The year 2012 was quite a forgettable one for Apache Corp. (APA) and quite honestly 2013 hasn't started off too fantastically either with the news Friday of an underwater natural gas flow problem. The stock has dropped from around $108 to a recent price of $76.85, as a combination of non-cash write downs, operational problems and higher debt levels have obscured what otherwise would be seen as an attractive energy production growth story. At the current price, Apache offers considerable value and an excellent margin of safety assuming flat to rising energy prices. While management has shown a strong willingness to go at it alone as one of the largest pure play exploration and production companies, I believe that it is now time for the company to either explore a sale, or significantly alter its capital allocation strategy to a more shareholder friendly approach. Apache is asset-rich and relatively cash poor, so the combination with a cash-rich company such as Chevron (CVX) or Exxon (XOM) would allow the company to harvest its extensive resource portfolio in most optimal way possible.
2012 was supposed to be a year of solid production and earnings growth. Instead it was marred by quarter after quarter of disappointments. For the full year the company posted earnings of $1.9 billion, or $4.92 per diluted common share. This was down sharply from $4.5 billion or $11.47 per share in 2011. Excluding write downs, particularly those due to lower natural gas prices, Apache reported adjusted earnings of $3.8 billion or $9.48 per share, compared with $4.7 billion or $11.83 per share in 2011. Despite various operational problems such as Hurricane Isaac and some North Sea production delays, the company was able to grow average daily production by 5.4% from the prior year to 779,000 barrels of oil equivalent per day. Management pointed out on the conference call that without those two production delays, production growth would have been 6.3%. Lower realized prices were another significant factor in the year's poorer performance. Apache's global diversity has helped it greatly with Brent Crude prices being realized at a premium to WTI, as 72% of the company's oil is priced off of Brent.
Despite these lower prices, Apache produced $10.2 billion in cash flow from operations before changes in operating assets and liabilities. The company averaged $42.86 of cash flow per boe in 2012. Apache finally began clicking on all cylinders as 2012 ended with the company producing in excess of 800,000 boe per day, driven largely by a 12% increase in North American oil production. Just like nearly every other E&P, Apache has significantly reduced its capital spending on natural gas projects so that it can fully monetize the much more attractive pricing available through oil production. Apache is the leading oil and gas driller in the Permian Basin and it also has a very strong position in the Central Region's Andarko Basin. In 2012, the company was able to boost production from these two regions by 18 and 37%, respectively. With production in full force, Apache should be able to report significant earnings growth in 2013 with these two regions doing much of the heavy lifting.
In the 4th quarter Apache had earnings of $649MM or $1.64 per diluted share, which was down from $1.17 billion or $2.98 per share in the prior year period. Adjusted earnings for the period were $907MM or $2.27 per share, compared with $1.2 billion, or $2.94 per share in the prior year period. Production averaged 800,000 boe per day, while cash flow from operations totaled $2.77 billion. This was actually up slightly from last year's 4th quarter where cash flow from operations was $2.66 billion. Throughout 2012, the company added 372 MMboe of reserves, which was 131% of production through discoveries and extensions, and another 73MMboe through acquisitions. Ultimately, the reserve replacement rate excluding revisions was 156%. The news wasn't all good though due to low prices from Canadian natural gas, which forced the company to do a ceiling test write-down resulting in negative revisions totaling 299MMboe. Apache still has the majority of this natural gas in the ground so if the price turns for the better the revisions would not ultimately reflect the true underlying economics, but of course there is huge uncertainty in this matter.
Apache has incredible acreage and property value that set the stage for a uniquely attractive long-term production growth profile, which is extremely rare for an E&P company its size. The company has 67,000 technically evaluated drilling locations in the onshore U.S. The company also has extensive operations in Egypt, the Gulf of Mexico, and the North Sea etc. Apache's Egyptian operations have long been a source of investor uneasiness due to political uncertainties, but despite the radical changes that have been occurring in the region, Apache's operations there have been enormously profitable and remarkably consistent. Apache is ramping up growth in Egypt and the North Sea, but the majority of production growth should come from the Permian and Central regions. Apache is investing a whopping $10.5 billion in capital expenditures in 2013, with $4 billion earmarked for onshore North America, where it expects 20% growth in production.
Apache owns 50% of the Kitimat LNG project, which should help the company monetize its over 50 TCF of natural gas that it has in the Liard and Horn river at oil-linked prices. Apache's LNG projects will require long-term capital spending that will offset what could potentially be achieved if the company invested the additional capital into enhancing its onshore drilling in North America. 21% of the 2013 CAPEX budget is being spent on long-term infrastructure projects and management believes that if the company used the long-term investments on short-term production, production growth would likely exceed 6% in 2013, as opposed to the revised 3-5% target. I believe management is making the right decision to invest for the long-term but the aggressive CAPEX plans in addition to the $16 billion spent on acquisitions in the last year have increased the debt load to a debt/capitalization rate of 28%. To combat the rising debt load the company intends to divest $2 billion of assets. If these assets are productive the result would be lower production growth, so I'd probably expect the company to sell some non-productive assets in the very near future. North American oil production is expect to grow by 14% in 2013, which is pretty remarkable considering the company grew oil production in the region by 12% in 2012.
Apache's long-term growth projects are expected to add materially to production. This provides tremendous leverage assuming prices rise, which in my opinion is quite likely due to faster global growth, and excessive currency devaluation by most developed countries. Management forecasted that based on current ownership of the long-term projects, the company expects them to add 150,000 barrels of oil equivalent a day over the next 5 years and over 2000,000 boe by the end of the decade. My concern would be if prices were to decline, Apache would be stuck with a huge asset based of value declining assets, without the financial wherewithal to invest at more attractive prices. Chevron and Exxon are extremely cash-rich and I believe that purchasing Apache is a much cheaper way to acquire huge reserves and production growth than with the drill-bit. The two major LNG projects in Apache's pipeline are expected to increase production by in excess of 200,000 boe per day.
I do believe that the company has been smart to use a little more debt because of its ability to raise $5 billion in 2012 at an all-in cost of 3.6%. The problem is that the company has invested tens of billions into acquisitions and exploration, when it might have been able to find better value by simply buying back its own stock. I'm not 100% sure that management is totally dedicated to growing per share net asset value, as opposed to focusing on the company getting larger in asset size. This is a common theme in E&P companies and is why I only invest in them when I believe prices are likely to rise, or when the margin of safety is so significant that I can't resist. I do indeed feel both these circumstances are present with Apache at current prices.
Apache's market capitalization is right around $30 billion with another $11.355 billion in long-term debt, as of 12-31-2012. The company actually trades right around book value, which has already been reduced by the non-cash natural gas write-downs. According to Morningstar the mean earnings estimates for Apache in 2013 are about $9.73, which would give the company at forward p/e ratio of 7.9. I believe those earnings estimates are overly conservative and are actually indicative of the many problems Apache had in 2012. The company should be able to grow long-term production by roughly 6% per annum as the large growth projects come online. At year end, Apache had total boe (MBOE) of reserves of 2,851,679. Proved and developed reserves were 1,981,945 and oil and natural gas liquids comprised 50.1% of proved reserves. Since we began investing in Apache in 2012, we are down on our positions and the only thing that has helped is that we got into the stock primarily through selling long-term put options, which carried very high premiums allowing us to substantially reduce our cost basis. If you aren't already long the stock, we'd recommend buying it at $76.85 and in unison selling the January 2015 $75 puts for $10.50. This will give you 100% of the upside or downside associated with owning the stock, and we believe that if energy prices rise, Apache could trade well over $130 in a few years. In a worst case scenario where Apache expires below $75 at expiration, the breakeven price on the stock for the option position would be $64.50. If the option expires worthless, which we expect, the target profit on the maximum risk of $6,450 would be about 16.2% in about 698 days. With 100 shares bought at $76.85 and 100 share acquired at $64.50, the breakeven would be $70.68, which is about 8% below the current price. From that level I'd expect huge upside when energy prices go higher and Apache's exciting long-term growth prospects get to full production capacity.