Apache: Can You Make Money Buying APA Below Book Value?

| About: Apache Corporation (APA)

I'd like to examine Apache (NYSE:APA) as a potential candidate for investment. The most glaring risk is the price of oil, where combined with natural gas liquids, Apache generates 81% of its revenues.

At the time of this writing, WTI is trading at roughly $93 per barrel and Brent is trading at roughly $114 per barrel. The EU debt and equity markets are presently declining from unease over the Italian elections, and if the U.S. and world economies slow, oil prices will not be able to hold the current levels.

In addition to downside risks from slowing global GDP growth, we have extraordinary oil supply growth in U.S. To make an investment in Apache, the first factor for consideration is determining APA's exposure to an oil price plummet.

Let's take a look at APA's revenues. Oil and natural gas liquids accounted for 51% of production volume and 81% of revenues during 2012. At first glance, it seems that APA has upside potential from the likelihood of higher natural gas prices during 2013 versus 2012. While higher natural gas prices will help APA on the margin, on closer look, we find that APA actually achieved an average selling price of $3.80 for natural gas during 2012. Therefore, it would take a dramatic rise in natural gas prices to meaningfully enhance APA's 2013 earnings.

APA's 2013 oil production is only about 15% hedged with hardly any hedging in the out years, leaving the company significantly exposed to a global slow down and/or oil price reversal.

APA's 2013 oil production is hedged 1,972 Mbbls (about 15%) at $74.29 weighted average fixed price. APA's 2013 natural gas production is hedged 10,095 MMbtus (about 22%) at a weighted average fixed price of $6.74. APA's 2014 production is hedged 76 Mbbls oil at $74.50 and 1,295 MMbtus at $6.72 (about 2%).

During Q4 2012 oil production averaged 372,084 barrels per day, natural gas averaged 2,244,885 MCF per day and natural gas liquids averaged 53,733 barrels per day, in total 800,005 BOE per day.

APA has roughly 10 years' supply of reserves at current production levels, and the company spent $9 billion during 2012 to add roughly 1.56 years' supply. APA's cash flow from operations during 2012 was $10.2 billion. The cost for APA to replace 2012 production was approximately $5.8 billion. Therefore, the company generated $4.4 billion net cash flow.

APA achieved the following average prices during 2012: oil $102.53, NGL $33.4 and NG $3.80.

APA's assets are located in the Permian, Central, Gulf of Mexico Shelf, Gulf of Mexico Deepwater, and Gulf Coast Onshore in the United States; British Columbia, Alberta, and Saskatchewan provinces in Canada; Egypt; offshore Western Australia in the Carnarvon basin; offshore the United Kingdom in the North Sea; and in the Neuquén, Rio Negro, Tierra del Fuego, and Mendoza provinces of Argentina.

APA's total indebtedness obligations have a $12.34 billion carry value of which approximately $10 billion is in notes, $2 billion commercial paper and the balance outstanding on lines of credit. APA has current debt of $500 million at 5.25% and $400 million at 6%; along with $64 million under a credit line.

During 2012 APA sold $400 million 3-year notes at 1.75%, $1.1 billion 10-year notes at 3.25% and $1.5 billion 30-year notes at 4.75%. Interest expense was roughly $500 million during 2012.

APA was shrewd in using 2011 earnings to issue debt early during 2012.

At the current prices for oil, NGLs and natural gas, APA can generate $10 billion in cash flow. After replacing reserves, roughly $4 billion pre-tax and $2.5 billion net to shareholders.

Management can return the cash to shareholders through paying down debt, repurchasing shares, increasing dividends, making acquisitions or any combination of these options.

It seems as though the company is already stretched out over its skis from recent acquisitions, so let's strike that option.

For shareholders to benefit, the company needs a period of consolidation with a heightened focus on profitability. The company needs to reign in the spending and eliminate anything beyond reserve replacement investments. Take the $2.5 billion in annual earnings and pay down debt and repurchase shares at current prices. The company must be nimble in its capital allocation decisions, i.e. be ready to abandon the program if shares are materially higher and pay down high interest debt when and where that is the best option.

To increase the stock price, management needs to meaningfully hedge production for the next three years, maintain production volume and reserve replacement levels and return about $7.5 billion to shareholders through debt elimination, buybacks and dividend increases when the timing is right (depending on price and balance sheet strength).

If the company will take these actions, three years out, APA will have a strong and loyal shareholder base receiving a competitive dividend yield. APA will be a company with a much stronger balance sheet supported by a healthy debt/equity ratio. APA will then be positioned to resume growth through increased exploration and smart acquisitions.

If the price for oil assets were to decline significantly, creating an opportunity for a well hedged APA, APA would need to be nimble enough to make the allocation adjustments and purchase assets 'on sale' in such an event.

Hopefully senior management will review these ideas and move the company along this path. The present lack of direction (or lack of communication of the company's direction to shareholders) from the executives suggests the company and its shareholders will continue to suffer until a clear and achievable plan of action is in place and communicated to shareholders.

APA needs to insure against the following: significant commodity risk, selling an asset or two at some point and then replacing those assets shortly thereafter, paying down debt after an asset sale and then replacing the debt once again a few months down the road. Such a cycle would generate banking fees, but it would add no value for shareholders.

The bottom line is that APA needs to articulate a clear and achievable strategy to investors. The strategy outlined in this article, upon successful execution, would drive the price of APA shares meaningfully higher.

Without an effective strategy from APA's management team, direction could come from an activist investor or a new owner, but if none of these catalysts materialize, the stock is likely to languish.

Disclosure: I am long APA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.