What are the major risks Apache faces? As an independent oil and gas exploration and production company, Apache is exposed to a myriad of risks stemming from price fluctuations in oil and gas markets. As we see in the case, Apache has 80 percent of its proven resources in the United States, which puts the company at a disadvantage should oil prices rise significantly. When oil prices rise, production tends to shift away from domestic sources, as oil is relatively expensive to extract in the US as compared to elsewhere in the world.
Apache has also purchased a number of mature oil fields from larger producers, and these fields tend to be more expensive to extract from, since production falls and extraction costs rise as fields mature. Since Apache is a larger independent company, they have continued to grow and expand their holdings and reserves. As stated in the case, their strategy has been to maximize production and minimize cost through increasing exploration, development and acquisitions. The company has also attempted to increase its non-domestic holdings through acquiring new international holdings.
While these holdings might be less costly to develop, they are riskier in the respect that the reserves are not as proven and they bring additional risk in the form of political uncertainty. However, we see in the case that Apache made acquisitions in 2001 of over a billion dollars, and also anticipated spending an addition $1 billion in capital expenditures in the form of exploration. At the same time, Apache had also implemented a new, limited hedging program centered around these new acquisitions.
The company was evaluating the success of the hedging program, and attempting to determine whether the hedging should be extended to other activities within the company. With these additional risks come several questions. Is risk management valuable to Apache? Should Apache manage risk, and how should they go about doing so? Apache made their acquisitions in the earlier part of 2001, after seeing oil prices swing from a low of $11 a barrel in 1998 to a high of $27 a barrel in more recent times.
The value of the company’s new acquisitions depends on the price of oil, and volatility of oil prices can have a huge effect upon the stability of the company. Many oil and gas companies go through drastic changes as a result of fluctuating prices, including massive layoffs and the resulting losses of institutional knowledge during lean times, and misappropriations of funds during times of higher oil prices. Hedging, as applied to oil and gas companies, works to ease the transitions between these periods and minimize the negative effects that swings in oil prices can create for exploration companies.
Hedging can not only reduce the amount of equity that that oil companies need to support operations, it can also increase the desirability of said company, as outside investors see hedging as a sign of managerial competence. When companies hedge their acquisitions and operations, investors have more confidence in the company as a whole since these activities tend to ease the effects of fluctuating prices and signify competence on the part of management. However, managing risk through derivatives does have its downsides; the activity takes time and resources from management staff.
Also, while hedging can mitigate losses that a company might sustain in times of falling prices, it also limits the amount a company might profit in times of rising prices. Some investors prefer an exposure to the risk that oil companies incur, as with greater risk comes the potential for greater reward, i. e. profits. However, what we see in the case of Apache’s 2001 acquisitions is that the company was purchasing properties during a time of rising oil and gas prices.
Since the oil market was bullish at the time, the company’s concern was that the properties might be overvalued, since high current market prices would inflate the purchase price for said properties. If prices were to drop in the future, Apache may have over-paid for the resources. For this reason, many other companies chose not to acquire additional properties during times of rising oil prices; Apache instead chose to hedge their acquisitions in order to mitigate the risk of future losses.