Apache (NYSE:APA) is a large independent oil and gas exploration and production (E&P) company with operations around the world, although a majority of the company’s value on a PV-10 basis is located within North America.
In the U.S., key producing regions include the Gulf of Mexico (GoM) shelf and deepwater, and the Anadarko and Permian basins. In Canada, the company’s focus is in Alberta and British Columbia, including the House Mountain, Provost, Horn River and Noel developments. The company is also engaged in the development of the Kitimat LNG liquefaction facility.
Egyptian operations are centered in the Western Desert region with the Qarun and Khalda concessions. Key basins span from Faghur in the west to Bein Suef in the east. In Australia, the company operates in the Carnarvon and Exmouth basins and is involved in the Wheatstone LNG project. Resources from the Julimar field will be distributed to international markets through this project.
The North Sea primarily consists of the Forties field, a large mature play which Apache has had good success in managing. In Argentina, the company operates in the Neuquén, Austral and Cuyo basins, the first of which is a major unconventional shale gas play. The company also has undeveloped entitlements in Chile and is drilling an offshore project in East Africa with favorable geology similar to deepwater GoM and West Africa.
In 3Q11, on a revenue basis, about 75% of sales were crude oil, 22% were natural gas and 3% were natural gas liquids (NGLs). In terms of energy content, natural gas is the predominant resource produced followed by crude oil and NGLs. Production has steadily grown over the past several years from 548 kboe/d in 1Q09 to 752 kboe/d in 3Q11, an increase of 37%. A portion of the increase was driven by $11 billion of acquisitions undertaken in 2010, including asset purchases from BP (NYSE:BP) and Devon Energy (NYSE:DVN), and the acquisition of Mariner Energy.
Based on proved reserves as of year-end 2010 and annualized 4Q10 average daily production, Apache maintains reserves to production ratios with a mean of 6.4 times in crude, 10.8 times in natural gas and 15.1 times in NGLs, across all regions. The weakest reserve position compared to production is in Egypt, with a ratio of 3.2 times in crude. Egypt contributed about 32% of the company’s production in 4Q10 and continues to provide 30% in 3Q11 while contributing a similar amount of income from operations. The ratio of reserves to production has fallen in recent years as production has increased while reserves have not. Although the ratio is low and falling, the company has extensive undeveloped acreage in the country which may signal the ability to continue producing at the same rate.
Reserve ratios are much stronger across the balance of the company’s production regions and resource types. Where ratios are low, such as Australia, the company has significant undeveloped acreage which should turn into new proved reserves to some extent.
The largest area of near-term risk for current production is Egypt, due to that country’s early-2011 revolution and subsequent instability. The country is currently run my military leaders, but is in the process of electing representatives. These elections have been accompanied by increased violence in Cairo with numerous multi-day protests in November and December 2011. Through the election process, it is possible that a fundamentalist party will gain significant influence in the government. According to Reuters, one such organization called the Nour Party has already gained far more support than expected.
In addition to political instability, Egypt also faces a financial crisis due to cuts in foreign investment and deteriorating business conditions, especially in the important tourism industry. The country lost $2 billion in foreign reserves in December and for the year has seen such reserves decline by 50%. The country is in need of foreign financial assistance, but political instability is clouding the picture as to when it will be disbursed, although a number of countries have promised aid.
A detailed look at the global crude oil market as well as certain natural gas markets can be found in the article Long-Term Perspective On Crude Oil And Natural Gas Markets. Generally, today’s high oil prices are warranted, in my view while natural gas prices in the U.S. may be slightly cheap, but expectations of a significant boost in pricing should be tempered by the ample availability of supply. The outlook for LNG is brighter as current global supply capacity is limited by infrastructure.
Stock market valuations reflect a company’s current cash flows, long-term returns on invested capital and growth. In order to put valuation parameters around the company and extract the market’s expectations for future income generation an IRR-based economic profit model is employed. The first step to employing the model is to determine all the capital invested in the business in replacement cost terms.
Apache’s invested capital comprises the land rights and extensive set of machinery and capitalized third-party development services needed to extract oil and gas from the ground. A key feature of the modeling framework used to value Apache is the restatement of balance sheet accounts to approximate replacement cost. In the oil and gas industry, a simple example illustrates why this is necessary.
Consider a hypothetical oil and gas company with one producing oil field whose total development costs were $10 per barrel. The field produces 100 units per day at present and there is no opportunity to expand production, in fact the field will decline at a 6% annual rate. The company has an opportunity to reinvest as much cash flow in a second field as it wants, but the development costs are at $80 per barrel. In this way, the company can keep production stable or grow production if it chooses depending on how much cash flow it reinvests. The question to answer is whether this hypothetical company would have the same value as a company that could reinvest all its cash flow in the initial $10 field.
The obvious answer is that the company afforded the opportunity to reinvest at $10 would have far more value – the company would have capital costs one-eighth the level of the comparative firm and could pay large dividends to the holders while maintaining the same level of production. Put simply, such a firm would have high returns on capital relative to the other.
The problem arises in that both firms will appear to be creating the same returns on capital initially. Each year, the company that must reinvest at $80 will show incrementally worse returns on capital. But from a valuation perspective we want to use marginal returns on capital, because those are what drive value. Within the economic profit modeling framework, the solution to the problem is to adjust the historical asset base to reflect replacement costs by looking at a combination of resource and cost inflation. Also, by looking at current capital expenditures relative to depreciation in comparison with production growth, while also considering the average age of the company’s assets.
On a gross basis, oil and gas-related fixed assets have been marked up using about a 5% inflation rate, a slight discount to drilling and oilfield production inflation over the last decade.
[Note that the inflation rate chosen is informed by an analysis of 1) producer price inflation (PPI) data for various aspects of oil and gas field development (213111 and 333132 indices) published by the Bureau of Labor Statistics; 2) the evolution of crude oil and natural gas pricing; and 3) broad USD-based price inflation. Support for the approach comes from the book Cash Return on Capital Invested Capital, where on page 67 the author states
We suggest inflation-adjusting all the assets directly related to the reserves (including equipment) by the inflation rate of the underlying commodity.
In my view, inflating by the commodity itself may be a little too agressive and have chosen to use cost inputs related to drilling. Inflating by the resource prices would create a much larger adjustment and drive down returns on capital considerably, which some investors may want to consider.]
The overall cumulative adjustment is relatively small compared to most E&P companies due to Apache’s large recent acquisitions, which mean a large portion of the asset base is marked near replacement cost already.
A related issue is the adjustment of historical impairments, the effect of which have been reversed for modeling purposes. Impairments in the oil and gas industry are based on reductions in oil and gas pricing and are essentially realizations of diminished income prospects. However, when resource prices increase, as happened in 2010-11, there is no write-up of assets. Instead of dealing with resource price changes through the impairment mechanism, the model uses the inflation mechanism described above, in the case a resource price drop, that could turn into a deflation adjustment. In fact, the drop of natural prices is one factor driving the inflation adjustment made downwards.
The remaining categories of invested capital are leases for general and administrative assets and net other assets such as working capital.
The next step to determine current returns on capital is to estimate run-rate profitability. Profits are considered on a gross basis because they are compared to gross capital. The reference period used is the twelve month period 3Q12 through 2Q12 and net income represented in the table is the reported figure for the first quarter of the period and First Call estimates for the last three quarters.
Recent changes in the price of natural gas may impact the company’s ability to generate the above level of gross income. For example, my own estimates suggest a $1 move in natural gas will negatively impact net income by some $800 million. On the other hand, crude oil, especially WTI, has increased by several dollars versus 3Q11 which may recover a large portion of the impact from natural gas, exclusive of hedging. Considering crude oil and natural gas, a net income figure some $200 million lower is plausible.
Apache’s current returns on invested capital are 6.8% in IRR terms, a multiple of about 1.3 times the real cost of capital. In order to accurately model the value of growth, the IRR has been modified to account for partial reinvestment of cash flows. The modified IRR for Apache is 6.4%. Since the company is investing nearly all its cash flows, the value of the additional investment is included in the value of growth, which is further explained below.
The returns on capital calculation shows that Apache, like most oil and gas companies, is generally a cost-of-capital business, meaning returns on capital are about equal to the cost of capital. As with all resource-driven companies, the price of crude oil and natural gas are of critical importance to earnings and hence returns on capital. In my view, the long-term price of crude oil is appropriate at current levels which should continue to support underlying earnings.
Natural gas is a greater wild card with spot pricing around $3 and January 2012 futures around $3.85, both levels that will at some point considerably constrict investment in the U.S., continuing a trend that began over two years ago. However, before finding balance, the market may continue weaken; therefore, gas prices may continue to weigh for the next several quarters or longer. A rise in prices will bring a strong supply response so that pricing will likely not rise too far.
Capitalization and Implied Income
The table below exhibits the company’s current market capitalization with the equity trading at $97.16. About 29% of Apache’s capitalization is in debt or debt-like liabilities, the latter mainly funded debt, deferred taxes and asset retirement obligations.
For the current equity market valuation to be correct, Apache’s net income would need to decline about 20%, to $3.75 billion or in gross income terms, $8.25 billion. In such a scenario, the value of growth would be eliminated because returns on capital would fall to the cost of capital.
The value of the existing $9 billion of gross income is worth about $120 per share. Since the market price of the equity is below this figure, the market is not discounting any future growth; however, since the company is growing assets, either income needs to grow or returns on capital will decrease and impact the valuation negatively. The value of seven years of growth at 3% per year and with incremental returns on capital staying the same, is about $7, implying a total value of about $127. Apache should grow assets at a slightly faster rate than that in the near term based on capital expenditure trends.
It is reasonably clear from the valuation analysis that given current cash flows, Apache is trading at a low valuation. A look at traditional metrics such as enterprise value (EV) to EBITDA shows that Apache also trades at a discount to its peers. For example, while Apache trades at 3.7 times EV / EBITDA, two companies with similar resource exposures, Anadarko Petroleum (NYSE:APC) and EOG Resources (NYSE:EOG), trade at 7.5 times and 8.3 times respectively. A selection of 13 E&P companies, including the two mentioned above, but excluding Apache, trade at a 6.2 times mean EV / EBITDA multiple.
There are a couple of factors which are likely impacting value having to do with Egypt. The political instability there puts 15% of the company’s PV-10 at risk in the event of a seizure of the assets. However, the true value of the Egyptian operations to the company likely exceeds this amount because production from the country is quite high compared to reserves. A full seizure of assets seems quite unlikely as that would significantly impact foreign investment into all sectors of Egypt’s economy and would more than likely cut off promised direct aid. The troubles in Egypt could just as well turn into an opportunity as the country tries to increase exports to raise money; therefore, there is a trade-off to the situation there as well.
This brings up a second problem, which is the low level of proved reserves in the country, relative to production. In my view, this could reflect the company’s unwillingness to explore and develop significant acreage above what is needed to ensure production, in order to reduce the amount of capital invested in the country and subject to risk. Even if the company wanted to do so, Egypt itself may not want to concede resources until they are needed. It is worth noting that this state of affairs has persisted for some time and yet production has doubled since 2005 in the country. However, monitoring Egypt should be one of the primary concerns for an investor in Apache.
Balancing the above factors as well as other aspects of the company's operations, Apache’s equity is attractively priced, in my view. Some protection from a potential fall in crude oil prices is available from a successful resolution of the situation in Egypt. In the case of a partial loss of Egyptian production economics to Apache through, for example increased taxes, the stock will be very reliant on healthy oil prices.
Disclosure: I am long APA.