I've spent a lot of time thinking about the changing dynamics of North American energy production and how to potentially profit from it. I am very skeptical about any short-term energy forecasts, but I do believe that over the long term, oil and natural gas prices will be higher than they are currently, partially due to the fact that this global race to depreciate currencies will ultimately have an inflationary impact on most assets and resources. Over the shorter-term time frame, I have become much more accepting of the possibility that increased supply and transportation capabilities, combined with reduced demand in key markets might cause some rather dramatic disruptions in price. With this thesis, I want to buy energy producers that trade at large discounts to their net asset values, have a balance sheet that can withstand short-term earnings pressure, and a management team that understands that it doesn't always make sense to increase the asset base due to a belief that energy prices can only go up. I believe Apache Corporation's (NYSE:APA) recent issues have created an attractive opportunity to buy a growth-oriented E&P at a significant discount to intrinsic value.
Apache has a long history of being a very solid operator and producer of energy in the United States and abroad. The company has significant exposure to Egypt, which generates close to 30% of the company's cash flow and has been a lightning rod for investor concerns due the volatile political environment in the country. While Apache has one of the more attractive oil-rich liquids mixes of the larger E&P's, the company hasn't avoided the non-cash write-downs of natural gas assets in North America caused by the drastic reduction in prices. The company also has been very acquisitive of late, which has significantly increased the debt to capitalization ratio, and has prevented the company from buying back stock when the price has offered an attractive opportunity, or pay a more substantial dividend to shareholders. While these issues are indicative of why the stock has performed poorly over the last two years, I believe the solutions to these issues are what pave the way for future stock appreciation.
I believe that Apache's exposure to Egypt is less worrisome than many analysts proclaim it to be. I don't see an incentive for Egypt to do anything to prohibit the cost-effective development of the country's natural resources, as regardless of what government is in charge, the financial resources provided by those assets will be crucial to the country's prosperity. Apache has a tremendous production pedigree for these types of developments and there is just no incentive to halt production. The rig count in North America has been declining rapidly, while many power plants are opting for the cleaner burning natural gas to replace coal. Major manufacturers of chemicals, steel, etc. are increasing their utilization of cheap natural gas to lower their overall cost structures. Over the long term, this will lead to higher natural gas prices, and if the United States ever does become a material exporter of LNGs, then this would create another source of increasing demand. Apache has huge resources that could be monetized in a better natural gas pricing environment, which could lead to considerable upside for the stock. The company also has a large stake in the Kitimat LNG export facility in Canada, in addition to the proposed Wheatstone LNG terminal that can boost growth over the long term.
Apache's management understands that investors are frustrated at the company's recent misfires, and the concerns regarding both the capital structure, and the fact that CAPEX has been outpacing operating cash flow. Recently, management has begun reacting to these concerns with a rather clear plan of how the company could reduce debt without materially altering the company's long-term production growth strategy. Fortunately for E&Ps, oil prices have remained high, so the fact that Apache is addressing these issues now should give the company enough time to secure itself financially through deleveraging from divestitures at reasonable prices. I believe that the fact that management is finally addressing these issues openly and aggressively will ultimately lead to a more reasonable valuation for the company.
On May 9th, Apache announced 1st quarter earnings of $698MM, or $1.76 per diluted common share, and adjusted earnings of $806MM, or $2.02 per diluted share. In the prior-year period, the company reported earnings of $778MM or $2.00 per share, and adjusted earnings of $1.2 billion or $3.00 per share. First quarter earnings were impacted by a $31MM after-tax unrealized loss on derivative instruments, in addition to a $42MM noncash after-tax writedown of the company's Argentina oil and gas property balance that is the result of two concessions expiring in the next 2-4 years, that the company is discussing extending with the government. Earnings were down as a result of lower commodity prices, and cash flow from operations before changes in operating assets and liabilities totaled $2.4 billion, down from $2.6 billion YoY. Revenues in the quarter were $4.076 billion, down from $4.536 billion in the prior-year period. Capital expenditures, excluding acquisitions were $2.571 billion, up from $1.936 billion YoY. Pre-tax margins have exceeded 30% on a BOE basis, but costs per BOE run higher than peers largely due to the higher proportion of crude oil production versus natural gas.
In the quarter, worldwide production increased to 781,819 barrels of oil equivalent (BOE) per day led by a 45% increase in North America onshore liquid hydrocarbons output compared with the year-earlier period. Production from onshore North American drilling plays was 165,000 BOE per day in the first quarter, and there are ample opportunities to grow that output further in the future. Apache did experience some interruptions in its operations in the quarter due to cyclones in Australia and third-party gas plant downtime in Canada. Production was down from 800,005 BOE per day in the 4th quarter of 2012, largely due to these issues and the fact that the company didn't drill any North American dry gas wells in the quarter. Apache remains on track to achieve its full-year guidance of 3 to 5% production growth, but this doesn't include any loss of production from asset sales.
Apache's production in the Anadarko Basin (Central Region) increased 129% from the year-earlier period to 86,215 boe per day, largely as a result of successful drilling in the Tonkawa, Granite Wash and other liquids-rich formation. In the Permian Basin, production rose to 119,435 BOE per day, up 20% from the prior-year period, as a result of increased drilling and recompletion activity in oil and liquids-rich plays, including the Wolfcamp Shale, the Cline Shale, and Yeso. In the Tonto oil field in the United Kingdom sector of the North Sea, Apache commenced production with its first producing well, which came on stream at an initial rate of 10,346 barrels of oil per day through a tie-back to the Forties Bravo production platform. Production in Egypt declined to 152,250 BOE per day from 162,168 BOE per day one year ago. The company also recently announced three discoveries in three basins in Egypt, which is indicative of the rich potential for new development opportunities across that region. Australian production declined to 55,734 BOE per day from 67,788 BOE per day in the prior-year period.
Apache continues to benefit from its liquid-rich portfolio, with liquids representing 53% of first-quarter production and contributing 82% of revenues due to the premiums received for crude oil versus natural gas. Apache realized an average price of $101.72 per barrel of oil during the 1st quarter, down from $111.22 per barrel during the prior-year period. Apache's geographic footprint is beneficial with much of its production receiving premium Brent crude pricing. Over 85% of 1st quarter liquids production was crude oil, which is very attractive due to the fact that natural gas liquids prices have declined precipitously. The company received an average of $3.72 per thousand cubic feet (MCF) of natural gas, down from 3.82 per MCF in the prior-year period. Approximately, 37% of the company's natural gas output is produced outside North America, and as a result receives premium pricing related to the disparity between North American natural gas prices versus the rest of the world.
Over the last three years, Apache has spent more than $16 billion in acquisitions, which has significantly increased the company's leverage ratios, prompting investors to push for changes to be made to reduce debt. Apache's debt to capitalization ratio was 28% at the end of the 1st quarter, which I believe is about 8-13% higher than it should be based on the uncertainty of prices for oil and natural gas, given weak global growth and supply increases that have impacted the commodities markets. This might seem conservative, but when you look at the prices that companies like Chesapeake Energy (NYSE:CHK) and SandRidge Energy (NYSE:SD) are divesting assets at, it is important for Apache to maintain the flexibility to buy in a buyer's market, and to sell in a seller's market, instead of having to simply be forced into reacting like those companies.
In February, Apache completed a transaction with Chevron Canada to jointly build the Kitimat LNG facilities and develop the shale gas resources in the Liard and Horn River basins of British Columbia, and the net proceeds to Apache from the transaction were $405MM, which will help the balance sheet slightly. Apache seems to be responding to investor concerns regarding capital allocation with news that the company intends to divest $4 billion of assets, up from its initial plan to divest $2 billion. According to management, the plan is to use the first $2 billion to pay down debt and then the second $2 billion to buy back stock. I view this as being very intelligent, because at this stage in the commodity cycle, I believe a strong balance sheet is warranted to protect against the potential for declining prices, and I also view the stock as being an attractive buyback candidate due to the discount to intrinsic value at which it trades at. Management believes that the proceeds from this divestiture program could allow the company to buy back up to 30MM shares or approximately 7.5% of the shares outstanding. I believe the focus on increasing per share intrinsic value, as opposed to the overall production growth of the company, is an important aspiration that ultimately should improve shareholder returns over the long run.
Apache ended the quarter with 408MM diluted shares outstanding, which were up from 399MM shares YoY. At a recent price of $81.47, the market capitalization is roughly $33.24 billion. Long-term debt stood at $11.485 billion at the end of the 1st quarter, which is slightly offset by $248MM of cash and equivalents. Therefore, the enterprise value of the company is approximately $44.48 billion. Despite taking heavy write-offs of various natural gas assets last year due to lower prices, Apache's book value at the end of the quarter was $31.987 billion, so the company trades right around book value. Earnings peaked in 2011 at $4.5 billion, but I believe $4 billion is a reasonable starting place for normalized earnings, and I'm confident the company can grow production by about 5% per annum for the next 5-7 years. Natural gas prices should improve and longer-term oil prices should do quite well, meaning that the company has the potential to grow net income by 8-10% per annum.
The stock buyback program is a very encouraging development, and if the company decreases the share count by 3-5% per annum, there would obviously be additional upside to earnings per share growth. Apache pays at $.20 quarterly dividend that it has been increasing of late, and I believe that there is significant potential for long-term dividend growth after the first priorities of liability management and stock buybacks have been addressed. I believe that within the next 3-5 years, Apache could be earning $10-$12 per share with ease. I also wouldn't be surprised to see a spin-off of some of the company's midstream assets to take advantage of the attractive pricing in the MLP market. All of these factors lead me to believe that the stock trades at a large discount to a conservatively measured intrinsic value, and also offers a call option on higher energy prices over the long term.
Disclosure: I am long APA, SD. 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.