Apache Corporation (
) is one of the world's largest mid-major oil and gas exploration
and production companies. They have a diversified portfolio of
energy assets including on-shore, offshore, international, and
domestic exposure. Diverse revenue streams protect Apache against
volatility in any particular operating segment or region.
Apache operates an "acquire and exploit" strategy, acquiring
land previously explored by major oil companies and either boosting
production or further exploring the land. This strategy is entirely
dependent on management's ability to identify underutilized assets
and pay reasonable prices. Apache's management has come under
criticism lately for mis-execution and an apparent reversal of
strategy announced on their February, 2013 conference call in the
form of a potential $2 billion asset sale. Shares are down 28% over
the last twelve months and presently trade below their book value
of $76.84. The market is mistaken, and this note will explain the
rationale behind management's recent announcements and the path
Apache can take to reclaim significant value for investors.
From 2005-2009, Apache focused resources and investment
primarily on a balanced portfolio of oil and natural gas assets.
The company acquired a major presence in the Western Desert region
of Egypt, offshore assets in the North Sea near the United Kingdom,
natural gas assets in Western Australia, and significant natural
gas acreage in Canada's Horn River Basin. In 2005, prior to the
current oil and gas boom in the United States, Apache acquired
significant assets in West Texas's Permian Basin and Oklahoma's
Anadarko Basin. The latter two US acquisitions were prudent and
represent the bulk of Apache's near-term growth potential and
capital expenses, with 54% of 2012 investment directed towards the
Apache's prior strategy offered exposure to the rapidly growing
North American natural gas market just as hydraulic fracturing
technology opened previously inaccessible natural gas reserves.
Apache's acquisitions in Egypt and Australia offered both oil and
gas opportunities and the ability to sell gas into Europe (from
Egypt) and Asia (from Australia). The North Sea field, which was
nearly mature when acquired, is a large offshore development.
Unlike Gulf of Mexico offshore, which sells at lower WTI crude
prices, Apache's North Sea production is sold at higher Brent crude
prices, resulting in improved margins over comparable projects in
the Gulf. The North Sea field yields 12% of Apache's production
revenue and generates strong cash flow to support investment in
other areas. The North Sea field should be productive for years to
In 2009 and 2010, the rush to access North American natural gas
led to overbuilding and oversupply. An economic recession took
hold, and as a result the price of natural gas in the North
American market dropped from over $10/mbtu to below $3/mbtu.
Apache's strategy shifted with these unexpected market forces, as
management scaled back investment in gas-rich assets in favor of
In 2010, with offshore drilling halted due to BP's Macondo
disaster, Apache acquired the offshore energy company Mariner
Energy for $2.4 billion, making Apache a "player" in the Gulf of
Mexico offshore region. Apache curtailed investment in Canadian gas
fields, and instead shifted focus to development of its oil-rich
lands in Texas and Oklahoma. Apache spent $10.5 billion in
2010-2011 to acquire land in Texas and Oklahoma, mostly from BP. As
a result of these acquisitions, the Permian and Anadarko basins now
account for 25% of Apache's total production, and total firm-wide
production is presently 81% oil and 19% natural gas.
Going forward in 2013, management has taken the possibility of
another major acquisition off the table, citing a reluctance to
assume more debt. Apache's debt rose from $10 billion to $24
billion between 2008 and 2013 as a result of its acquisition
activities. It should be noted, however, the equity still exceeds
debt on Apache's balance sheet and 2012 cash flow of $8.5 billion
covered $500 million interest expense by 17x.
When announcing year-end 2012 results, management revealed they
expect capital investment to be steady in 2013 and primarily
directed at development in Texas and Oklahoma and with $1.5 billion
earmarked for construction of natural gas pipelines and export
terminals in Australia. These terminals are a good long-term
investment, because as technology makes gas transportation more
viable, the ability to move gas into high-demand Asian markets
should be profitable. Apache is securing access to the profits of
transporting future gas exports from Australia and Canada to the
Apache surprised the investment community by announcing plans to
sell $2 billion of assets, which management candidly admitted they
had not identified yet. Markets punished Apache for the admission,
seeing asset sales shortly after large purchases as a tacit
admission that management misunderstood industry trends and the
company is poorly positioned going forward. Further concerning the
market was management's plan to spend $2.5 billion in 2013
developing "long-term assets" which will yield no production until
2014 at the earliest, though management predicted these investments
would eventually yield 200,000bpd of production (25% of current
total). Markets were unconvinced, instead believing there is a risk
management masking near-term failures with promises of future
growth. The market's concerns, and others, are discussed below.
The announcement of unexpected asset sales dominated the Q&A
portion of Apache's recent conference call. Rationalizing the sale,
management stated that after making so many large acquisitions over
the past few years, they believe there is an opportunity to
evaluate their asset portfolio and selectively eliminate some less
attractive holdings. Some assets either cannot be developed
economically at present prices or could be developed at lower cost
by other firms. Selling these assets could generate cash and "load
the gun" for another acquisition, fund dividends or buybacks, or
repay debt. At worst, the sales boost returns by eliminating
underperforming components of Apache's portfolio. Far from being a
sign that management lost its way, the proposed sales show
management feels comfortable with the assets it has and is seeking
to consolidate and streamline operations - exactly the course
Apache needs to take in 2013.
Case in point, Apache recently reduced the time required to
drill a test well in the Permian Basin by six days. At a rig rate
of $60,000 per day, this amounts to a savings of $360,000 per test
well, and Apache intends to drill over 1,000 wells in the Permian
this year - no small savings. By focusing internally on cost
cutting and efficiency - hallmarks of Apache's style prior to
recent acquisitions - management can meaningfully boost profits,
cash flow, and share price. Management was explicit that any asset
sale would not meaningfully decrease production, since any asset
sold would be either undeveloped or in early stages of
On 03/06/2013, Bloomberg reported Apache is considering sale of
its deep-water Gulf of Mexico assets (900,000 acres). Offshore
drilling is more costly than onshore drilling, and deep-water
drilling is extremely expensive, especially when considering
liability costs after BP's Macondo disaster. The Mariner
acquisition gave Apache both shallow and deep assets in the Gulf,
but deep-water drilling is not a core competency. Apache would
retain its major shallow-water presence off the Texas coast, and by
divesting itself of its costly deep-water assets, Apache improves
its position if energy prices remain low.
Further, by reducing investment in deep-water projects that are
vulnerable to costly overruns, management is eliminating
uncertainty in development. Management alluded to this strategy on
their recent conference call, noting that in some cases, other
firms could develop Apache's assets more efficiently. Deep-water is
surely among those assets, and proceeds from any sale would likely
be used to repay debt. Debt repayment is important, and we trust
management's capital allocation decisions, but with the U.S.
natural gas industry about to undergo a round of consolidation,
Apache may be better served by holding cash for a year or two.
While management is right to be conservative, current debt levels
are sustainable and interest rates are low, so debt repayment need
not be a priority.
Apache's decision to make long-term investments that yield
little if any production increases in 2013 and 2014 rattled
investors. Some are concerned that management is attempting to buy
time, first predicting greater production in the long-term to
soothe markets and then later figuring out a way to actually do it.
Others prefer an investment in the Permian or Anadarko, returning
7% by management's estimates. Apache's CEO, Steven Farris, has been
with the company since 1988 and has been CEO since 2002. Management
has historically been conservative and has delivered as promised on
past strategies and representations to shareholders.
On their recent earnings call, management was upfront in
disclosing the expected returns on the foregone investment in the
Permian, suggesting they were confident in the long-term returns on
their capital allocation. Management is extremely shareholder
friendly and earned the trust of investors to execute on its chosen
development plan. Nothing in the plan is unreasonable or requires
the occurrence of some unlikelihood, so long-term investors have
less reason to be concerned.
Geopolitical Risk in Egypt
Apache is the largest investor in the oil-rich lands of Egypt's
Western Desert. Approximately 10% of Apache's Plant, Property, and
Equipment investments are in Egypt, but the region accounted a
disproportionately high percentage of the company's operating
income - approximately $3.50 billion in 2012. In 2011, populist
uprisings in Egypt led to the removal from power of the oppressive,
pro-Western President Hosni Mubarak. After Mubarak's removal,
populist support and electoral votes flowed towards the Muslim
Brotherhood, a political group that is not openly hostile towards
the West but is decidedly less friendly than the previous regime.
Unrest and occasional mass protests still occur in Egypt, and the
situation is not nearly resolved. If an anti-Western government
assumes power or the Muslim Brotherhood reverses Mubarak's friendly
policies towards foreign oil companies, Apache's assets in the
country could be adversely affected.
While Apache has not seen any production disturbances in its
Egypt operations, the company continues to invest in the region,
planning 270 new wells in 2013. In a worst-case scenario, the
Egyptian government could nationalize Apache's assets, resulting in
their total loss.
While risks associated with Apache's Egyptian assets have
weighed on the stock, nationalization of foreign assets would
cripple foreign investment in Egypt, restrict the country's ability
to borrow, and alienate Western governments. Egypt is the 27th most
indebted country in the world and largely depends on foreign
investment for economic growth, so nationalization is unlikely
barring a completely irrational government. For its part, Apache
should consider reducing capital investment in Egypt until the
geopolitical situation begins to resolve.
Apache partially hedges its exposure to Egyptian instability by
carrying insurance to hedge the risk of nationalization. The
company's $4.79 billion of Egyptian assets are insured for over $1
billion and have been undisturbed in the remote Western Desert.
Regardless, investors in Apache should monitor the situation in
Egypt closely, keeping an ear to the ground for anti-Western
rhetoric that so far has been notably absent, relative to the rest
of the Middle East. A surge of anti-American rhetoric in Egypt is
probably the single biggest warning signs that risks underlying the
stock are beginning to materialize.
Valuation and Growth
Apache replaced 131% of production with organic reserve growth
(156% including growth from acquisitions). Growing total reserves,
even as production depletes them, improves Apache's position in the
long run and ensures production growth is sustainable. Apache has
sufficient reserves to sustain production over the forecast period.
Catalysts for Apache include rising oil and/or natural gas prices
that would boost margins and profitability. A stronger than
expected Chinese economy could boost demand for natural gas exports
from Australia and boost utilization of Apache's infrastructure
there. Increased demand for North American natural gas, either from
transportation, manufacturing, or utilities could increase prices
if supply becomes more disciplined. Favorable resolution of
uncertainty in Egypt would result in valuation returning to those
heavily discounted assets. Finally, Apache could sell assets like
deep-water acreage outside their core competency, using the
proceeds to acquire on-shore land over the next five years.
Valuation conclusions are based on management guidance and
assumptions regarding investment, growth, and profitability. I
assume constant revenue growth of 6% annually for the next five
years. This encompasses management's guidance for 6%-9% annual
production growth over that period, weighted towards the later
model years. Any price increase in oil or gas would improve revenue
growth rate, but price increases are not explicitly factored into
our model. Terminal growth rate is estimated at 2.00% with
short-term and long-term operating margins constant at 25%, roughly
in line with 2012 performance.
A meaningful increase in oil or gas prices would improve
Apache's margins. Cost of capital is computed at 8.00% and no
equity dilution is forecast. Further, I do not consider any asset
sales in my model, and the effect of asset sales on valuation would
depend on the productivity, price, and planned use of proceeds.
Capital expense is forecasted at $9.5 billion for 2013, with
depreciation at nearly $5 billion and taxes at 35%. Under these
assumptions, I model fair value for Apache at $100, with a
realistic downside value of $78 per share. Shares currently trade
for $75.09 (as of 04/12/13) and are discounted below book value.
Apache is a strong buy for investors with a time horizon of 24
months or more.
Apache's previous strategy included development split evenly
between oil and natural gas. When natural gas prices collapsed,
management shifted focus towards liquids, which now make up over
80% of 2012 revenue. Apache is one of the largest players in the
Permian, Anadarko, and shallow-water Gulf regions. In 2013,
management expects to consolidate, invest in new development, and
potentially sell less attractive assets to rebuild Apache's balance
sheet. These asset sales, which may include deep-water assets,
would improve operations and benefit Apache, especially if used to
bolster cash and not repay debt. Apache will invest $9.5 billion in
2013, much of it in long-term projects that will not yield
production before 2014. While markets are skeptical of these moves,
investors should buy the uncertainty as management is excellent and
can be trusted to execute in the interests of shareholders.
Geopolitical risk remains in Egypt, but nationalization is unlikely
and investors can mitigate their risk by monitoring the situation
closely for anti-American rhetoric.
Some analysts have asserted that Apache lowered its growth
projections on its recent conference call, but in reality
management reaffirmed its guidance for 6%-9% annual production
growth over the next five years. Using this conservative growth
forecast and assuming no increase in the price of oil or gas,
Apache's fair value is $100. This represents a 38% upside to recent
prices, and shares of Apache can presently be acquired in the
market for less than their book value. Investors seeking to add
exposure to the international energy market, play the unrest in
Egypt, or hedge their personal finances against rising gasoline
costs would be well-served by considering an investment in Apache
below $75 per share. Price target of $100.
I 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. I have no business relationship with
any company whose stock is mentioned in this article.
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