mainly in what they expected in the near term, during the Persian Gulf crisis, and in their specific predictions for the long-term rate of price increase Estimates of operating expenses and overhead in Exhibits 3-7 also were developed by independent engineers and by Amoco and Morgan Stanley, respectively, not Apache. They were based, in the first instance, on historical costs, and in the second, on cash overhead savings Amoco actually expected to realize if Mw were sold. Apache's experience could be better or worse, depending on how efficiently the properties were operated. Depreciation, depletion, and amortization estimates were compiled by the casewriter, based on schedules produced by amoco and Morgan Stanley for the MW offering memorandum. These depended on the total purchase price, the allocation of the purchase price over the different reserves, and on the nature and timing of capital expenditures. Finally, Exhibit 7 assumes that all opportunities are exploited without in 1991 and proceeds subsequently as shown in Exhibits 3-6. If some or a/ ssible reserves commences postponed, the corresponding operating cash flows also would be delayed these expenditures were Risks Oil and gas exploration and production in the United States had been a volatile business during the preceding twenty years. The prime cause was volatility in energy prices, which had been pronounced since the early 1970s. Oil prices in particular had long been influenced by global political and economic events in addition to local supply and demand conditions. The sharp drop in oil prices in 1986 was followed by a period of volatile, though generally rising prices, punctuated by an upward spike associated with the invasion of Kuwait by Iraq in August 1990. By January 1991, war had broken out in the Persian Gulf region. However, other oil-producing countries, principally Saudi Arabia, had increased production to offset disruptions in supply and most of the world was united in opposition to Iraq s occupation of Kuwait. As a result, by year-end 1990 oil prices had actually fallen from their September highs. Nevertheless, prices were volatile in early 1991 and many analysts expected them to remain so. The annualized standard deviation of oil price changes, calculated based on observed weekly price fluctuations, was just over 50% per year at the end of January 1991. During 1989 and the first half of 1990, this annualized standard deviation was usually between 20% and 30%o, but it had risen steadily since the beginning of the Persian gulf crisis. Exhibit 8 displays historical data on oil prices and the standard deviation of changes estimated from historical data on weekly prices Gas prices had declined gradually from their relatively high levels in 1984, but had become much more volatile as they were decontrolled. During most of 1988 and 1989, the standard deviation of changes in gas prices was lower than for oil price changes. Then, in the fall of 198 the volatility of gas price changes jumped upward to an annualized standard deviation of about 40% per year, nearly twice as high as for oil price changes. Not until the fall of 1990 did oil once again become more volatile than gas. Exhibit 8 displays data on historical gas prices and the standard deviation of gas price change n addition to price volatility, Apache naturally would face uncertainties about the quantities of oil and gas to be produced from the MW fields and the expense of producing it. Some risks derived from unanswered geological and engineering questions regarding the amounts of oil and gas physically present and the likely success of secondary and tertiary recovery operations MWs reserves had been quantified by Amoco and Amoco's external engineering consultants based on seismic and other geological data, Amoco's production experience to date, and other factors that determined the effectiveness of specific recovery techniques. Apache's engineers and advis
DO NOT COPY 295-029 MW Petroleum Corporation (A) 6 mainly in what they expected in the near term, during the Persian Gulf crisis, and in their specific predictions for the long-term rate of price increase. Estimates of operating expenses and overhead in Exhibits 3-7 also were developed by independent engineers and by Amoco and Morgan Stanley, respectively, not Apache. They were based, in the first instance, on historical costs, and in the second, on cash overhead savings Amoco actually expected to realize if MW were sold. Apache's experience could be better or worse, depending on how efficiently the properties were operated. Depreciation, depletion, and amortization estimates were compiled by the casewriter, based on schedules produced by Amoco and Morgan Stanley for the MW offering memorandum. These depended on the total purchase price, the allocation of the purchase price over the different reserves, and on the nature and timing of capital expenditures. Finally, Exhibit 7 assumes that all opportunities are exploited without delay; that is, capital spending for proved undeveloped, probable, and possible reserves commences in 1991 and proceeds subsequently as shown in Exhibits 3-6. If some or all of these expenditures were postponed, the corresponding operating cash flows also would be delayed. Risks Oil and gas exploration and production in the United States had been a volatile business during the preceding twenty years. The prime cause was volatility in energy prices, which had been pronounced since the early 1970s. Oil prices in particular had long been influenced by global political and economic events in addition to local supply and demand conditions. The sharp drop in oil prices in 1986 was followed by a period of volatile, though generally rising prices, punctuated by an upward spike associated with the invasion of Kuwait by Iraq in August 1990. By January 1991, war had broken out in the Persian Gulf region. However, other oil-producing countries, principally Saudi Arabia, had increased production to offset disruptions in supply and most of the world was united in opposition to Iraq's occupation of Kuwait. As a result, by year-end 1990 oil prices had actually fallen from their September highs. Nevertheless, prices were volatile in early 1991 and many analysts expected them to remain so. The annualized standard deviation of oil price changes, calculated based on observed weekly price fluctuations, was just over 50% per year at the end of January 1991. During 1989 and the first half of 1990, this annualized standard deviation was usually between 20% and 30%, but it had risen steadily since the beginning of the Persian Gulf crisis. Exhibit 8 displays historical data on oil prices and the standard deviation of oil price changes estimated from historical data on weekly prices. Gas prices had declined gradually from their relatively high levels in 1984, but had become much more volatile as they were decontrolled. During most of 1988 and 1989, the standard deviation of changes in gas prices was lower than for oil price changes. Then, in the fall of 1989, the volatility of gas price changes jumped upward to an annualized standard deviation of about 40% per year, nearly twice as high as for oil price changes. Not until the fall of 1990 did oil once again become more volatile than gas. Exhibit 8 displays data on historical gas prices and the standard deviation of gas price changes. In addition to price volatility, Apache naturally would face uncertainties about the quantities of oil and gas to be produced from the MW fields and the expense of producing it. Some risks derived from unanswered geological and engineering questions regarding the amounts of oil and gas physically present and the likely success of secondary and tertiary recovery operations. MW's reserves had been quantified by Amoco and Amoco's external engineering consultants based on seismic and other geological data, Amoco's production experience to date, and other factors that determined the effectiveness of specific recovery techniques. Apache's engineers and advisors also
PEtroleum Corporation(A) 295029 were evaluating reserves and production operations. In addition to checking the independent both direct costs and overhead--would be an important determinant of MWs profitability costs- reserve estimates, they were looking for cost-saving opportunities. The ability to manage Structuring a proposal To take advantage of what they regarded as an attractive opportunity for growth, Apache's executives and advisors had to design a transaction that would satisfy Amoco's desire to sell MW at a good price; that would be profitable for Apache; and that could be financed externally with a large component of debt. This last requirement was expected to be especially difficult, given the large size of MW, the Ba3 rating of Apaches debt, and the current lending environment In 1991, the maximum loan-to-value ratio permitted by banks lending against oil and gas assets was typically 50% of the value of proved reserves. In addition, the credit approval process would require the analysis of a worst-case scenario, and loan terms would be set to protect the lender as much as possible in the worst case. The lending environment in 1991 was even tighter than these restrictions suggested, however, because U.S. banks were under pressure from regulators to improve the quality of their loan portfolios following losses on some highly levered transactions of the 1980s. Highly levered transactions were clearly out of favor, and some institutions were out of he market altogether, after the posting of reserves against bad loans had reduced their lending capacity. Consequently, there was a limited number of institutions among which to syndicate a There were several possible ways to make an MW acquisition more attractive to lenders One was to reduce its size, though both Amoco and Apache would oppose reducing it beyond a certain point. Another was to have Apache or MW issue equity either to Amoco, to the public, or to some other private investor. Both Amoco's and Apaches shares were traded on the New York Stock Exchange; historical stock price data for both companies is presented in Exhibit 9. Yet another possibility was for Amoco itself to lend to Apache, or to guarantee some part of Apaches external acquisition debt. Finally, Apache could expect to borrow more, the more it could reduce the banks'exposure to a worst-case scenario. Experienced lenders' prime concern was an unexpected drop in oil prices like the one that had occurred in 1986. In early 1991, with a war underway in the Persian Gulf, most experts foresaw higher rather than lower energy prices, though they varied a among the most conservative forecasters. Some had lent too aggressively follor. ugh, banks were great deal in their prediction of the near-term path of prices. Not surprisingly Despite the problems Apache had to overcome, in at least one respect the lending environment was favorable. Inflation in the United States had been low for nearly a decade and interest rates had been generally falling. Long-term treasury bonds offered yields of 8% to 8.25% and yields on B-rated debt had dropped more than 150 basis points in two months, despite the turmoil in the Middle East. Lower rates made whatever financing was available less expensive, and a lower opportunity cost of capital made long-term investments like MW more attractive Contemporary financial market data are presented in Exhibit 10
DO NOT COPY MW Petroleum Corporation (A) 295-029 7 were evaluating reserves and production operations. In addition to checking the independent reserve estimates, they were looking for cost-saving opportunities. The ability to manage costs— both direct costs and overhead—would be an important determinant of MW’s profitability. Structuring a Proposal To take advantage of what they regarded as an attractive opportunity for growth, Apache's executives and advisors had to design a transaction that would satisfy Amoco's desire to sell MW at a good price; that would be profitable for Apache; and that could be financed externally with a large component of debt. This last requirement was expected to be especially difficult, given the large size of MW, the Ba3 rating of Apache’s debt, and the current lending environment. In 1991, the maximum loan-to-value ratio permitted by banks lending against oil and gas assets was typically 50% of the value of proved reserves. In addition, the credit approval process would require the analysis of a worst-case scenario, and loan terms would be set to protect the lender as much as possible in the worst case. The lending environment in 1991 was even tighter than these restrictions suggested, however, because U.S. banks were under pressure from regulators to improve the quality of their loan portfolios following losses on some highly levered transactions of the 1980s. Highly levered transactions were clearly out of favor, and some institutions were out of the market altogether, after the posting of reserves against bad loans had reduced their lending capacity. Consequently, there was a limited number of institutions among which to syndicate a large loan. There were several possible ways to make an MW acquisition more attractive to lenders. One was to reduce its size, though both Amoco and Apache would oppose reducing it beyond a certain point. Another was to have Apache or MW issue equity either to Amoco, to the public, or to some other private investor. Both Amoco’s and Apache’s shares were traded on the New York Stock Exchange; historical stock price data for both companies is presented in Exhibit 9. Yet another possibility was for Amoco itself to lend to Apache, or to guarantee some part of Apache’s external acquisition debt. Finally, Apache could expect to borrow more, the more it could reduce the banks' exposure to a worst-case scenario. Experienced lenders' prime concern was an unexpected drop in oil prices like the one that had occurred in 1986. In early 1991, with a war underway in the Persian Gulf, most experts foresaw higher rather than lower energy prices, though they varied a great deal in their prediction of the near-term path of prices. Not surprisingly though, banks were among the most conservative forecasters. Some had lent too aggressively following the oil price shocks of the 1970s, only to lose badly when oil prices fell. Despite the problems Apache had to overcome, in at least one respect the lending environment was favorable. Inflation in the United States had been low for nearly a decade and interest rates had been generally falling. Long-term treasury bonds offered yields of 8% to 8.25%, and yields on B-rated debt had dropped more than 150 basis points in two months, despite the turmoil in the Middle East. Lower rates made whatever financing was available less expensive, and a lower opportunity cost of capital made long-term investments like MW more attractive. Contemporary financial market data are presented in Exhibit 10