Why You Should Be Long Apache

| About: Apache Corporation (APA)

Summary

Apache has recovered impressively this year on the back of operational improvements in its production profile and a slight recovery in oil prices, a trend that will continue.

Apache has achieved substantial cost reductions that have allowed it to achieve positive cash margins across the board on the back of low operating costs.

Apache’s Egyptian and North Sea assets have realized a cash margin of $26/barrel and $33/barrel due to favorable production sharing contracts, so it is investing more in these areas.

Apache’s robust asset base will allow it to reduce capital expenses by 65% this year but keep the production decline down to just 7%-11%.

For Apache (NYSE:APA), 2016 has turned out to be a good year so far. The stock has recovered remarkably in the past two months, gaining close to 15% on the back of its operational improvements and a recovery in oil prices. In fact, Apache's operational improvements have been strong enough to enable it to do well in a weak pricing environment, and this was clearly reflected in the company's fourth-quarter results where it had beaten the bottom line estimate by a huge margin of $0.41 per share despite a 53% drop in revenue.

More importantly, Apache seems to have lowered its costs by a good enough margin to do well even in a weak pricing environment, which should allow it to sustain its recent momentum on the market. In this article, we will take a closer look at Apache's cost reduction efforts and see why it is one of the best-positioned companies in a weak oil price environment.

Focusing in the right areas for growth

In order to counter the oil price weakness, Apache has focused extensively on those assets where production will be high and costs will be low. As a result, it has decided to prioritize spending in areas with higher rates of returns such as Egypt and the North Sea as they are capable of generating free cash flow in a low oil price environment.

For example, Apache's assets in Egypt are able to realize a cash margin of $26 per barrel of oil equivalent at an average realized price of $37 per barrel of oil, which means that operating costs are just $11 per barrel. Meanwhile, North Sea has the potential of generating a cash margin of $33 per barrel with an average realized price of $49 per barrel of oil equivalent, as shown in the chart below.

Source: Apache

The higher cash margin generated by Apache in these two areas can be attributed to a favorable contract structure and tax regimes. More specifically, the higher cash margin in Egypt is a result of the fact that Apache's production sharing contracts allow it to recover more cost for each barrel under a low oil price scenario. So, the tax benefits in Egypt are allowing the company to actually increase its net volumes, thus improving its cash margins.

As a result of the favorable performance in this area, Apache is deploying more money over here. In fact, it plans to allocate approximately $800 million, or around 50% of its 2016 capital expenditure, to Egypt and the North Sea. More importantly, the company plans to further reduce drilling and completion costs at the Ptah & Berenice and the Hydra fields. So, with higher capital spending and further reduction in costs, Apache should be in a position to deliver higher cash margins from these regions.

Also, as seen in the chart above, Apache has robust cash margins in the Permian Basin even at a low oil price of $31 per barrel, while at its other North American assets, the company can generate positive margins despite low oil price realizations of $22/barrel of oil. This clearly indicates why Apache was able to reduce its losses by a wide margin on a year-over-year basis last quarter. In fact, as discussed below, the company is capable of keeping its production profile in good shape despite steep reductions in capital expenses, which is a good thing in a weak pricing environment.

Impressive cost reductions

Apache has managed to record huge cost reductions across the board, which is why it has been able to reduce its losses in a weak pricing scenario. In fact, in the last reported quarter, Apache was able to reduce average well costs by 35%, lowered its G&A expenses by 30%, and managed to decrease lease operating costs by 4% per barrel of oil equivalent, as shown in the chart below.

Source: Apache

The company was able to achieve such impressive cost reductions on the back of its focus on improving the internal efficiency of its assets by following measures such as delineating the acreage, improving the wellbore design, and improving and optimizing the well spacing. As a result of its focus on moves to drive efficiency, Apache was able to reduce its capital expenses by 60% last year to $4.7 billion, but despite this huge drop in capital spending, Apache's production was down just 10%.

This clearly indicates the efficiency of its cost-reduction efforts as Apache has been able to produce more oil by spending a lot less money, therefore reducing its unit costs. Even this year, Apache projects that its capital expenses will go down to a range of $1.4 billion-$1.8 billion, representing a decline of almost 66% from last year. But, despite this steep drop, its production will go down by only 7%-11%.

Thus, by focusing on areas where production costs are low, as discussed earlier in the article, Apache is doing the right thing to overcome the weakness in the end market. This strategy is already delivering results as in the fourth quarter of 2015, Apache's loss went down to just $0.06 per share as compared to a loss of $0.37 in the prior-year period.

Conclusion

Apache has managed to reduce its cash operating costs by significant margins, which has allowed the company to achieve positive cash margins in adverse circumstances. Therefore, the company looks well-placed to continue doing well in the long run on the back of a low cost base and take advantage of a potential recovery in oil prices. This is why investors should remain invested in the stock as it is capable of sustaining the momentum that it has gained this year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.