Zhimeng Ye 1081890

Colin Sproat 1100503

Apache Case Study

Colin Sproat & Zhimeng Ye
FIN 413 section A1
Barbra Jamieson
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Colin Sproat 1100503

1.
Systematic Risk Insecurity arising from daily operating activities,
such as product delivery and oil drilling; as well as its financing
activities, such as issuance of bonds and shares.

Price Risk Uncertainty about future profits and losses occurring

from selling un-hedged oil & gas in the market.

Hedging Risk The Chance of foregoing any additional profits if

prices were to increase dramatically under the collar strategy.

Political Risk Uncertainty stemming from investing internationally

and the associated foreign policies in different countries.

2.
When prices are up the firm has a higher income therefore will
have larger cash flows directed towards investing and operating
activities. However, when prices are down, the company tends to
report lower (even negative) net income and have smaller cash flows
going into operating and investing activities. Financing activities
were kept fairly stable due to the required debt-to-capital ratio to
keep good credit so cash flows had little effect on the financing
activities. In addition, price fluctuations can also affect the amount of
taxes Apache has to pay. Since when prices are low, the firm is able to
defer its taxes whereas when their high, Apache has to pay up.

Operating activities are affected when oil and gas prices

fluctuate. Apache wishes to produce and sell as much as possible to
profit when prices are high, which entails hiring a great deal of
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employees and specialists. However, when prices are low, Apache

lays-off these excess employees to dampen their losses.

Low prices may force cutbacks on technology whereas higher

prices could induce more spending on technological research and
development. Furthermore, certain drilling operations may be shut in
due to low prices, only to be re-drilled when they are back up. Price
volatility also has the potential to disrupt acquisition and development
of current assets in the firm. This can steer the firms investment
strategy awry.

3.
Hedging price risk enables Apache to reduce the amount of
equity needed to support operations. This arises from the fact that
they can increase the amount of leveraging with more confidence.
Therefore, hedging price risk can reduce the net cost of capital. In
addition, hedging can increase a firms access to capital markets and
improve the terms on which they raise that capital thus creating value
for the firm.

Reducing price volatility removes the noise created by

fluctuating prices, and thus it makes evaluation of managers easier to
execute. This also creates value for the firm by being able to identify
managers who are performing poorly and those who are performing
well. As a result, cost due to excess compensation is dampened.
Moreover, this also ensures effective bonus distribution because
incentives are dispersed were they belong. Finally, investors can get
a better idea of the firms performance and can make more informed
decisions.
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Lastly, stabilizing the price at which Apache can sell oil and gas,
the firm can obtain a better credit rating. This creates value for the
firm because a higher credit allows the firm to borrow at a lower
interest rate. Also, a higher credit rating attracts more risk-averse
investors and allows the firm to borrow more cash in general. This
creates value for the firm since it will save cash on its borrowing and
have higher flexibility by being able to borrow larger amounts.

4.
There are a lot of oil and gas producers that avoid hedging their
price risk. They do this because it can be a very costly endeavor.
From hiring specialists to transaction costs, the bill can really add up.
Not only does it require initial resources and cash to do, hedging isnt
guaranteed to save you money. Some can be tempted to look at
hedging as speculation rather than as insurance. Take Nick Leeson
from Barings Bank for example, he was able to drive the firm into
bankruptcy by making unauthorized trades. Therefore, this requires
monitoring the oil and gas prices very closely and monitoring the
hedgers even closer.

Some more reasons oil and gas producers avoid hedging is

because hedging itself is risky. Prices may not end up moving down.
This could mean that Apache could lose or forego potential profit if
they are wrong. Thus hedgers should beware that there could be a
looming opportunity cost in their decisions. Some also argue that it is
the job of the investors to hedge their risks and not that of the firm.
By hedging, a firm could also lose a lot of its investors.

5.
Apache manages its risks in three ways. The first of which
involves how they invest. Diversifying their investments geologically
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helps the firm to hedge a domestic price risk by keeping assets in

foreign countries. In addition, Apache invests in different projects to
meet there goals, which includes, exploratory drilling, development of
existing projects and selection of property acquisition. They also
manage virgin fields in addition to the more mature properties. This
keeps a certain diversity of holdings.

Secondly, Apache is a large independent oil company. This

means that it can use its size to help manage its risk. Its bulk allows
for benefits, such as liquidity, stability and diversity, especially with its
technology risks. Apache can reap these benefits by using its
enormity to undertake many projects at a time.

Lastly, the firm also strategically manages its risk by

considering where it will operate. Apache avoids potentially unstable
international areas, like West Africa and territories in the former
Soviet Union. These areas bring about political risk and only work to
complicate the risk situation.

6.
Even if Apache is not very good at forecasting, this does not
mean they should stop hedging. The firm benefits from more than just
the security from hedging its price risk. As noted in the case, hedging
contributed to their credibility. Not only does this add to their credit
rating, it also contributes to their reputation of always closing a deal
and gives them advantages in the acquisition market. This financial
flexibility increases Apaches ability to execute faster.

7. a)
Exhibit 10 reveals that the beta for % change in oil is 0.24, and
the beta for % change in gas is 0.42. This means that Apaches return
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will increase/decrease by 0.24% per 1% increase/decrease in the oil

price, holding the gas price constant. In turn, this means the firms
return will increase/decrease by 0.42% per 1% increase/decrease in
the gas price, holding the gas price constant.

Exhibit 11 tells us about the price sensitivity of the firms stocks on oil
and gas. The beta for oil stock price is 0.2 and that for the gas stock
price is 0.43. For every percentage point increase/decrease in oil
stock price, holding other variables constant, the firms overall stock
return inclines/declines by 0.2%. Similarly, the firms return on stock
increases/decreases by 0.43% for one percentage point
increase/decrease in gas stock price, holding other factors constant.

b) The limitation to this is that the regressions are estimated using

historical data, not current data. Therefore they reflect the sensitivity
of the return to the firms stock to changes in oil and gas prices.

8. a) Apache is a conservative hedger so I would suggest that the

strike be near $3.50 so I would suggest $3.25.

b) From the B-S Model NDP Stock Formula we obtain a put premium
of $0.94.

c) Using the B-S Model NDP Stock Formula we obtain a strike for the
call of $5.31 to get a costless collar.

d)
Conditions Put Option Call Option Natural Gas Total Payoff
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Payoff (Long) Payoff (Short) Payoff (Long)

ST < 3.50 3.50 - ST 0 ST 3.50
3.50 ST 0 0 ST ST
5.31
ST > 5.31 0 - (ST 5.31) ST 5.31

e) Using the Black-Scholes model, we found a premium of $4.35.

f) According to the Goal seek in Excel, we found a strike price of

$46.59 for the call.
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g)
Conditions Put Option Call Option Oil Total Payoff
Payoff (Long) Payoff (Short) Payoff
(Long)
ST < 27 27 - ST 0 ST 27
27 ST 0 0 ST ST
46.59
ST > 46.59 0 - (ST ST 46.59
46.59)

h) According to Goal Seek, the strike is $29.06 for the call premium.
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i)
Conditions Put Option Call Option Oil Total Payoff
Payoff Payoff (Short) Payoff
(Long) (Long)
ST < 27 27 - ST 0 ST 27
27 ST 0 0 ST ST
29.06
ST > 29.06 0 - (ST ST ST + 14.53
29.06)

9. a) Forward Price = 27exp(0.07*3) = 33.30930762.

b) Forward Sale:
The forward sale provides downside protection so if the price falls, the
firm wont lose any value. However, this protection comes at a cost
(an opportunity cost!). Apache will have to forgo any profit if the spot
price at the expiration of the forward contract is in excess of the
forward price. There are no, however, no initial costs to this strategy.
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Colin Sproat 1100503

Collar Strategy with a put/call ratio of 1:

This strategy offers downside protection as well. Once again,
however, the combination of the put and call creates an interesting
situation. The firm is protected at the downside but once again will
forgo its future profits if prices lie above the call strike price. So this
option also comes at an opportunity cost. Since the premium of the
put is set so it is the same as that of the call, this strategy has no
initial cost.

Collar Strategy with a put/call ratio of 2:

Once again, this offers downside protection or insurance as well.
However, this strategy doesnt place a roof on profits if the prices
were to rise. So there is unlimited upside potential. There is no
initial cost to this strategy but the profits made are reduced to pay for
this protection.
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10. a)

One-Step Binomial Tree Model

Two-Step Binomial Tree Model

Five-Step Binomial Tree Model

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Colin Sproat 1100503

Thirty -Step Binomial Tree Model

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Colin Sproat 1100503
Zhimeng Ye 1081890
Colin Sproat 1100503

b)

c) The price oscillates around the Black-Scholes premium, getting

closer to it as the steps get larger.

11.
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Colin Sproat 1100503

Heres a quick walk-through of how we obtained the forward price

and payment for the first exchange as well as how we computed the
total value:

Note:
T = time to maturity
Payment = Spot price forward price
Present value = payments made at time T, discounted for T years

At T = 0.5

f = 69.58 * exp [(0.06 + 0.0442) * (0.5/12)] = 69.88274991

Payment = (64 - 69.88274991) * 500,000 = - 2,941,374.96

Present Value = Payment * exp [-(0.0442) * (0.5/12)] = 2,936,079.00

Total Value = Summation of all the present values.