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As commodity companies acquire assets, hedging can help take the caveat out of the emptor.
Tim Reason, CFO Magazine
April 1, 2001
Forget buy low, sell high. An increasing number of commodity companies realize that their acquisition strategies need not be held hostage to economic cycles--as long as they can hedge their risk.
Take Pogo Producing, a Houston-based oil and natural-gas exploration and production company. Despite soaring gas prices last year, Pogo announced in November that it planned to acquire another oil and
natural-gas concern, Noric Corp., for $630 million plus debt assumption. Or oil company Apache Corp., also in Houston, which acquired natural-gas fields in the Gulf of Mexico from Occidental Petroleum Corp. for $385 million in August, followed by a $490 million purchase of gas reserves in the Zama region of Alberta, Canada, from Phillips Petroleum Co. in December. In each case, the growing disparity between the price of gas in the ground and the market price allowed these companies to protect their new purchases with hedges.
The oil and gas business, explains Apache CFO Roger B. Plank, is "feast or famine. Mostly famine." For instance, when gas prices shot up in 1997, "investors threw money at the industry on the theory that prices would stay high," he recalls. As capital flowed in to buy gas reserves and ramp up production, drilling rigs and other equipment became scarce commodities, creating an upward spiral of costs. When the market fell the following year, many companies were badly burned as tumbling gas prices undercut their pricey capital investments.
When gas prices began to rise again toward the end of 1999, says Plank, Apache officials expected a repeat of the 1997 frenzy. By midyear, however, it was clear that painful memories of price collapses still lingered. "Investors were sitting on the sidelines--their knee- jerk reaction was that it was not the time to buy properties," says Plank.
That skittishness drove the price of gas reserves down to as little as two to three times cash flow by mid-2000. Historically, explains Plank, Apache paid four to five times cash flow for acquisitions. "We had no competition [from other buyers]," he says, "and we could pay off the assets in two to three years. What a great opportunity."
COLLARS AND FLOORS
Nonetheless, adds Plank, "it is a little nerve-racking if you don't know what the [market] price will be." So Plank decided to use a so- called costless collar--an increasingly popular strategy for hedging various types of risk, including commodity risk--to protect Apache's acquisition price of about $1.12 per 1,000 cubic feet (Mcf) for Occidental's gas reserves.
In 2000, for example, Apache bought a put that locked in a floor price of $3.50 per Mcf. To recoup the cost of the put (and create a costless collar), the company then sold a call for the same amount it had spent on the put. In this case, that gave Apache a ceiling price of $5.26.
The floors, which drop to $3 this year and $2.80 in 2002, "were basically within 30 cents of what we assumed in our acquisition economics," says Plank. "We will get a double-digit rate of return if prices fall." If prices rise, as they have continued to do, and the collar's ceiling is exercised, "then our rate of return will be extremely rewarding--probably 30 percent or better," he notes.
The risk of a collar hedge is that companies sacrifice additional profits if prices continue to rise beyond the ceiling set by the company's call price. Gas prices have already risen beyond Apache's call price of $5.26. But Plank points out that if he had hedged with a traditional forward swap at the time of the Occidental acquisition, Apache would be selling gas at $3.30, and losing $2.
"So if it goes to $7.25, we miss $2, but we are still getting $2 better than we anticipated, and our rate of return is still way better than we expected," says Plank. "You can't complain. You have to have that kind of psychology or you'll never use this kind of strategy." Of course, he notes, "Everybody has a different opinion with hedging."
Indeed, Pogo Producing did not use collar hedges. Immediately after the company announced plans to acquire Noric for an Mcf price of about $1.40, says CFO James P. Ulm II, he purchased a floor of $4.25 per Mcf for April 2001 through March 2002, and a floor of $4 from April through December 2002.
"We used floors because it allowed us to lock in the economics and guarantee the cash-flow levels we wanted--and we kept all of the upside for investors," says Ulm. Unlike the costless collar, however, that hedge cost $24 million on a total acquisition cost of $750 million. "We have used collars and fixed-price swaps in the past," he says. "Those are all hedging tools at your disposal, and you pick the best tool. In this case, using floors was the best thing to do."
Hedging is a relatively recent phenomenon in the gas market, adds Ulm, noting that the New York Mercantile Exchange first listed natural gas as a commodity in 1990. "There is a convergence of high commodity prices and a developing hedge market that has made companies more accustomed to hedging over the past five years," he says.
SPOT DEFERRED CONTRACTS
Hedging has long been a strategy for other extractive commodities, such as gold, where sharp differences in price have always existed between reserves and finished products. "The price of metal in the ground is low relative to the price of refined metal--the difference is much more severe than it is in the oil and gas industry," explains Jeffrey M. Christian, managing director of New Yorkbased metals commodities consultant CPM Group. "The major cost for oil and gas is exploration, whereas in metals it is extraction."
Christian points to Toronto-based Barrick Gold Corp., which has been hedging for 15 years, as a leader in hedging strategies. "If the gold price moves against them, their hedge book becomes a tremendous financial asset," he says. "They can go out and buy depreciated assets-- reserves in the ground--with their appreciated asset: the hedge book."
Barrick hedges about 25 percent of its gold reserves and a portion of its production. The company uses spot deferred contracts, explains CFO Jamie Sokalsky, which can be deferred for any period up to 15 years if prices rise. For example, although spot prices are currently around $270 per ounce, Barrick has locked in a price of $340 per ounce for this year and next. "But if the spot prices rise above those levels, we will sell at the higher price and defer these existing contracts at increasingly higher prices," says Sokalsky. Barrick, he claims, has sold its gold at prices higher than the spot price for 52 consecutive quarters.
However, he adds, there is a significant difference between gold and most other commodities. "There is always a forward premium for gold hedging, so we have the confidence of being able to put on hedges that we know will grow in value by about 5 percent a year," he says. "That allows us to plan for the future with a lot of certainty. In every other extractive industry, there is no such assurance."
Despite differences between gold and gas, however, both industries find that hedging is a useful acquisition aid. Sokalsky is quick to note that hedging "is a disciplined strategy not related just to acquisitions." However, he adds, "Our hedging program gives us additional strength to make acquisitions no matter where the gold price is."
In 1999, Barrick acquired Sutton Resources, owner of the Bulyanhulu gold mine in Tanzania, for $280 million. "That acquisition was made with the equivalent of one year's hedge gain," says Sokalsky, providing Barrick with Bulyanhulu's 10 millionounce reserve.
In fact, over the past 13 years, Barrick's hedging strategy has earned it an average $68 over the spot price of gold, or an additional $1.8 billion in revenue. "Often people think hedging reduces the upside exposure to the commodity," says Sokalsky, "but because the additional revenue allows us to buy more reserves, more production, and lowers our cost of capital, we think it ultimately increases our participation in higher gold prices."
Hedging is considered primarily an acquisition strategy at Apache, notes Plank. "Generally, shareholders have not appreciated hedging," he says. "Our approach is to leave our base unhedged, but to use hedges on acquisitions to build the company. Acquisition economics are hypersensitive in the first few years of investment, so we try to protect through a period of payout."
Debt agencies like the strategy. And with almost $1 billion worth of acquisitions closing in the first half of 2001, Apache's debt rating was upgraded to A-, putting it just behind oil heavyweights ExxonMobil Corp. and Chevron Corp. Likewise, Barrick has the only A credit rating in its industry. "Rating agencies see this as a very sober way to proceed with a growth strategy during this part of the [economic] cycle," notes Plank.
Indeed, Apache has a reputation for solid financial management. Its production has grown for 24 years in a row, and its tight management of expenses earned it the top mark among oil and gas companies included in CFO's 2000 Cost Management Survey (December 2000).
CFO Ulm says Pogo has historically grown "through the drill bit"; that is, through exploration and development of its existing asset base. The company's acquisition of Noric was "a little bit of a departure" from that path, he admits, but "very complementary to our existing strategy." It was the quality of the Noric assets and not the ability to hedge in a high-priced environment that was the primary impetus for Pogo's recent acquisition, he says, "but if you can back that up with hedging on the back end, that's a powerful combination."
Tim Reason is a staff writer at CFO.