Cover Your Assets

As commodity companies acquire assets, hedging can help take the caveat out of the emptor.

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.

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