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FINA 5520 – Risk Management and Financial Instruments

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FINA 5520 – Risk Management and Financial Instruments

Oil Hedging Case Background Santos Ltd. (STO.ASX) is an Australian energy company, the country’s second-largest independent oil and gas producer. In a recent Annual Report STO has noted that it does indeed hedge some of its oil price risk. See the extract of the note below. On page 97 of the Annual Report, the company outlines the accounting treatment of this hedge, specifically that any movement in fair value will be recorded in the income statement. 1In August 2018, STO announced the acquisition of Quadrant Energy . This acquisition increases the oil price exposure of STO materially. Quadrant did not hedge its production. For the purpose of this assignment assume the following;

a) The hedge exists for STO’s 2018 financial year, January 1, 2018 to December 31, 2018.

b) STO oil production for 2018 is 12.5 million barrels, constant over the year.

c) STO’s marginal tax rate is 30%.

d) The Quadrant acquisition is anticipated to close on Sep 30, 2018.

e) Quadrant 2018 production levels are expected to be the same level as 2017, constant over the year.

f) Quadrant has not hedged its oil and condensate production for 2018.1 https://www.santos.com/media/4502/graphite-asx-combined-22-august-2018.pdf The Task The board has asked you to provide an assessment of the existing hedge strategy for STO’s oil production for 2018.

This analysis should include;
a) A detailed description of the strategy, including pay offs on oil prices from U$30-U$100 per barrel.

b) The strategy’s impact on earnings (pre and post-tax) for each of the first three FY2018 quarters.

c) The strategy’s potential impact of earning for 4Q2018.

d) Comment on the materiality of the hedging strategy’s impact on EPS.

Part B – Impact of Quadrant Acquisition The board is concerned that as a consequence of the Quadrant Acquisition, the 4Q2018 oil production will now be under hedged. The board has instructed you to recommend a cost less hedging solution for 4Q that provides at least the down side coverage of the existing strategy. This recommendation should include;
a) A detailed description of the strategy, including pay offs on oil prices from U$30-U$100 per barrel.
b) The strategy’s potential impact of earning for 4Q2018, under baseline assumptions.
c) The strategy’s potential impact of earning for 4Q2018, under distressed assumptions.

d) Outline the materiality of this strategy’s impact on EPS.

For the purpose of this assignment assume your are doing this task as of the end of 3Q18.

Instructions You are to prepare a financial model and Board paper covering tasks A) and B).

A) Board Paper (50%) This is to be in the form of a slide deck covering no more than 12 slides, submitted as a PDF. You can add as many appendices as you like, but do not expect these to be read. Include all necessary sources so the board can independently verify any claims/assumptions. The Board paper is to be presented in the week 12 by the group and will be assessed on three key criteria:•

Validity of Analysis and Recommendation ( 15% )

Material and presentation quality, incl. charts, structures, references. (10%)

Group Q&A performance (25%)

B) Financial Model (50%) You are to prepare a financial model to support your recommendation. It is likely the directors will have differing views on assumptions. As such, the financial model should dynamically recalculate findings based on varying assumptions. All assumptions are to be presented on one sheet. The model should accommodate period to period variation in any key assumption. Periods should monthly, covering 2018. Results should be rolled up to financial quarters and annuals. All instruments need to be priced as of Monday, October 1st, 2018. This model is to be in Microsoft Excel. The model will be assessed on three key criteria:

Assumptions & Data (15%)

Modelling of Strategies (15%)

Reporting of Results (20%)

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