Despite The Risks APCO Oil And Gas Offers Potential Upside Of 40%

| About: Apco Oil (APAGF)
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Since earning the wrath of investors by expropriating YPF (NYSE:YPF) from its Spanish parent Repsol (OTCQX:REPYY), Argentina's government has worked hard to attract investment in the country's energy sector. This has seen a range of measures introduced aimed at attracting foreign energy companies to invest in Argentina. These measures include concessions on import duties for particular equipment, tax relief and the introduction of a more favorable crude and natural gas pricing model.

During my last review of the sector one company that has caught my attention is APCO Oil and Gas Corporation (NASDAQ:APAGF). The company is focused on the exploration and production of oil and gas principally in Argentina with some promising exploration assets in Colombia. After reviewing the company's operations and valuing its assets I believe the company is currently unfairly valued by the market, offering investors potential upside of around 40%.

Investment case summary

Already over the last year APCO's share price has shot up 62%, but the company still appears to be under-valued by the market solely on the basis of its existing assets and operations alone. This is because there has been a general flight to quality among investors as they seek to avoid higher risk small-cap E&P companies operating in what are perceived to be higher risk jurisdictions like Argentina.

As a result APCO is trading at a considerable discount to its indicative fair-value, offering patient risk tolerant investors potential upside of around 40%, when the value of its existing assets are calculated using a net-asset-valuation (NAV) methodology.

There are a range of positive catalysts that will boost APCO's financial performance and unlock further value for shareholders, including:

  • Growing crude oil production in Colombia, where the government has a far more business friendly approach than Argentina as well as lower royalties and taxes.
  • Higher oil and natural gas prices, particularly with Argentina's government having recognized that price caps and punitive taxes on profits from oil exports were deterring investors. This includes the government paying a natural gas price of $7.50 per MBtu, which is more than double the international spot price.
  • The ability to benefit from the extension of the Argentine government's Oil Plus program as it increases production and reserves in Argentina.

It will take time for these catalysts to fully materialize, but they will further improve APCO's operational and financial performance that should translate into a growing share price for investors.

Company profile

APCO Oil and Gas is a Cayman Island domiciled small-cap independent oil and gas explorer and producer with its head office located in the U.S. that commenced operations in the 1960s. It is focused on oil and gas exploration and production in Argentina as well as having commenced operations in Colombia.

APCO's largest share holder is U.S. domiciled WPX Energy (NYSE:WPX) which owns just under 69% of APCO's shares. APCO has an almost 41% equity interest in Argentine oil and gas E&P company Petrolera Entre Lomas. It operates and has a 73% interest in the Entre Lomas, Bajada del Palo and Charco de Palenque concessions.

The company has 9 oil and gas producing concessions and 2 exploration permits in Argentina, totaling over 1.2 million gross acres, with exposure to what is believed to be the world's second largest shale oil basin the Vaca Muerta. It also has 3 exploration and production contracts in Colombia totaling 374,000 gross acres. The details of APCO's assets in Argentina and Colombia are set out in the chart below.

Source: APCO Oil & Gas Annual Report 2012.

APCO's key producing operations are located in the Neuquén, Austral and Northwest basins in Argentina, with Argentina accounting for around 98% of its proved assets and production.

It has 36 MMBOE of proved reserves (1P) and over the last 5 years grown its 1P reserves by an impressive 227%. But disappointingly the company reported that its proven reserves had declined at the end of 2012 as the chart below illustrates. .

Source data: APCO Oil & Gas Annual Reports 2008 to 2012.

The reduction in APCO's 1P reserves as reported for 2012 in comparison to 2011 is the result of the company reducing its development assumptions and forecasts of future well production volumes in its natural gas fields. APCO also reclassified a portion of its undeveloped proved reserves in the provinces of Río Negro and Tierra del Fuegoto as unproved reserves, because it had not been successful in obtaining 10 year concession extensions.

But even after this revision saw the company's proved reserves fall, it is still under-valued by the market on the basis of those reserves alone as the NAV later in this article will demonstrate.

APCO's proved and probable reserves also compare favorably too many of the company's peers operating in South America as shown by the chart below.

Source data: APCO Oil & Gas, Americas Petrogas, Canacol, Gran Tierra and Parex Resources financial filings and reserves reports 2012 to 2013.

Furthermore, unlike its peers Americas Petrogas (OTCPK:APEOF) and Canacol (OTC:CAEEF) the majority of its proved reserves are higher margin oil as the chart illustrates.

Source data: APCO Oil & Gas, Americas Petrogas, Canacol, Gran Tierra and Parex Resources financial filings and reserves reports 2012 to 2013.

This increases the value and margins that APCO is able to generate from its production and translates into the company having far more valuable assets. However, it still does have a significant portion of its 1P reserves made up of natural gas and this is higher than peers Gran Tierra (NYSEMKT:GTE) and Parex Resources (OTCPK:PARXF), which does make them a more appealing investment on that basis.

But APCO is able to offset this because at the time of writing the Argentine government pays a price for natural gas that is significantly higher than the international spot-price. Currently the natural gas price in Argentina is $7.50 per MMBTU, whereas the spot price on international markets is $3.62 per MMBTU. Giving APCO a premium of just over 100% for the natural gas it produces and sells in Argentina, making its natural gas reserves more valuable than they typically would be for a company unable to access the Argentine natural gas market.

Financial performance is disappointing

APCO's third quarter 2013 financial performance was disappointing particularly in comparison to the previous 4 quarters. For the third quarter revenue fell 20% QoQ and 3% YoY to $34 million, while net income plunged 142% QoQ and 160% YoY to minus $6 million as the chart below illustrates.

Source data: APCO Oil & Gas 3Q12 to 3Q13 Financial Filings.

The fall in revenue can be primarily attributed to lower sales volumes of oil, natural gas and LPG, which was marginally offset by slightly higher realized sales for oil and natural gas.

The significant fall in APCO's bottom-line can be primarily attributed to changes in Argentina's taxation laws, which saw the income tax exemption applied to income derived from the sale of shares, titles, bonds and other securities removed. As a result the sale of such securities is subject to an effective capital gains tax of 13.5%.

This caused APCO's third quarter 2013 tax liability more than double both QoQ and YoY and the company record a $13.7 million deferred tax expense for its equity investment in Petrolera Entre Lomas.

Production costs remained relatively flat YoY and APCO generated a solid EBITDA margin of 44% for the third quarter. As the chart below shows APCO's EBITDA margin compares favorably to its peers operating in South America, despite the Argentine government capping the price per barrel of oil below the spot price.

Source data: APCO Oil & Gas, Americas Petrogas, Canacol, Gran Tierra and Parex Resources Financial Filings 3Q12 to 3Q13.

This solid EBITDA margin indicates that management has a firm control of costs and that APCO's operational profitability is strong.

Maintains a solid balance sheet

APCO has a particularly solid balance sheet, which is a remarkable achievement for a company with a market cap of just over $450 million that is operating in such a capital intensive industry. This mitigates a considerable portion of the risk generally associated with investing in a small-cap oil and gas E&P company.

The company is virtually debt free with long-term debt totaling $5.5 million, giving it a particularly low debt-to-equity ratio of 0.03, which is significantly lower than the average of 0.6 for the independent oil and gas industry.

The minimum maturity dates of this debt is also particularly favorable for APCO and spread over a 5 year period as the chart below indicates.

Source: APCO 3Q13 Financial Filing.

The company's balance sheet is also particularly liquid as evidenced by APCO's solid current ratio of 2.7 and its cash and cash equivalents of $47 million at the end of the third quarter 2013. At the end of the same period APCO also had a net asset position of $ 314 million and working capital of almost $51 million.

This gives APCO some very attractive risk ratios with a debt-to-EBITDA ratio of 0.1 and operating-cash-flow-to-debt ratio of over 10, which indicate APCO is a low risk investment for a small-cap oil and gas E&P company. These ratios also compare favorably too many of its peers operating in South America as the chart below illustrates.

All of which indicates that with its particularly low degree of leverage and high level of liquidity, the amount of investment risk associated with APCO is low. It also indicates that APCO is well positioned to fund planned capital expenditure for exploration and development for the remainder of 2013 and into 2014 from a combination of cash-on-hand and projected cash flow.

Production has declined

A disappointing aspect of APCO's operations is that production over the last 5 quarters has continued to decline. For the third quarter 2013 APCO's production fell by 8% QoQ and 11% YoY as the chart below illustrates.

Source data: Americas Petrogas 2Q12 to 2Q13 Financial Filings.

This ongoing decline in production can be attributed to an overall decline in production volumes in Argentina, despite Colombian production volumes increasing. The key drivers of this declining production were decreased rig availability, longer than expected concession extension negotiations and worse than expected performance from new wells.

However, declining production and sales volumes were offset by a higher average realized price per barrel, with international crude prices over $80 per barrel and the company's eligibility for oil plus benefits. For the third quarter 2013 APCO received an average realized price of $51.37 per BOE, which is almost a 3% decline QoQ but a 3% increase YoY as shown by the chart below.

Source data: APCO Oil & Gas 3Q12 to 3Q13 Financial Filings.

This higher average realized price per barrel bodes well for the company's ongoing profitability and its ability to continue generating sufficient cash flows to continue its exploration and production program.

A significant driver of the increase in average realized price per BOE is the pricing oil pricing regime introduced by the Argentine government. In the past, the Argentine government had capped the price of crude at $42 per barrel and punitively taxed any proceeds from the sale of oil exports, which received a higher price. This prevented oil producers operating in Argentina from being able to benefit from higher international spot prices and acted as a deterrent to foreign investment in Argentina's energy sector.

But in order to attract much needed investment in the country's energy sector, the government introduced a sliding scale export tax regime and agreed to higher domestic oil prices. The pricing regime essentially means that exporters are able to receive a higher price per barrel of oil exported when the international spot price for crude is over $80 per barrel.

As a result since 2012 the price of crude has stabilized at around $75 per barrel in Argentina. But recent higher international crude prices, has seen the average realized price per barrel of oil reach $78 per barrel in the third quarter 2013.

The Oil Plus Program, which was originally introduced by the Argentine government in 2008, also incentivizes smaller oil producers to boost production and grow reserves through a series of tax concessions and incentive payments.

But despite these measures the average realized price per barrel received by APCO is still lower than the majority of its peers that operate in South America as illustrated by the chart below.

Source data: Americas Petrogas, BPZ Resources, Petroamerica and Parex Resources Financial Filings 2Q12 to 2Q13.

APCO's average realized price per BOE is significantly lower than fellow Argentine operator Americas Petrogas, because 42% of its sales volumes are made up of lower priced natural gas, whereas 100% of Americas Petrogas' production and sales volumes are made up of light sweet crude.

Investors should also note that the average realized price per barrel received is dependent upon the Argentine government maintaining its current pricing policy and the Oil Plus program. If the current pricing regime and/or the Oil Pus Program is terminated then the average realized price per BOE will decrease, thus impacting APCO's revenue.

Another positive pricing factor for APCO is that as discussed earlier the Argentine government pays a price for natural gas that is significantly higher than the spot price. At $7.50 per MBtu it is more than double the spot price at the time of writing of $3.62. This certainly works to the benefit of APCO as it seeks to monetize its natural gas assets, leaving it less exposed than the majority of its peers to any further gyrations in the natural gas price.

Overall this bodes well for APCO to grow its profitability through increased production and a higher average realized price. But it also underscores the company's continued reliance on Argentine government policy and the risks this creates.

Netback per barrel is declining

Another negative aspect of APCO's performance is that over the last 5 quarters its netback per barrel has continued to decline. For the third quarter 2013 its netback per BOE fell by 4% QoQ and 3% YoY to $36.98 as the chart below illustrates.

Source data: Petroamerica 2Q12 to 2Q13 Financial Filings.

APCO is eligible to receive Oil Plus Program benefits, which for the third quarter 2013 totaled $1.5 million. In theory these should be included in the calculation of the netback per BOE but they have been excluded because the ongoing receipt of these benefits is highly subjective. They are dependent on a number of conditions being met which are beyond the control of APCO.

I am expecting that as APCO is able to resolve its operational problems in Argentina the average netback per barrel will grow. But this growth will only be moderate and still leave it with a lower netback than those companies operating in South America that are able to obtain the full spot price for crude.

In comparison to many of its similarly sized peers operating in South America APCO's netback per BOE is among the lowest as the chart below highlights.

Source data: APCO Oil & Gas, Americas Petrogas, Canacol, Gran Tierra and Parex Resources Financial Filings 3Q12 to 3Q13.

*NB: Americas Petrogas Netback excludes Oil Plus benefits.

A key reason for this is the pricing regime in Argentina which prevents operators from being able to obtain the full spot price per barrel of crude. Another is that around 42% of APCO's total sales volumes are made up of lower margin natural gas.

Whereas its peers Americas Petrogas, Gran Tierra and Parex Resources receive a significant majority of production and sales volumes from higher margin crude. But even at $36.98 per BOE this netback compares favorably to many similar sized operators in North America.

Exploration and development program

APCO maintains a solid exploration and development program. For the nine months ending September 2013, APCO had completed the drilling of 20 development wells and 3 exploration wells in the company's Neuquén Basin properties.

But disappointingly this program in Argentina has experienced delays due to a lack of drilling rig availability and prolonged exploration concession negotiations. At this time it is unclear as to whether these issues will be an ongoing problem for APCO, but they are offset to a degree by the exploration program the company has underway in Colombia.

APCO has 3 exploration blocks in Colombia, with 2 located in the prolific Llanos basin and the remainder is located in the Middle Magdalena basin, totaling 347,000 gross acres. Both of these basins sit in one of the richest hydrocarbon trends in the world, the Sub-Andean basins as shown by the map below.

Source: Pacific Rubiales Investor Handout July 2013.

The level of exploration success and production in both of these basins bodes well for the success of APCO's exploration and development program. Already companies such as Pacific Rubiales (OTCPK:PEGFF) and Colombian government controlled Ecopetrol (NYSE:EC) have significant operations in both basins.

In the Llanos basin APCO's assets owns a 20% interest in Llanos block 32 and a 50% interest in Llanos block 40. The company has already experienced considerable success with its investment in block 32 with an oil discovery being made by the operator Canadian domiciled P1 Energy Corp in 2012.

During the third quarter 2013, 2 additional wells were drilled in the block with the first found to hold oil and put on production from the Mirador formation. But the second was dry and APCO incurred dry-hole costs of $1.4 million for that well. Currently the company is scheduled to being a 4 well exploration drilling campaign in block 40 during the fourth quarter 2013.

APCO also has 100% ownership of the Turpial block in the Middle Magdalena basin. The Middle Magdalena has been the site of oil exploration and production in Colombia since the 1920s. During the third quarter 2013 APCO executed a farm out agreement for this block which will allow it to mitigate some of the costs and risk associated with exploring this asset.

Both APCO's Argentine and Colombian exploration and development programs hold considerable potential for the company. Furthermore, the ongoing development of its Colombian assets will add considerable value and allow it to mitigate the risk of being solely dependent on its Argentine operations for oil and gas production.

The price of crude remains uncertain for the short-term

Since hitting a 52 week high of $111 per barrel in August 2013 oil prices have continued to soften. At the time of writing the price of light sweet crude or West Texas Intermediate (NYSE:WTI) has fallen by 16% o just over $93 per barrel. The short-term outlook also indicates that the price of crude will continue to soften, with WTI futures set for delivery in January 2014 being $92.25 per barrel and Brent futures are at $110.65 per barrel.

This doesn't bode well for the short-term profitability of junior oil and gas E&P companies like APCO. But, the key oil price per barrel for companies operating in Argentina is $80 per barrel. This is because when the spot price of crude is over this price, oil producers in Argentina are eligible to receive the higher price per barrel of crude, which with crude prices at current levels has settled at around the $75 to $78 per barrel mark.

It is not expected that the spot price of crude will fall to as low as $80 per barrel or lower at this time. The U.S. Energy Information Administration has forecast an average price per barrel for WTI in 2013 of $97.74 and $965 in 2014, while for Brent it is expected that it will average $108 per barrel in 2013 and $103 in 2014.

These estimates are far more positive than the outlook for the prices of crude that the EIA released earlier in 2013, with both being around 16% higher than they were in April this year. But with oil futures contracts deliverable in January 2013 having fallen to a lower price per barrel than the EIA's forecasts, its prices do appear somewhat optimistic.

The long-term outlook for the price of crude is more optimistic. Analysts have predicted that over the medium-term ongoing geopolitical tensions, labor disputes and conflict in the Middle-East will create supply outages and supply uncertainty. The uncertainty that this creates will help to form a price floor and support the price of crude.

The International Energy Agency recently forecast that crude consumption will increase 16% by 2035 and that the price of crude will increase to $128 per barrel over the same period. This bodes particularly well for the profitability of oil and gas E&P companies like APCO over the long-term.

But companies such as APCO that are operating in the energy sector in Argentina, will not be able to enjoy the full appreciation in value for crude prices unless there is a significant change in oil pricing policy in the country. This is because oil exports in Argentina are subject to a sliding-scale export tax regime as discussed earlier, which caps oil prices at a lower level than the spot price.

Unlike many of its peers APCO does not hedge its commodity risk, primarily because of the pricing regime for domestic and exported oil in Argentina. This leaves APCO exposed to movements in the price of crude which can have a significant impact on the revenue and cash flow of a small-cap oil and gas E&P producer.

The company's crude prices are negotiated with the Argentine government on a short-term basis which means it is unable to predict future sales prices. Furthermore, while the negotiated crude prices are set in U.S. dollars they are paid in Argentine pesos and given the volatility of the Argentine currency APCO's realized prices are particularly sensitive to any further devaluation of the Argentine peso.

Finding APCO's indicative fair value per share

Despite APCO's share price having shot up by 62% over the last year, the company is still unfairly valued by the market with a number of valuation ratios making it appear under-valued. These include currently trading with an enterprise-value that is under 7 times its EBITDA and 11 times its proved reserves.

Making it appear undervalued in comparison to some of its South American peers as shown by the chart below.

But while these ratios are a useful indicator as to whether APCO is under-valued by the market - especially in comparison to its peers - they do not give the full picture because they are typically backward looking in nature.

In order to obtain a clearer picture of APCO's true indicative fair-value per share I have calculate it using a net-asset-value (NYSE:NAV) methodology. To do this I have calculated the present-value of the after-tax cash flows generated by APCO's proved reserves. I have then factored in a number of assumptions into the calculation and then dividend the final value by the number of shares outstanding, giving an inactive fair-value per share.

When conducting this calculation I have used the following assumptions:

  • I have only used APCO's proved reserves because it does not report probable reserves. Typically I also include a discounted portion of a company's probable reserves in the calculation, making this a particularly conservative valuation.
  • I have discounted the future value of the company's cash-flows derived from those reserves by 10%, to determine their present value.
  • I have assumed an average basket price per barrel of oil of $75, representing both the outlook for the price of crude, the pricing regime in Argentina and the application of Oil Plus benefits. This is significantly lower than the third quarter gross price for Argentine oil exports of $78 per barrel and the spot price for WTI of $93 per barrel.
  • I have factored in a minimum royalty rate of 12.5% reflecting the standard Argentine royalty rate applicable to Americas Petrogas' production of conventional oil.
  • Even though the company is domiciled in the Cayman Islands and is not subject to income tax in that jurisdiction I have factored in both provincial and federal taxes payable in Argentina and Colombia.
  • I have also factored in the impact of the recent taxation changes in Argentina, which has seen APCO's effective taxation rate increase, over the valuation period.
  • I have conducted the valuation over a 10 year period.
  • I have calculated the present value of debt and asset retirement obligations using a 3% growth rate (representing the long-term GDP growth rate) over the valuation period. This factors in the likelihood that both debt and asset retirement obligations will continue to grow as the company expands.
  • Despite the particularly positive exploration and development outlook I have not factored in any increase in reserves from those operations or future discoveries. This is because of the uncertainty that surrounds oil exploration and the long lead times to bring new discoveries online.

After applying these assumptions and factoring in each of the catalysts discussed, an indicative fair value of $22.16 per share for APCO as displayed in the chart below.

With APCO currently trading at $15.60 per share this represents potential upside of just over 41% for investors, making APCO a deep-value investment opportunity. This becomes even more apparent when the conservative valuation methodology (including only using its 1P reserves) and substantial margin of safety is considered.

Key risks

Investing in a small-cap oil and gas E&P company can be risky. Typically they don't have the financial resources or cash flow to weather any sustained or catastrophic downturn in energy prices. The level of investment risk is further heightened where they operate in an emerging economy.

Typically investments in emerging economies are subject to greater risk in comparison to those made in a developed economy. This is particularly true of investing in Argentina, which has a particularly volatile economy that is subject to significant government intervention.

The key risks associated with investing in Argentina are:

  • Heightened political risk, with Argentina's current government under President Cristina Fernandez de Kirchner having demonstrated a clear preference for intervening in the economy and business sector. This is highlighted by the 2012 expropriation of YPF from its Spanish parent Repsol and capital control measures that prevent companies from paying dividends or transferring capital outside of Argentina.
  • A multilayered bureaucratic legal and regulatory system that lacks transparency and has limited avenues for appeal coupled with high levels of corruption and patronage. This has the potential to delay or derail licensing applications and lead to unforeseen taxation and royalty changes. Transparency International's Corruption Perceptions Index 2012, rated Argentina 102 out of the 176 countries rated, where the higher the rating the greater the degree of corruption.
  • There is a high degree of currency risk with the Argentine peso regularly gyrating in value. Already for the year-to-date it is down by around 26% against the U.S. dollar and will more than likely continue to depreciate. This is caused by a combination of factors including Argentina's volatile economy, high inflation, capital controls and government policy aimed at reducing its value so as to increase the competitiveness of exports.
  • APCO's key dependency on Argentine production to generate revenue leaves it critically exposed to any negative impacts coming from changes in the Argentine government's regulation of the oil and gas sector. This includes the discontinuation of the Oil Plus program, changes to the pricing regime, taxation changes and any increases in royalties.

A significant portion of the political and regulatory risk is mitigated by the fact that the Argentine government has recognized the importance of developing the oil and gas sector to its economic growth and stability. This has seen it introduce a range of investor friendly policies to encourage foreign companies to invest in accessing the country's vast oil reserves, in particular the unconventional shale reserves of the Vaca Muerta.

This is emphasized by the Argentine government's decree 929/2013, which sets an investment target of $1 billion over a five year period and exempts 20% of production sales from export retention. The decree has also established a regime with no currency or repatriation restrictions. All of which indicates that much of the commonly perceived political risk associated with investing in Argentine has been negated or mitigated.

APCO's move to continue developing its assets in Colombia, which includes commencing production in Colombia and further developing those assets to boost production also mitigates some of the risk associated with obtaining the majority of its production from Argentina.

Investment strategy

Investors have the option of either purchasing shares in APCO, but this will mean that they face the full range of risks discussed or they can purchase shares in WPX Energy which owns 69% of APCO. This would give investors the benefit of WPX's diverse asset and production base, which other than the investment in APCO is focused on the lower risk jurisdiction of North America.

Any significant gain in APCO's share price would more than likely translate into a commensurate gain in WPX's share price. But the disadvantage is that investors are exposed to the additional risks that WPX's operations present and the potential upside is diluted.

Bottom line

Despite many of the risks associated with investing in Argentina's energy sector or companies that operate in that sector, APCO appears to be significantly undervalued. This is because of the higher perceived and real risks associated with investing in Argentina combined with a general move to quality as investors seek to reduce the level of overall risk in their portfolios.

As such it has created a deep-value investment opportunity with APCO offering investors potential upside of around 40% solely on the basis of its existing assets. Over the long-term the company has the potential to offer investors considerably higher upside given its exploration and development program which to date has seen oil discoveries and production commence in Colombia.

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