Apache (APC) is a well-oiled machine in the world of small independent oil and gas explorers and developers. There is a lot to be optimistic about in the oil and gas subsector generally, but I think that Apache is the most promising company in terms of long-term profitability, reliability, and fundamental outlook. Much of its recent production growth has been due to acquisitions from which I believe there is still considerable upside to be seen. In this article, I will show why Apache is a strong stock for the long-term investor.
Apache stock has recently fallen and has since stabilized at $91 from a first quarter 2012 high of $111. I believe that Apache is still slightly undervalued, even at $111, and thus, $91 is an ideal purchase price. Analysts agree on an upside of at least 40%, with conservative estimates putting the 12-month target around $135 to $140 dollars. This discount on Apache, therefore, makes it a very appealing buy. There are other E&P purchase possibilities with substantial upsides, such as Kosmos Energy (KOS), with a 96% upside. However, as I justify below, Apache has the added benefit of being a less volatile and more profitable company with a strong and sustainable outlook. After first quarter earnings are reported on May 3rd, I expect the share price to jump several percentage points.
The Strategy: Acquire and Develop
Apache's overall managerial approach involves acquiring holdings with some production history and then developing them into high-production holdings. This contrasts with the strategy of other peers, such as Anadarko (APC), that search for lands that provide a "first nester" opportunity. The latter approach has its merits, allowing the first nester to acquire the land more cheaply and, if it is productive, to experience greater output. Apache's strategy fuels its strong financial structure. The debt to capital ratio of Apache is 19.9%, compared to Anadarko at 45%, and Chesapeake (CHK) at 37.2%. The cost structure of Apache's model drives down exploration costs by settling less risky production plots.
The recent acquisition of Cordillera Energy Partners for $2.8 billion is an example of this approach. Paying in cash, Apache made the decision based on present opportunity and past experience in the Texas and Oklahoma oil markets (the locations of Cordillera's primary holdings). This will increase Apache's debt over the coming year, but, as part of its fruitful strategy, Apache will simultaneously have adequate cash flow to pay for its anticipated $9.5 billion in capital expenditures for 2012. The Cordillera acquisition will be ready to finance opportunistic acquisitions within the next year or two. Apache has a sustainable model for expansion that does not involve a great deal of risk. Furthermore, due to Apache's significant holdings in the area, this acquisition is more of an add-on than a new production effort, mitigating the associated risk of this project.
Generating Growth and Avoiding Risk
At the moment, liquid-rich orientations are particularly profitable. In 2011, the average realized oil price was $102/bbl, whereas it was only $77/bbl in 2010. Apache's oil production provided 80% of its total profits in the fourth quarter 2011. With 11 years of future production proven in reserves, Apache's primary source of future growth will emerge from its large set of acquired holdings, which include Mariner Energy and some assets from Devon Energy (DVN) and BP (BP). Production on the Texas panhandle in the wake of the Cordillera acquisition is expected to increase 50%, with a total of 25 rigs in production phase. Though production will be lack-luster in the Gulf of Mexico, Apache expects a 5% increase in production in the Western Canada properties, 80% of which will be in oil production. Oil production in Egypt and gas production in Argentina are both expected to undergo a 5% increase in 2012.
These are exciting prospects, but commodity prices are cyclical and volatile, as in the case of Iranian holdings and other politically sensitive holdings in the Middle East. Commodity prices are subject to may different market forces. Apache management operates under this assumption and is unlikely to make impulsive purchases. Looking at the 2011 Apache Annual Report, Apache's total gas production is roughly equal to the total oil production in 2011. While many companies are rushing to liquid, Apache is already there. Chesapeake Energy, for instance, has a less favorable balance, with a proportion of natural gas liquids (40%) to oil (60%). Natural gas liquids trade at a discount to oil, and Apache has extensive Brent crude reserves, giving it decreased exposure to the lousy gas price slump that should last throughout 2012.
When gas prices settle around a long-term actual price of $4.50/MMbtu, Apache will have a competitive advantage in continuing revenue from gas. Furthermore, oil prices will be overpriced for the near future, at least until 2015. However, the long-term actual price of $90/bbl, compared to the current $117/bbl, means that the oil gravy-train is not going to be perpetual. Apache is in a position to weather this circumstance with its diversified production break-down.
Apache's excellent fundamentals make it an excellent buy in an uncertain commodity market. Its upside is greater than the "super major" oil and gas companies, and its fundamental cost and debt structure is perhaps the best among the E&P companies. The upside on BP, for instance, is only 26%, assuming optimistic target prices. The uninspiring financials (Argus rating: low) for Chesapeake keep me from recommending it also. Apache, on the other hand, embodies two positive qualities that reflect its two-edged approach of acquiring a balanced group of oil and gas plots and spending less on risky purchases, while spending more on the development of presently held assets.