S0 J 5,31

3,50 . S0 0 0

0 0 . 3S0 & 5,314

S0 S0 S0

3,50 S0 5,31

Payoff of Collared Natural Gas

6 5 4 Payoff 3 2 1 0 0 1 2 3 4 5 6 7 Natural Gas Price Combined Payoff

e) -sing the #lac/.Scholes model) +e 'ound a premium o' F",35, ) According to the Goal see/ in B6cel) +e 'ound a stri/e price o' F"K,59 'or the call,

Zhimeng Ye 1081890 Colin Sproat 1100503

g)
Conditions 9ut 7ption 9ayo'' 38ong4 Call 7ption 9ayo'' 3Short4 7il 9ayo'' 38ong4 0otal 9ayo''

S0 H DL DL I S0 I "K,59 S0 J "K,59

DL . S0 0 0

0 0 . 3S0 & "K,594

S0 S0 S0

DL S0 "K,59

Payoff of Collared Oil

50 45 40 35 30 25 20 15 10 5 0 0 10 20 30 40 50 60 70 Oil Price

Payoff

Combined Payoff

!) According to Goal See/) the stri/e is FD9,0K 'or the call premium,

Zhimeng Ye 1081890 Colin Sproat 1100503

i)
Conditions 9ut 7ption 9ayo'' 38ong4

M Call 7ption
9ayo'' 3Short4

7il 9ayo'' 38ong4

0otal 9ayo''

S0 H DL DL I S0 I D9,0K S0 J D9,0K

DL . S0 0 0

0 0 . M 3S0 & D9,0K4

S0 S0 S0

DL S0 M S0 N 1",53

Payoff of Collared Oil

38 36 34 32 Payoff 30 28 26 24 22 20 0 10 20 Oil Price 30 40 50 Combined Payoff

". a) For+ard 9rice O DLe6p30,0LP34 O 33,30930LKD, b) Forward Sale: 0he 'or+ard sale pro(ides do+nside protection so i' the price 'alls) the 'irm +on:t lose any (alue, 2o+e(er) this protection comes at a cost 3an opportunity costQ4, Apache +ill ha(e to 'orgo any pro'it i' the spot price at the e6piration o' the 'or+ard contract is in e6cess o' the 'or+ard price, 0here are no) ho+e(er) no initial costs to this strategy,

Zhimeng Ye 1081890 Colin Sproat 1100503

Collar Strategy with a put/call ratio of 1: 0his strategy o''ers do+nside protection as +ell, 7nce again) ho+e(er) the com$ination o' the put and call creates an interesting situation, 0he 'irm is protected at the do+nside $ut once again +ill 'orgo its 'uture pro'its i' prices lie a$o(e the call stri/e price, So this option also comes at an opportunity cost, Since the premium o' the put is set so it is the same as that o' the call) this strategy has no initial cost, Collar Strategy with a put/call ratio of 2: 7nce again) this o''ers do+nside protection or insurance as +ell, 2o+e(er) this strategy doesn:t place a roo' on pro'its i' the prices +ere to rise, So there is unlimited upside potential, 0here is no initial cost to this strategy $ut the pro'its made are reduced to pay 'or this protection,

Zhimeng Ye 1081890 Colin Sproat 1100503

1#. a) $ne%Ste& 'inomial (ree )odel

(*o%Ste& 'inomial (ree )odel

+i,e%Ste& 'inomial (ree )odel

Zhimeng Ye 1081890 Colin Sproat 1100503

(!irty %Ste& 'inomial (ree )odel

Zhimeng Ye 1081890 Colin Sproat 1100503

Zhimeng Ye 1081890 Colin Sproat 1100503

b)

c) 0he price oscillates around the #lac/.Scholes premium) getting closer to it as the steps get larger,

11.

Zhimeng Ye 1081890 Colin Sproat 1100503

2ere:s a 5uic/ +al/.through o' ho+ +e o$tained the 'or+ard price and payment 'or the 'irst e6change as +ell as ho+ +e computed the total (alueR !oteR

0 O time to maturity 9ayment O Spot price & 'or+ard price 9resent (alue O payments made at time 0) discounted 'or 0 years

At 0 O 0,5 ' O K9,58 P e6p S30,0K N 0,0""D4 P 30,5E1D4T O K9,88DL"991 9ayment O 3K" . K9,88DL"9914 P 500)000 O . D)9"1)3L",9K 9resent Ualue O 9ayment P e6p S.30,0""D4 P 30,5E1D4T O D)93K)0L9,00 0otal Ualue O Summation o' all the present (alues,