2016 has been a banner year for energy stocks in general and Apache Corporation (NYSE:APA) in particular as oil prices came back strongly after dropping to multi-year lows of less than $27 a barrel in February. I believe Apache will continue to do well in 2017.
The SPDR Energy Select Sector ETF (NYSEARCA:XLE), the industry's benchmark fund, is up almost 26% on a year-to-date basis. The SPDR S&P Oil and Gas, Exploration and Production ETF (NYSEARCA:XOP), however, which focuses on oil and gas producers, has outperformed the broader energy industry by posting a 39% gain in the same period. Apache has pulled off an even better performance, rising by more than 50% since the start of the year. The company will likely continue to outperform.
That's because firstly, despite the outperformance, Apache's shares are still undervalued. Apache stock is trading at a significant discount as compared to most of its large-cap exploration and production peers, in terms of EV/EBITDA ratio based on Thomson Reuters consensus estimates for 2017.
Apache stock is priced just 7.6x EV/EBITDA (2016e.), as opposed to its peers Concho Resources (NYSE:CXO), Devon Energy (NYSE:DVN), EOG Resources (NYSE:EOG), Hess Corp. (NYSE:HES), Occidental Petroleum (NYSE:OXY) and Pioneer Natural Resources (NYSE:PXD) who are all priced above 9x. A look at P/CF, which is another valuation metric, also gives a similar result. This shows that Apache is not only one of the cheapest large-cap E&P stock, but it also has significantly greater room to run as it catches up with others.
Secondly, Apache, like its peers, is positioned to improve its earnings and cash flows from the strength in oil prices. The company is heavily levered to movements in oil prices since its production mix has been almost 65% liquids and it does not have significant hedges in place. The company has already gradually narrowed losses on the back of improvement in oil prices.
In the first quarter, with WTI spot price averaging around $33 a barrel, the company posted an adjusted loss of $0.40 per share. As oil prices increased to average approximately $45 a barrel in the third quarter, the company's losses (adj.) narrowed to $0.03 per share. Since then, the price environment has improved even further, with WTI averaging $47.75 a barrel in Oct.-Nov. and $49.80 in the first two weeks of Dec. At this rate, the fourth quarter price could end up averaging around $48 a barrel, which would be the highest quarterly price level of this year. This price level could even push Apache to profitability. Indeed, analysts on an average are already expecting a fourth quarter profit of $0.09 per share, data compiled by Thomson Reuters.
Remember, Apache boldly claimed that it could achieve cash flow neutrality at $35 oil. It backed up that claim by delivering operating cash flows in excess of capital expenditure and dividends (or positive free cash flows) in the second quarter and the third quarter. There are few oil producers that can report positive free cash flows at sub-$50 oil, and even fewer who can report positive free cash flows as well as a small profit in this environment. If Apache returns to profitability in the fourth quarter, then that would reaffirm the company's position as one of those rare oil producers.
This should give confidence to investors regarding Apache's ability to perform well in 2017, a year when oil is forecasted to average in the $50s by a number of analysts, including those at Goldman Sachs, as well as US Energy Information Administration. That's going to have a positive impact on the company's valuation and its shares could outperform.
Thirdly, earlier this year, Apache discovered Alpine High, a new resource play located in Texas's Delaware Basin, which is a part of the larger Permian Basin. Alpine High could hold up to 15 billion barrels of oil equivalent reserves, with upside potential, which makes it one of the most prolific onshore discoveries of recent times. Apache still has a lot of delineation work to do on this play, which is still in early stages of development. But even if Apache ends up adding a small part of Alpine High, say around 10% of the resource potential, to its books, then it could potentially double its reserve base. Such a large increase in resource base would justify a higher valuation.
Finally, the Alpine High discovery also provides the company with increased optionality in terms of asset sales. If Alpine High lives up to its potential, then the company can afford to re-adjust its asset portfolio by identifying and selling high-cost, non-core oil and gas producing properties. The company can use the proceeds from asset sales to improve its financial health by paying down debt. Reduction in debt will have a positive impact on the company's valuation.
For these reasons, I believe Apache can prove to be a promising pick for 2017.
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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.