Apache Corporation (NYSE:APA) is one of the world's largest mid-major oil and gas exploration and production companies. They have a diversified portfolio of energy assets including on-shore, offshore, international, and domestic exposure. Diverse revenue streams protect Apache against volatility in any particular operating segment or region.
Apache operates an "acquire and exploit" strategy, acquiring land previously explored by major oil companies and either boosting production or further exploring the land. This strategy is entirely dependent on management's ability to identify underutilized assets and pay reasonable prices. Apache's management has come under criticism lately for mis-execution and an apparent reversal of strategy announced on their February, 2013 conference call in the form of a potential $2 billion asset sale. Shares are down 28% over the last twelve months and presently trade below their book value of $76.84. The market is mistaken, and this note will explain the rationale behind management's recent announcements and the path Apache can take to reclaim significant value for investors.
From 2005-2009, Apache focused resources and investment primarily on a balanced portfolio of oil and natural gas assets. The company acquired a major presence in the Western Desert region of Egypt, offshore assets in the North Sea near the United Kingdom, natural gas assets in Western Australia, and significant natural gas acreage in Canada's Horn River Basin. In 2005, prior to the current oil and gas boom in the United States, Apache acquired significant assets in West Texas's Permian Basin and Oklahoma's Anadarko Basin. The latter two US acquisitions were prudent and represent the bulk of Apache's near-term growth potential and capital expenses, with 54% of 2012 investment directed towards the United States.
Apache's prior strategy offered exposure to the rapidly growing North American natural gas market just as hydraulic fracturing technology opened previously inaccessible natural gas reserves. Apache's acquisitions in Egypt and Australia offered both oil and gas opportunities and the ability to sell gas into Europe (from Egypt) and Asia (from Australia). The North Sea field, which was nearly mature when acquired, is a large offshore development. Unlike Gulf of Mexico offshore, which sells at lower WTI crude prices, Apache's North Sea production is sold at higher Brent crude prices, resulting in improved margins over comparable projects in the Gulf. The North Sea field yields 12% of Apache's production revenue and generates strong cash flow to support investment in other areas. The North Sea field should be productive for years to come.
In 2009 and 2010, the rush to access North American natural gas led to overbuilding and oversupply. An economic recession took hold, and as a result the price of natural gas in the North American market dropped from over $10/mbtu to below $3/mbtu. Apache's strategy shifted with these unexpected market forces, as management scaled back investment in gas-rich assets in favor of oil-rich assets.
In 2010, with offshore drilling halted due to BP's Macondo disaster, Apache acquired the offshore energy company Mariner Energy for $2.4 billion, making Apache a "player" in the Gulf of Mexico offshore region. Apache curtailed investment in Canadian gas fields, and instead shifted focus to development of its oil-rich lands in Texas and Oklahoma. Apache spent $10.5 billion in 2010-2011 to acquire land in Texas and Oklahoma, mostly from BP. As a result of these acquisitions, the Permian and Anadarko basins now account for 25% of Apache's total production, and total firm-wide production is presently 81% oil and 19% natural gas.
Going forward in 2013, management has taken the possibility of another major acquisition off the table, citing a reluctance to assume more debt. Apache's debt rose from $10 billion to $24 billion between 2008 and 2013 as a result of its acquisition activities. It should be noted, however, the equity still exceeds debt on Apache's balance sheet and 2012 cash flow of $8.5 billion covered $500 million interest expense by 17x.
When announcing year-end 2012 results, management revealed they expect capital investment to be steady in 2013 and primarily directed at development in Texas and Oklahoma and with $1.5 billion earmarked for construction of natural gas pipelines and export terminals in Australia. These terminals are a good long-term investment, because as technology makes gas transportation more viable, the ability to move gas into high-demand Asian markets should be profitable. Apache is securing access to the profits of transporting future gas exports from Australia and Canada to the Asian market.
Apache surprised the investment community by announcing plans to sell $2 billion of assets, which management candidly admitted they had not identified yet. Markets punished Apache for the admission, seeing asset sales shortly after large purchases as a tacit admission that management misunderstood industry trends and the company is poorly positioned going forward. Further concerning the market was management's plan to spend $2.5 billion in 2013 developing "long-term assets" which will yield no production until 2014 at the earliest, though management predicted these investments would eventually yield 200,000bpd of production (25% of current total). Markets were unconvinced, instead believing there is a risk management masking near-term failures with promises of future growth. The market's concerns, and others, are discussed below.
The announcement of unexpected asset sales dominated the Q&A portion of Apache's recent conference call. Rationalizing the sale, management stated that after making so many large acquisitions over the past few years, they believe there is an opportunity to evaluate their asset portfolio and selectively eliminate some less attractive holdings. Some assets either cannot be developed economically at present prices or could be developed at lower cost by other firms. Selling these assets could generate cash and "load the gun" for another acquisition, fund dividends or buybacks, or repay debt. At worst, the sales boost returns by eliminating underperforming components of Apache's portfolio. Far from being a sign that management lost its way, the proposed sales show management feels comfortable with the assets it has and is seeking to consolidate and streamline operations - exactly the course Apache needs to take in 2013.
Case in point, Apache recently reduced the time required to drill a test well in the Permian Basin by six days. At a rig rate of $60,000 per day, this amounts to a savings of $360,000 per test well, and Apache intends to drill over 1,000 wells in the Permian this year - no small savings. By focusing internally on cost cutting and efficiency - hallmarks of Apache's style prior to recent acquisitions - management can meaningfully boost profits, cash flow, and share price. Management was explicit that any asset sale would not meaningfully decrease production, since any asset sold would be either undeveloped or in early stages of development.
On 03/06/2013, Bloomberg reported Apache is considering sale of its deep-water Gulf of Mexico assets (900,000 acres). Offshore drilling is more costly than onshore drilling, and deep-water drilling is extremely expensive, especially when considering liability costs after BP's Macondo disaster. The Mariner acquisition gave Apache both shallow and deep assets in the Gulf, but deep-water drilling is not a core competency. Apache would retain its major shallow-water presence off the Texas coast, and by divesting itself of its costly deep-water assets, Apache improves its position if energy prices remain low.
Further, by reducing investment in deep-water projects that are vulnerable to costly overruns, management is eliminating uncertainty in development. Management alluded to this strategy on their recent conference call, noting that in some cases, other firms could develop Apache's assets more efficiently. Deep-water is surely among those assets, and proceeds from any sale would likely be used to repay debt. Debt repayment is important, and we trust management's capital allocation decisions, but with the U.S. natural gas industry about to undergo a round of consolidation, Apache may be better served by holding cash for a year or two. While management is right to be conservative, current debt levels are sustainable and interest rates are low, so debt repayment need not be a priority.
Apache's decision to make long-term investments that yield little if any production increases in 2013 and 2014 rattled investors. Some are concerned that management is attempting to buy time, first predicting greater production in the long-term to soothe markets and then later figuring out a way to actually do it. Others prefer an investment in the Permian or Anadarko, returning 7% by management's estimates. Apache's CEO, Steven Farris, has been with the company since 1988 and has been CEO since 2002. Management has historically been conservative and has delivered as promised on past strategies and representations to shareholders.
On their recent earnings call, management was upfront in disclosing the expected returns on the foregone investment in the Permian, suggesting they were confident in the long-term returns on their capital allocation. Management is extremely shareholder friendly and earned the trust of investors to execute on its chosen development plan. Nothing in the plan is unreasonable or requires the occurrence of some unlikelihood, so long-term investors have less reason to be concerned.
Geopolitical Risk in Egypt
Apache is the largest investor in the oil-rich lands of Egypt's Western Desert. Approximately 10% of Apache's Plant, Property, and Equipment investments are in Egypt, but the region accounted a disproportionately high percentage of the company's operating income - approximately $3.50 billion in 2012. In 2011, populist uprisings in Egypt led to the removal from power of the oppressive, pro-Western President Hosni Mubarak. After Mubarak's removal, populist support and electoral votes flowed towards the Muslim Brotherhood, a political group that is not openly hostile towards the West but is decidedly less friendly than the previous regime. Unrest and occasional mass protests still occur in Egypt, and the situation is not nearly resolved. If an anti-Western government assumes power or the Muslim Brotherhood reverses Mubarak's friendly policies towards foreign oil companies, Apache's assets in the country could be adversely affected.
While Apache has not seen any production disturbances in its Egypt operations, the company continues to invest in the region, planning 270 new wells in 2013. In a worst-case scenario, the Egyptian government could nationalize Apache's assets, resulting in their total loss.
While risks associated with Apache's Egyptian assets have weighed on the stock, nationalization of foreign assets would cripple foreign investment in Egypt, restrict the country's ability to borrow, and alienate Western governments. Egypt is the 27th most indebted country in the world and largely depends on foreign investment for economic growth, so nationalization is unlikely barring a completely irrational government. For its part, Apache should consider reducing capital investment in Egypt until the geopolitical situation begins to resolve.
Apache partially hedges its exposure to Egyptian instability by carrying insurance to hedge the risk of nationalization. The company's $4.79 billion of Egyptian assets are insured for over $1 billion and have been undisturbed in the remote Western Desert. Regardless, investors in Apache should monitor the situation in Egypt closely, keeping an ear to the ground for anti-Western rhetoric that so far has been notably absent, relative to the rest of the Middle East. A surge of anti-American rhetoric in Egypt is probably the single biggest warning signs that risks underlying the stock are beginning to materialize.
Valuation and Growth
Apache replaced 131% of production with organic reserve growth (156% including growth from acquisitions). Growing total reserves, even as production depletes them, improves Apache's position in the long run and ensures production growth is sustainable. Apache has sufficient reserves to sustain production over the forecast period. Catalysts for Apache include rising oil and/or natural gas prices that would boost margins and profitability. A stronger than expected Chinese economy could boost demand for natural gas exports from Australia and boost utilization of Apache's infrastructure there. Increased demand for North American natural gas, either from transportation, manufacturing, or utilities could increase prices if supply becomes more disciplined. Favorable resolution of uncertainty in Egypt would result in valuation returning to those heavily discounted assets. Finally, Apache could sell assets like deep-water acreage outside their core competency, using the proceeds to acquire on-shore land over the next five years.
Valuation conclusions are based on management guidance and assumptions regarding investment, growth, and profitability. I assume constant revenue growth of 6% annually for the next five years. This encompasses management's guidance for 6%-9% annual production growth over that period, weighted towards the later model years. Any price increase in oil or gas would improve revenue growth rate, but price increases are not explicitly factored into our model. Terminal growth rate is estimated at 2.00% with short-term and long-term operating margins constant at 25%, roughly in line with 2012 performance.
A meaningful increase in oil or gas prices would improve Apache's margins. Cost of capital is computed at 8.00% and no equity dilution is forecast. Further, I do not consider any asset sales in my model, and the effect of asset sales on valuation would depend on the productivity, price, and planned use of proceeds. Capital expense is forecasted at $9.5 billion for 2013, with depreciation at nearly $5 billion and taxes at 35%. Under these assumptions, I model fair value for Apache at $100, with a realistic downside value of $78 per share. Shares currently trade for $75.09 (as of 04/12/13) and are discounted below book value. Apache is a strong buy for investors with a time horizon of 24 months or more.
Apache's previous strategy included development split evenly between oil and natural gas. When natural gas prices collapsed, management shifted focus towards liquids, which now make up over 80% of 2012 revenue. Apache is one of the largest players in the Permian, Anadarko, and shallow-water Gulf regions. In 2013, management expects to consolidate, invest in new development, and potentially sell less attractive assets to rebuild Apache's balance sheet. These asset sales, which may include deep-water assets, would improve operations and benefit Apache, especially if used to bolster cash and not repay debt. Apache will invest $9.5 billion in 2013, much of it in long-term projects that will not yield production before 2014. While markets are skeptical of these moves, investors should buy the uncertainty as management is excellent and can be trusted to execute in the interests of shareholders. Geopolitical risk remains in Egypt, but nationalization is unlikely and investors can mitigate their risk by monitoring the situation closely for anti-American rhetoric.
Some analysts have asserted that Apache lowered its growth projections on its recent conference call, but in reality management reaffirmed its guidance for 6%-9% annual production growth over the next five years. Using this conservative growth forecast and assuming no increase in the price of oil or gas, Apache's fair value is $100. This represents a 38% upside to recent prices, and shares of Apache can presently be acquired in the market for less than their book value. Investors seeking to add exposure to the international energy market, play the unrest in Egypt, or hedge their personal finances against rising gasoline costs would be well-served by considering an investment in Apache below $75 per share. Price target of $100.