Anadarko Petroleum: Moderate Potential Upside But Strong Growth Prospects

| About: Anadarko Petroleum (APC)
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In continuing my search for value investments in the oil and gas industry, I have broadened my search from being focused exclusively on South America to now considering globally diversified exploration and production companies. One company that recently attracted my interest is Anadarko Petroleum (NYSE:APC), a large cap independent oil and gas explorer and producer, with a globally diverse range of operations. As this article will demonstrate, the company has consistently been able to execute its production and exploration operations, delivering value for shareholders. I also believe that the company is currently unfairly valued by the market and as I will clearly demonstrate, there is around 15% potential upside for investors.

Recent Share Price Performance

Overall Anadarko's share price has remained flat over the last year having only risen by around 3% over that period. This as the chart below illustrates is superior to many of its similarly sized peers, including Apache (NYSE:APA), Occidental Petroleum (NYSE:OXY) and Devon Energy (NYSE:DVN) but is inferior to the performance of integrated oil and gas major Chevron (NYSE:CVX).

Source: Yahoo Finance.

The reason for this poor performance can be attributed to traders and investors seeking to reduce risk and exposure to oil and gas explorers and producers operating in high-risk countries. It is this sentiment based sell down that I believe has created considerable opportunity in the medium to large cap oil and gas exploration and production industry for investors.

Company Profile

Anadarko is a geographically diversified oil and gas exploration and production company, with a portfolio of assets encompassing premier positions in U.S. onshore shale oil and gas, as well as other resource plays in the Rocky Mountains region, the southern United States and the Appalachian Basin. The company is also a deep-water producer in the Gulf of Mexico, and has further production in Alaska, Algeria, and Ghana. It also has substantial portfolio of exploration assets in West Africa, Mozambique, Kenya, South Africa, Colombia, Guyana, New Zealand and China. The company's key production and exploration assets are illustrated by the chart below.

Source: Howard Weil 41st Annual Energy Conference Anadarko Presentation March 18, 2013.

The company has solid proven 1P reserves of 2.56 billion BOE, which is well within the range of its peers as the chart below illustrates, although they are lower than Apache, Occidental and Devon.

Source data: Anadarko, Apache, Occidental, Devon and Chevron Financial Filings Full Year 2012.

However, despite these reserves being marginally lower than many of its peers, Anadarko, based on current daily average production volumes of 668,000 BOEPD, has a reserve life commensurate to many of those peers as the chart below illustrates.

Source data: Anadarko, Apache, Occidental, Devon and Chevron Financial Filings Full Year 2012.

I also expect the company to be able to continue growing its reserves and increase its production because of its ongoing geographically diversified exploration activities. These activities allowed the company to grow its reserves in 2012 by 434 MMBOE, giving it a proven reserve replacement rate of 162%, thus boding well for proven reserve growth.

Financial Snapshot

Anadarko's revenue over the last five quarters has remained flat, growing marginally by 4% QoQ but falling by around 4% YoY to $3.4 billion. The company's net income has been particularly lumpy on a quarterly basis, and for the fourth quarter 2012 it grew by 81% QoQ and 161% YoY to $217 million as the financial snapshot below illustrates.

Source data: Anadarko Financial Filings 4Q11 to 4Q12.

For the full year 2012, Anadarko's results were quite impressive despite revenue falling by 4% YoY to $13.3 billion, because net income grew significantly, up by 190% YoY to $2.4 billion.

The company also has a solid balance sheet with cash and cash equivalents totaling around $2.5 billion, indicating that it is well placed to weather any sustained downturn in the demand for oil. This does represent a 2% QoQ and 9% YoY fall in cash and cash equivalents, but more importantly the company has been able to reduce its short-term debt from $1 billion in the third quarter 2012 to nil in the fourth quarter. It has also seen its long-term debt remain steady, increasing marginally by 1% QoQ and falling by 12% YoY to $13.3 billion.

This solid level of cash and cash equivalents combined with the company being able to gradually deleverage has given it some particularly appealing risk metrics including a conservative debt-to-equity ratio of 0.64 and a solid current ratio of 1.6. However, it does have a particularly high debt-to-EBITDA ratio of over 2 and a cash-flow-to-debt ratio of around 0.6, indicating that it may be over-leveraged in comparison to its ability to generate earnings.

Furthermore, as the chart below illustrates, these risk ratios do compare favorably to similarly sized peers such as Apache and Devon, but are inferior to larger integrated oil and gas companies such as Occidental and Chevron.

This underscores the additional risk that investors need to accept when choosing to invest in the oil and gas exploration and production sector rather than in integrated oil majors, which have far more diversified operations and income streams.

The Company is a Low Cost Producer

One standout feature of Anadarko is that it is a low cost producer, with a cost of goods sold (COGS) to revenue ratio of 29% in the fourth quarter 2012. This as the chart below illustrates is significantly lower than many of its peers, being less than half of Chevron's 71% and Devon's 64%, as well as being around half of Occidental's 58% and Apache's 50%.

Source data: Anadarko, Apache, Occidental, Devon and Chevron 4Q11 to 4Q12 Financial Filings.

The company's ability to control costs and the likelihood of it being able to continue reducing costs in the future, is evident when its history of reducing its lease operating expenses (LOE) are taken into account. As the chart below illustrates, the company has been able to reduce its lease operating expense in comparison to its barrels of oil equivalent (BOE) by 27% since 2008, which is an impressive reduction.

Source: Anadarko Operations Report Fourth Quarter 2012.

This bodes well for a continued reduction in costs, which should translate into improved future margins and profitability, allowing the company to generate increasing value for shareholders.

Continues to Maintain a Solid EBITDA Margin

The low production costs are translating into a particularly solid EBITDA margin for Anadarko, which for the fourth quarter 2012 was 51%. However, as the chart below illustrates, while this is superior to Chevron and Occidental, it is inferior to both Apache and Devon.

Source data: Anadarko, Apache, Occidental, Devon and Chevron 4Q11 to 4Q12 Financial Filings.

This high EBITDA margin indicates that Anadarko's core profitability is quite high and operating costs along with COGS are being well controlled by management, and this bodes well for the company's future profitability.

Production Continues to Grow

Anadarko has been able to successfully continue growing production over the last five quarters, and for the fourth quarter 2012, the company reported production of 741 (MBOEPD), which is a 0.2% increase QoQ and 9% YoY. This significant growth in production can be attributed to strong oil production rates from the company's Caesar/Tonga project in the Gulf of Mexico and increased U.S. onshore production at the Wattenberg Horizontal program, Eagleford Shale, East Texas Horizontal program and Permian oil.

This increased production, particularly in the U.S. can be attributed to the company's renewed focus on its U.S. operations, which reduces the degree of political and country risk that its production is exposed to. This obviously reduces the risk of production being interrupted by unstable security, political and economic situations that exist in many developing countries.

The company's level of production also compares favorably to many of its peers being higher than both Chevron and Devon, but is marginally lower than Apache and Occidental as the chart below illustrates.

Source data: Anadarko, Apache, Occidental, Devon and Chevron 4Q11 to 4Q12 Financial Filings.

This consistent growth in production indicates that the company has a consistent history of production and sales growth which bodes well for it to be able to continue growing reserves, production, sales, revenue and ultimately its share price.

In addition, as the chart below illustrates Anadarko, has forecast oil production CAGR of 5 to 7 % and gas production CAGR of 7 to 9% over the next 7 years, and based on the company's historical production growth, I believe that these rates of growth are achievable.

Source: Howard Weil 41st Annual Energy Conference Anadarko Presentation March 18, 2013.

These production growth forecasts combined with its solid history of production growth makes me confident that even oil prices were to fall the company is capable of growing revenue through increasing production and growing sales.

Revised Outlook for the Price of Oil

In previous articles, where I have analyzed the value of a range of oil and gas explorers and producers, I have taken a negative outlook regarding the price of oil through 2013 and 2014. This outlook was based on the bearish forecast made by Citigroup, which predicted an overall 14% fall in the price of oil over that period, for both Brent and West Texas Intermediate.

However, recent trends in the oil price, combined with statements from OPEC have seen me revise that outlook to be somewhat more positive. OPEC recently stated that it believes world demand for oil in 2013 will grow faster than expected and this growth in demand will help to support the price for oil.

The U.S. Energy Administration (EIA) has also lifted its forecast prices for 2013 and 2014 based on its views that demand over that period will exceed that originally forecast. Accordingly, the EIA has revised its price for West Texas Intermediate, now predicting that its average price per barrel will be $91.92 in 2013 and $92.17 in 2014. These prices represent approximately a 2% decrease in the average price per barrel in 2012. The EIA has also predicted that Brent will average $108.33 per barrel in 2013 and $100.75 per barrel in 2014. This represents an aggregate fall of 6% in comparison to the 2012 price for Brent. Accordingly, I have used this revised outlook for oil prices in the valuation model used to determine the indicative fair value per share for Anadarko.

These revised forecasts for global oil demand and prices obviously bode well for oil producers to be able to grow revenue and profitability, but I don't believe they take into account the potential long-term impact of the shale oil revolution. This will see global oil production grow markedly, particularly as companies are able to bring online the vast shale oil reserves of Argentina's Vaca Muerta and various shale oil fields throughout the U.S. This, I believe, may see growing downward pressure on the price for oil as shale oil production grows, and this is a concern listed in a recent Deloitte Outlook for Oil and Gas and something that investors should be cognizant of when investing in oil and gas explorers and producers.

Exploration and Development Prospects Remain Strong

Anadarko has a particularly positive exploration outlook with a large geographically diversified exploration portfolio encompassing 83 MM acres across 11 countries as illustrated by the chart below.

Source: Howard Weil 41st Annual Energy Conference Anadarko Presentation March 18, 2013.

The company has a 67% deep water exploration and appraisal drilling success rate for 2012 and on average this success rate has been at around 70%, which bodes well for the company to continue making further oil discoveries.

In 2012 Anadarko made 2 of the world's largest natural gas discoveries offshore from Mozambique at the Golfinho and Atum prospects. These discoveries more than doubled Anadarko's previous estimated recoverable resources in the operated Offshore Area 1 to a range of 35 trillion cubic feet (Tcf) to 65-plus Tcf, the details of which are set out in the chart below.

Source: Howard Weil 41st Annual Energy Conference Anadarko Presentation March 18, 2013.

The company also has some extremely interesting offshore exploration operations in Colombia where it is operating in partnership with the Colombian government controlled Ecopetrol (NYSE:EC) to explore and develop 6 offshore blocks totaling 8 million gross acres. It is also conducting deep water exploration off the coast of Kenya across 5 blocks totaling 6 million gross acres, as illustrated by the chart below.

Source: Howard Weil 41st Annual Energy Conference Anadarko Presentation March 18, 2013.

I would expect each of these exploration operations to yield positive results for Anadarko. In addition, when the overall size of the company's exploration acreage, geographical diversification and solid deep water exploration success rate is taken into account, it bodes extremely well for the company to continuing adding to its proven reserves.

Another positive aspect of Anadarko's operations is its focus on developing both its U.S. onshore production and offshore Gulf of Mexico production. This I believe allows the company to reduce the risk in its production portfolio because it is focusing on developing production in a stable jurisdiction that is not fraught with the level of political and economic risk that African or Latin American countries possess.

The company's onshore U.S. operations are illustrated in the chart below, and it is clear that with Anadarko allocating 60% of its 2013 capital expenditure to developing its U.S. onshore operations that production will continue to grow.

Source: Howard Weil 41st Annual Energy Conference Anadarko Presentation March 18, 2013.

The company has also allocated 15% of its 2013 capital allocation to its Gulf of Mexico operations, across 3MM acres, with a view to developing its existing production and continuing exploration across its acreage in the area as the chart below illustrates.

Source: Howard Weil 41st Annual Energy Conference Anadarko Presentation March 18, 2013.

This includes drilling a further five wells in 2013 as highlighted by the blue dots in the chart above and expanding existing production. All of this increased activity bodes well for the company to be able maintain its impressive proven reserve replacement rate of 162% and continue to build its oil and gas reserves, creating further value for investors.

Diversifying Into Mid-stream Assets Will Reduce Risk and Boost the Bottom Line

A key aspect that I find particularly appealing about Anadarko's growth strategy is the move into midstream assets, including gathering, storage and transportation assets in the regions where it operates. This provides the company with the ability to control costs and the timing for bringing online new production allowing it to enhance its margins and profitability.

The control of these mid-stream assets becomes even more important when it is considered that transportation, gathering and processing infrastructure in the U.S. has not kept pace with the growth of shale oil and gas in the country. By expanding into mid-stream assets, it provides Anadarko not only with a means of controlling costs and production timing but also a growing future revenue stream. However, for the full year 2012, Anadarko's revenue from midstream operations fell by 13% YoY to $911 million, but gathering, marketing and processing expenses fell by around 4% YoY to $763 million.

Shareholder Remuneration

Despite my preference for investing in companies that focus on reinvesting profits as a means of enhancing growth in the current environment, I do believe that dividends can form an important part of investor returns. This is particularly the case when investing in companies that operate in volatile or high-risk industries such as oil and gas exploration and production.

An appealing aspect of Anadarko is that as the chart below illustrates, the company has been consistently paying a dividend since January 2000, with the last dividend payment of 9 cents per share being declared on 14 February 2013.

Source data; Anadarko Investor Relations.

At the time of writing, this gives Anadarko a nominal trailing twelve month (TTM) dividend yield of around 0.4%, with a payout ratio of 8%, which as the chart below illustrates is comparable to similar sized peers such as Apache and Devon. But its dividend yield is considerably lower than larger integrated oil and gas companies such as Occidental and Chevron.

Source data: Yahoo Finance, Ycharts, Anadarko, Apache, Occidental, Devon and Chevron Investor Relations.

Such a low yield does not make this an investment for income hungry investors, despite the company's dividend growth history and low payout ratio indicating that the dividend is sustainable and should continue to grow. For dividend investors seeking exposure to the oil and gas industry, they would be better off considering one of the majors with a solid dividend payment history such as Chevron.

Valuing Anadarko

At the time of writing, Anadarko has some attractive valuation metrics, such as a price per flowing barrel of $79,000, an enterprise value to EBITDA ratio of around 8.7, an enterprise value to 1P reserves of 21 and price to operational cash flow ratio per share of 5. But while they are relatively attractive they do indicate that the company has been fairly valued by the market. In addition, when compared to Anadarko's peers, it does make the company appear to be expensive.

As the chart below illustrates, both Apache and Devon Energy appear to be far better value on an enterprise-value-to-1P-reserves basis with ratios of 14.5 and 9, respectively.

Furthermore, both Apache and Devon are cheaper on a price-per-flowing-barrel basis, which for Apache is $53,336 and Devon $40,457. In addition, Apache, Devon and Occidental have lower enterprise-value-to-EBITDA ratios of 3.4, 6.4 and 5.5. Finally, Apache has the lowest price-to-operating-cash-flow ratio of 3.4, indicating that on an operating cash flow basis, the company is undervalued and the cheapest of those compared.

However, I don't believe that these ratios provide a comprehensive picture of Anadarko's true indicative value per share and, as a result, I have used a net-asset-value (NAV) methodology to determine the indicative fair value per share.

To do this I have determined the present value of Anadarko's' after-tax cash flows from its reserves and midstream activities and then divided this by the number of common shares outstanding. In order to do this, I have used the following assumptions:

  • I have discounted the future value of the company's cash flows derived from those reserves by 10%, to determine their present value.
  • The oil price for both Brent crude and WTI has been discounted over the life of the valuation by 6% to represent my revised bearish outlook for oil prices.
  • I have conducted the valuation over a ten year period, which represents the production life of the company's 1P reserves, at its current rate of production.
  • I have reduced the company's level of leverage over the valuation period to represent the gradual deleveraging process being undertaken by the company.
  • I have calculated the present value of asset retirement obligations using a 3% growth rate (representing the long-term GDP growth rate) over the period of the valuation, factoring in the likelihood that these will continue to grow in value as the company expands.
  • I have applied an average tax rate of 34% over the life of the valuation, representing the ten year average tax rate paid by the company.
  • I have not factored in any increase in reserves from exploration operations and future discoveries because of the uncertainty that surrounds oil exploration.

After applying each of these assumptions and factoring in the positive and negative catalysts discussed above, I have determined that the indicative fair value per share for Anadarko is $99 as per the NAV chart set out below.

With Anadarko at the time of writing trading at around $87 per share, this represents potential upside for investors of around 15%. This is not a tremendous amount of upside nor does it provide a large margin of error, but it has been determined using a particularly conservative valuation methodology.

This methodology has not taken into account the probability of success of the company's exploration operations, nor does it take into account the additional value that any significant boost in reserves would add to the company. Yet it is highly likely given Anadarko's solid reserve replacement rate and significant exploration potential that these reserves will continue to grow.

Risks to Consider

Anadarko, as a geographically diversified oil and gas explorer and producer, operates in a range of environments that represent increased risk for the company and hence investors. Currently, the company has operations in countries such as Mozambique, Algeria and Ghana, which have unstable political and security environments. Along with which the company's Latin American operations are also subject to increased political and economic risk, given the history of conflict and corruption in the region. But I do believe that the degree of risk in that region is falling overall and it does not represent the same degree of risk as Africa.

Finally, the company was involved in the Deepwater Horizon oil spill in the Macondo field in the Gulf of Mexico in 2010. Despite reaching a settlement with BP totaling $4 billion, Anadarko may still be subject to further monetary and non-financial impacts from this incident should BP fail to comply with the settlement it has reached with the U.S. government. While it appears to be highly unlikely that BP would breach that settlement, it is necessary for investors to be cognizant of this risk.

Bottom Line

Anadarko is certainly a solid oil and gas exploration and production company that has a strong history of successfully executing its business strategy and growing proven reserves and production. It is also clear that this is due to the company having a strong management team, which is focused on building profitability, while reducing risk and controlling costs, all of which I believe makes it an attractive addition to any risk tolerant resource investor's portfolio. The company has solid exploration potential, and with a focus on developing its onshore U.S. production operations, it is clear that the company's risk profile will continue to fall. This reduced the risk of production outages and other security, political and economic issues related to higher risk environments such as Africa and Latin America.

Finally, while the company's valuation metrics do make it appear to be expensive in comparison to many of its similar sized peers, I do believe that on a NAV basis the company offers investors potential upside of 15%. While this is not a significant amount of upside, it does present an opportunity for investors to build a position in a well-managed company with solid exploration potential that currently rewards investors with a nominal dividend payment.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in APC over 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.