Apache: Despite Ongoing Performance Issues, Stock Offers Solid Potential Upside For Investors

| About: Apache Corporation (APA)
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I recently analyzed Anadarko Petroleum (APC), one of the largest independent global oil and gas explorers and producers. During the course of that analysis I compared Anadarko to its key peers including Apache Corporation (NYSE:APA). During the course of that analysis I noted that Apache had some particularly compelling valuation metrics, which made it appear to be better value than many of its U.S. based peers. In this article I am going to take a closer look at Apache to see how it stacks up against its peers and determine by way of a net-asset-valuation (NAV) methodology whether it is unfairly valued by the market.

Recent Share Price Performance

Apache's share price has performed poorly over the last year, to be at the time of writing down by around 25% over that period. This performance, as the chart below illustrates, has been worse than many of its peers including Anadarko, Chesapeake (NYSE:CHK), Devon Energy (NYSE:DVN) and EOG (NYSE:EOG).

Source: Yahoo Finance

The reason for this poor performance can be attributed to traders and investors seeking to reduce risk by selling down holdings in higher risk oil explorers and producers. It can also be attributed to Apache's flat revenue growth and declining margins, which as I will show in this article have led to the company underperforming many of its peers. This negative sentiment towards the company has I believe created an opportunity for risk tolerant investors particularly with Apache trading with a forward price-to-earnings ratio of 7.5 and a price-to-book ratio of 0.97.

Company Profile

Apache is one of the largest global independent oil and gas explorers after Anadarko and it has a range of geographically diversified oil and gas production and exploration assets. It has a focus on offshore and onshore production in North America with operations across four international locations including the North Sea, Australia, Egypt and Argentina as illustrated by the chart below.

Source: Apache 2012 Earnings Release Operations Supplement.

The company's increased focus on its North American portfolio is a key growth catalyst because it will reduce the company's risk profile and reduce the likelihood of production outages or the appropriation of assets in high risk geopolitical environments such as Egypt and Argentina.

This is also emphasized by the company's 2012 production profile, which as illustrated by the chart below saw the majority of Apache's total production derived from North American operations.

Source: Apache 2012 Annual Report.

The company has solid proven 1P reserves of 2.9 billion BOE, which is higher than many of its peers including Anadarko, Chesapeake and EOG as the chart below illustrates, although this is slightly lower than Devon.

Source data: Apache, Anadarko, Devon, Chesapeake and EOG Financial Filings Full Year 2012.

These reserves give Apache a solid reserve life of 10 years based on its 2012 average annual production of 779 (MBOEPD) and this is commensurate with its peers as the chart below illustrates.

Source data: Apache, Anadarko, Devon, Chesapeake and EOG Financial Filings Full Year 2012.

Out of Apache's peers compared in the chart above, it is only Devon and EOG that have a marginally higher reserve life, while Chesapeake has a significantly lower reserve life. In the case of Chesapeake this can be attributed to the majority of that company's reserves being natural gas rather than crude oil or non-gas liquids. When including natural gas in any proven reserves calculation one barrel of natural gas equivalent is based on 6 thousand cubic feet (mcf) to one barrel of oil equivalent.

I expect to see Apache continue growing its reserves and hence its reserve life due to its diversified geographical and geological operations along with its solid exploration program. The company has a particularly solid drilling success rate, which for the fourth quarter 2012 was one of the best in the industry at 94%.

Furthermore, Apache was able to replace 156% of the previous 12 month's production through discoveries, extensions and acquisitions. The company has a solid history of being able to grow reserves since 2003 as illustrated by the chart below.

Source: Apache 2012 Annual Report.

All of these factors bode well for Apache to be able to continue growing its proven reserves and therefore extending the production life of those reserves while being able to grow production.

Another important aspect regarding the geographical distribution of Apache's assets are that the majority of those assets including proven reserves and acreage are located in the politically stable environments of Australia, Canada, the U.K. and the U.S. as the chart below illustrates.

Source data: Apache 2012 Full year Report.

This as mentioned earlier makes the company less vulnerable to political, security and economic risk associated with operating in less stable emerging economies such as Argentina and Egypt, while still giving it a broad geographically diversified portfolio of assets.

Financial Results Continue to Disappoint

Apache's revenue growth over the last 5 quarters has been particularly disappointing for investors, only growing marginally by 7% QoQ and 3% YoY to $4.4 billion. As stated earlier this has been one of the drivers behind the substantial fall in the company's share price over the last year. The company's net income has been particularly lumpy on a quarterly basis, for the fourth quarter 2012 it grew by 271% QoQ, but fell by around 44% YoY to $668 million as the financial snapshot below illustrates.

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

These results have left Apache with a particularly poor operating profit margin, which in the fourth quarter dropped to 0% and over the last 4 quarters has been 2% or less.

Apache's full year 2012 results were also unimpressive with revenue remaining flat only increasing by 0.4% YoY to $16.9 billion. In addition, net income fell by just over 56% to $2 billion and this is despite the company delivering record production for 2012 of 779 MBOEPD.

Despite, these disappointing financial results Apache has a solid balance sheet with some particularly strong risk metrics that indicate the company is relatively low risk for investors. This is despite the company seeing cash and cash equivalents fall by 55% QoQ and 68% YoY.

These impressive ratios include a debt-to-equity ratio of 0.38, which as the chart above illustrates is well below the debt-to-equity ratio of the peers listed.

Furthermore, Apache has an operational cash flow-to-debt ratio of 0.69, which while not impressive is superior to the peers analyzed in the chart above. This indicates that the company is able to take on more debt in order to grow its operations and has a relatively low risk balance sheet in comparison to its peers.

The weakness of some of these ratios also underscores the increased risk and capital intensive nature of the oil and gas exploration and production sector particularly in comparison to integrated oil majors, which have far more diversified operations and income streams.

Despite a Poor Operating Profit Margin a Solid EBITDA Margin Highlights Potential Profitability

As the financial snapshot presented earlier highlighted because of the company's flat revenue growth combined with Cost-of-Goods-Sold (COGS), Apache's OPM is particularly poor. But despite this as the chart below illustrates, Apache for the further quarter 2012 continued to deliver a solid EBITDA margin of 72%.

Source data: Anadarko, Apache, Devon, Chesapeake and EOG Financial Filings 4Q11 to 4Q 12.

As the chart also shows this margin is superior to the majority of the company's peers and is well in excess of Anadarko, Devon and EOG all of which have solid EBITDA margins of around 50%.

Furthermore, this indicates that Apache's core profitability is quite high despite revenue growth being flat and the company's operating margin being quite poor. This can be explained by the company having quite high operating expenses particularly in the form of depreciation and amortization and taxes, as illustrated by the financial snapshot presented earlier.

Continues to be a Low Cost Producer

The high EBITDA can be attributed to the company's low COGS, which makes it one of the lowest cost producers among its peers and is one of the standout positive attributes of the company. As the chart below illustrates for the fourth quarter 2012 Apache reported a COGS-to-revenue ratio of 18%, which is only marginally higher than EOG and significantly lower than, either Anadarko, Chesapeake or Devon.

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

NB: Depreciation & Amortization have been excluded from COGS and captured as OpEx in the Financial Snapshot.

But despite being a low cost operator, Apache unlike its peer Anadarko has seen its lease operating expense (LOE) per barrel of oil equivalent (BOE) increase by 8% YoY, whereas Anadarko's fell by almost 9% YoY. In addition, Apache's LOE/BOE at $11.49 is quite high, particularly in comparison to its peers as the chart below illustrates.

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

This high LOE/BOE cost is of some concern because it indicates that operating expenses will continue to affect Apache's margins and hence the value the company can deliver for investors.

Production Continues to Grow

An outstanding aspect of Apache's performance has been the company's ability to continue to grow production over the last 5 quarters. For the fourth quarter 2012 Apache achieved a production record of 800 MBOEPD, which represents an increase of almost 4% QoQ and just over 6% YoY as illustrated by the chart below.

Source data: Apache Quarterly Financial Filings 3Q11 to 4Q12.

Apache has also built an impressive production growth rate over the last 20 years delivering a compound annual growth rate (OTCPK:CAGR) of 12% as illustrated by the chart below.

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

This significant growth in production can be attributed to strong oil production rates from the company's onshore U.S. operations in the Permian and Central Regions, which grew by 7% over the fourth quarter. These operations averaged combined net production of 197 MBOEPD, seeing them make up approximately 25% of worldwide production in the fourth quarter.

Like its peer Anadarko, this increased production, particularly from onshore U.S. operations can be attributed to the company's renewed focus on its U.S. operations. This reduces the degree of political and country risk that Apache's production is exposed to, thus reducing the risk of production being interrupted by unstable security, political and economic situations that exist in many emerging economies.

The company's level of production also compares favorably to many of its peers being higher than Anadarko, Devon and EOG as the chart below illustrates.

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

This peer comparison also emphasizes Apache's ability to not only maintain a higher level of production than its peers but also consistently increase production. 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.

Revised Outlook for the Price of Oil

I recently revised my outlook for the oil price in my article on Apache's peer Anadarko from an overall fall in value of 14% through 2013 and 2014 to an aggregate decrease of 6% over that period. I based this on reports of increased global demand from OPEC and the U.S. Energy Administration. I have used this forecast as the basis of the NAV methodology used to value Apache.

But it is important for investors to note that oil prices may actually rise over that period, with some conjecture in the market that oil prices may increase by up to 20% in response to the Cypriot banking crisis and bailout. While I have not factored this into the valuation model, any increase in the oil price will have a significant positive impact on the value of Apache and its peers such as Anadarko, Devon and EOG.

Exploration and Development Prospects Remain Strong

One of Apache's key strengths is its strong exploration and development program. At the end of 2012 the company was holding around 42 million gross acres across 6 countries (its 10 operating regions) and with plans to drill 483 gross development and exploratory wells across that acreage during 2013.

There were a number of key highlights in the company's exploration and development program in 2012, which I believe bode well for continued growth in 2013. The first of these was the drilling of 28 gross wells in Argentina with a 100% success rate. The second is its Australian exploration success, with the Tallaganda gas discovery. Thirdly, the company was able to complete drilling of 198 gross wells in Egypt, including 51 exploration wells with an 88% success rate. Fourthly, the company was awarded 12 new licenses for its U.K. North Sea operations allowing it to increase its operational footprint in the region. Finally, Apache was able to increase its liquids production in its U.S. operations by 18% YoY through increased development of its U.S. wells.

These high levels of success bode well for future exploration and development particularly when the company's planned exploration and development program for 2013 is considered.

Exploration and Development Outlook for Argentina

Currently Apache is the number 1 North American explorer and producer in Argentina with its operations focused on the Nuequen Basin. This is located in the Vaca Muerta, which is shaping up to be one of the largest shale oil plays in the world. Apache holds approximately 1.3 million net acres in the Vaca Muerta shale window, of which 586,000 net acres are in the oil window of the play.

During 2012 the company's operations in the basin accounted for around 6% of its production and 4% of its proven reserves. It also had a drilling success rate of 99% in its operations in the basin and I would expect a comparable success rate to be achieved during 2013. For 2013, Apache plans to participate in the drilling of 20 gross wells and operate 16 of those wells. This drilling program should continue to add to the company's proven reserves and production capability in the basin, but it does come with the additional political and economic risk that arises from operating in Argentina.

Exploration and Development Outlook for Australia

Apache has a solid presence in Australia and a world class development pipeline with a focus on liquid natural gas (LNG). The company's operations are focused on the northwest shelf in Western Australia as illustrated by the map below.

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

These operations were responsible for around 8% of the company's 2012 production and hold around 12% of its proven reserves. During 2012 Apache experienced a disappointing drilling success rate of 53% for this operation and obviously this does not bode well for future well development and exploration. But there are a number of positive indicators for 2013 for these operations with the Macedon gas project, in which Apache is a 10% partner with BHP (NYSE:BHP), expected to come online in the third quarter 2013. The company will also continue development of the Wheatstone LNG, Coniston and Balnaves oil fields and the Varanus gas compression project, through the year.

In addition, Apache along with Chevron and other partners has entered into an agreement to supply liquefied natural gas to Japan's Chubu Electric Power Company from their Wheatstone project in Western Australia. The agreement will see the Wheatstone partners supply 1 million metric tons of LNG annually over the next 20 years, which is 11.2% of the project's forecast 8.9 million ton annual production capacity.

Exploration and Development Outlook for Canada

Apache has 7 million gross acres in Canada across the Blue Sky, House Mountain and Virginia Hills projects. During 2012 this region accounted for around 14% of the company's total production and 19% of its proven reserves and it experienced an impressive drilling success rate of 86%.

For 2013 Apache plans to invest approximately $680 million in drilling and development projects, equipment upgrades, production enhancement projects and seismic acquisition in Canada, including the ongoing development of the Kitimat LNG project in partnership with Chevron. The company also plans to drill up to 150 gross wells in Canada and continue the transition to oil and liquids-rich plays, allowing the company to boost production of higher value oil and liquids. This will also help to reduce the company's exposure to lower margin natural gas, which over recent years has also experienced a volatile price.

Exploration and Development Outlook for Egypt

The company also has significant operations in the higher risk operating environment of Egypt with those operations accounting for around 20% of 2012 production and 10% of the company's end of 2012 provable reserves. It also had an impressive drilling success rate of 88% during 2012 for these operations.

For 2013 Apache plans to drill up to 270 gross wells including 60 exploratory test wells with a focus on Bahariya, Abu Roash, Jurassic and AEB targets. Given Apache's high 2012 success rate in the country I expect to see similar results in the 2013 program.

Exploration and Development Outlook for U.K. North Sea

Apache is the number one independent operator producing Brent oil in the North Sea off the coast of the U.K. with its production operations focused on the Forties field which it purchased from BP (NYSE:BP) in 2003. It also has exploration assets in the region as illustrated by the map below including the Beryl, Scot, and Telford fields.

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

During 2012 the U.K. North Sea operations provided around 9% of the company's production and held 6% of its end of year provable reserves. Apache also saw a drilling success rate during 2012 of 76% in the region. Of some concern is the age and declining nature of the company's Forties field, which at its time of discovery in the 1970s was the U.K.'s most prolific oil field.

In order to combat this Apache has invested $608 million aimed at extending the life of the Forties field, through the commissioning of the Forties Alpha Satellite Platform in 2013. It also plans to participate in the drilling of 27 gross wells in the region to build upon its exploration and development success.

Exploration and Development Outlook for U.S. Onshore

Apache has established an ambitious exploration and development program for its U.S. based assets and operations; this program forms an important plank in its strategy of a renewed focus on these operations.

One of the company's key U.S. onshore operations is the Apache Central Region with over 3,500 producing wells primarily located in western Oklahoma and the Texas panhandle and controlling nearly 1.9 million gross acres, as illustrated by the chart below.

Source: Apache 2012 Earnings Release Operations Supplement.

This region in 2012 was responsible for 8% of annual production and 9% of the company's proven year end reserves. The company also experienced a drilling success rate of 99% for all wells drilled during 2012 in the basin. This bodes well for future success rates through 2013, particularly as Apache has plans to spend $1.4 billion in the region on drilling, recompletions, upgrades and infrastructure enhancement to increase production and take away capacity.

Another of Apache's major U.S. onshore operations is the Permian Basin, which sits across the states of New Mexico and Texas and contains the Wolfcamp and Cline Shale formations as the chart below illustrates.

Source: Apache 2012 Earnings Release Operations Supplement.

In 2012 the Permian Basin accounted for around 15% of production and at the end of 2012 accounted for 28% of Apache's proven reserves. The company also had a drilling success rate of 100% in the basin during 2012 and this in itself bodes well for continued successful development through 2012. During 2013, the company has plans to invest $2.4 billion in drilling, recompletion projects, equipment upgrades and expansion of existing facilities.

Exploration and Development Outlook for U.S. Gulf Coast and Offshore

The company also has a variety of operations in the U.S. Gulf Coast region, with both offshore shelf and deep water projects and onshore projects in the region. During 2012 the company had a drilling success rate across these projects of 80%, 60% and 86% respectively, with the operations in total contributing 18% of 2012 production and 12% of year end proven reserves.

Overall, the combined region while being oil prone has remained relatively undeveloped for Apache and it presents as an excellent exploration and development opportunity. During 2013, Apache plans to invest an approximate total of $1.3 billion in the combined region with $700 million invested in the Gulf of Mexico shelf, $400 million to be invested in the Gulf of Mexico Deepwater and $250 million in the Gulf Coast onshore regions. The capital expenditure will be spent on drilling, recompletion and development projects, equipment upgrades and production enhancement projects.

In summary it is quite clear that Apache has an impressive portfolio of geographically and geologically diversified development and exploration projects. These will continue to allow the company to build its proven reserves and boost production. All of which bodes well, for increased shareholder value through the further development of assets and increased revenues and profitability.

Shareholder Remuneration

At the time of writing Apache pays an impressive dividend yield for a large-cap oil and gas explorer and producer of 1.1% and as the chart below illustrates, this dividend has consistently grown in value over the last 10 years.

Source data: Apache Investor Relations.

Over this period, Apache's dividend has an impressive compound annual growth rate of around 11%, and while its dividend yield is lower than the majority of the integrated oil majors it is higher than the majority of its large-cap exploration and production peers as the chart below illustrates.

Source data: Yahoo Finance, Ycharts, Apache, Anadarko, Chesapeake, Devon and EOG Investor Relations.

Furthermore, Apache has a particularly low payout ratio of 13%, which as a quick and dirty measure of dividend sustainability indicates the company should be able to at the least maintain its current dividend and more than likely continue to grow it. As a result, while the yield is lower than what I would normally consider for an income generating share investment, it is for the reasons discussed still quite compelling as a means of gaining exposure to oil and gas exploration and production within an income generating portfolio.

Valuing Apache

When examining Apache's valuation metrics it is clear that at the time of writing with the company trading at around $77 it is quite attractively priced. This includes the company having a price-per-flowing-barrel of $53,336, an enterprise-value-to-1P reserves-ratio of 14 and a price-to-operational-cash-flow of 3.5. When these metrics are compared to Apache's peers, the company appears undervalued and attractively priced in comparison to those peers as the chart below illustrates.

This is especially the case when Apache's EV to 1P Reserves is considered, which at 14.5 is cheaper than Anadarko, Chesapeake and EOG and only marginally more expensive than Devon. Furthermore, its price to operating cash flow is the lowest out of Anadarko, Chesapeake, Devon and EOG, indicating it is the cheapest out of those companies.

However, I don't believe that these ratios provide a comprehensive picture of Apache's true indicative value per share. In order to determine this I have used a net-asset-value (NAV) methodology, where I have determined the present value (PV) of Apache's future after-tax cash flows from its reserves and midstream activities using 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 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 factored in cash flow from the company's exploration and midstream activities with a growth rate of 3% representing the long-term GDP growth rate.
  • I have increased the company's level of leverage over the valuation period to represent the ongoing need for capital to fund its exploration and development programs.
  • 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 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 Apache is $109 as set out in the NAV chart set out below.

At the time of writing Apache trading at around $77, so this indicative valuation per share represents potential upside of almost 42% for investors and as such I believe it makes Apache a compelling deep-value investment opportunity.

This indicative valuation provides a solid margin of error and was calculated using a relatively conservative valuation methodology and does not take into account the probability of success in the company's exploration operations. Furthermore, as discussed earlier in this article, any positive increase in the oil price will act as a catalyst to drive this valuation higher.

Risks to Consider

Apache as a geographically diversified oil and gas explorer and producer operates in a range of environments that represent increased risk for the company and therefore investors. Currently, the company has operations in high risk countries including Egypt and Argentina, which both have unstable political and economic environments. Furthermore, the security situation in Egypt is highly fluid and unstable.

Apache has previously entered into an agreement with BP to acquire a range of that company's assets including; its oil and gas operations, acreage and infrastructure in the Permian Basin and Egypt's Western Desert. It was also agreed that Apache would purchase substantially all of BP's upstream natural gas business in western Alberta and British Columbia in Canada.

However, should any of the legal entities controlled by BP that owned those properties become insolvent as a result of ongoing action attributable to the 2010 Gulf of Mexico oil spill. If this were to occur then it is likely that these agreements will not proceed and Apache will be unable to enforce its rights under those agreements.

Bottom Line

Apache is a difficult company to form a view on, in the past it has underperformed with flat sales growth and issues relating to the control of operational expenses. This can be attributed to the company's management consistently failing to appropriately execute the businesses growth strategy while maintaining control of costs and effectively monitoring its operations. This has seen the company fall into disfavor with the market and its shares sold down, which I believe has created an opportunity for value investors.

Everything about the company says it has strong future prospects with solid proven reserves, growing production and geographically diverse exploration portfolio. Furthermore, the company has a proven history of being able to replace its reserves with an impressive replacement rate of 156% and an overall drilling success rate of 94% in the fourth quarter of 2012. When all of this is considered in conjunction with Apache's shares at the time of writing trading at a discount of 42% to their indicative fair value, I believe it presents a solid value investment for the risk tolerant investor seeking to diversify into large cap oil and gas exploration and production.

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