I’m usually not much for energy stocks. Given their cyclical nature and high capital requirements, they’re a unique kind of investment. Besides, unlike virtually any other business, oil and gas producers have very little ability to set market prices.
That said, there’s always something alluring with businesses that sell a product the public absolutely needs. Oil and natural gas is, with complete certainty, something that will always have value. Let’s take a look at Apache Corp. (APA), an independent oil and gas player.
Apache Corp. is the second-largest independent oil and natural gas firm in the United States by market cap. In terms of the energy industry at large, it’s still a small player. Apache’s market cap of just over $35 billion makes it the 18th largest energy company.
Its smaller size makes the firm nimble in operations. The company is well-known for its simplicity – it purchases oil assets to develop. I repeat: development, not exploration. Apache operates in the “safer side” of the oil business, though it has made some recent investments in international and domestic deepwater exploration.
The company is undeniably one of the most conservative in the space, keeping its balance sheet clean and financing expansion with cash flow from operations, not debt. The firm grew over its 57-year history with safe investments in legacy assets from other oil companies. It is the leader in acquire and exploit operations, maximizing the potential from proven acquisition opportunities.
Here’s a chart from Apache’s recent analyst and shareholder meeting that compares Apache’s leverage relative to other firms in the space:
Apache is well managed, and I tend to favor its somewhat contrarian, go-anywhere style. The firm has assets all over the world and tends to act oppositely of most energy companies.
Recent Growth and Acquisitions
Apache went on a spending spree in which it made several multi-billion dollar deals for new assets. The company merged in a $4 billion deal with Mariner Energy, purchased $11 billion in assets in a series of transactions from BP, Devon Energy, and Exxon Mobil, and struck a $3 billion deal with a long list of private equity players for Cordillera Energy Partners III LLC.
Its recent acquisitions are focused in the United States. Management recently announced a plan to increase its total output by 34% in four years fueled by recent acreage acquisitions. By 2016, it will produce proportionately more oil and natural gas in the US, and less overseas.
Currently, 22% of the company’s energy production comes from Egypt, a location that brings significant political and economic risks. Following its plan to develop more on-shore US oil plays, US production will nearly double to 41 percent of output from 21 percent. Egyptian production will fall from 22 percent to 15 percent of total output. From the 2011 annual report, Egyptian production makes up 17% of its current discounted cash flows into the future.
The new US locations provide some of the lowest-cost oil and natural gas in the United States, adding disproportionally larger free cash flows than rival firms.
Apache is very good at mobilizing assets for the best possible return. As other firms chased natural gas acreage in the United States, Apache turned the other way, seeking acreage with less gas and more liquids – crude.
Moving to North American liquids production as other firms sought natural gas acreage may have been the best move in the company's history. A large build up of gas makes North American natural gas too cheap to produce profitably:
Due to infrastructural complexities and limited arbitrage opportunities, North American natural gas prices should remain depressed for quite some time. This gives Apache a long-term competitive advantage that it needs to secure rigs and produce at the lowest possible cost.
By 2016, 58 percent of its production will be liquids, compared to 50 percent today.
Catalysts for Upside
I see several catalysts for upside potential. Here they are, in no particular order:
- Less risky output – Apache will shift to US production sites, which reduces Egypt’s total effect on the company’s bottom line. As Egypt is an undeniably dangerous place to do business, Apache’s earnings in the area earn an obvious discount for risk. As earnings growth from American wells flows into future earnings, Apache’s geographic diversification will mirror most every other oil company on the market. Less risk should bring a higher market value. Wall Street has effectively discounted Egyptian production entirely, and then some.
- Dividend protection – Apache executives declined to give an indication as to the company’s preference for future repurchases, but it did say it would continue to re-evaluate its dividend annually. A higher dividend would help to fend off short-sellers, who can afford to short Apache as a hedge on international risk. Of the 147 energy companies that currently pay a dividend, Apache is ranked 135th in yield. At the moment, management finds future development more rewarding than spewing cash to investors.
- Shift to drilling – Apache has spent the better part of its existence buying more and more acreage to drill more wells. Management noted that the company can grow its reserves and drill for more current output at the same time without acquisitions. I still think it is the aggressive acquisitions that have depressed the company’s stock. At some point (now!) Apache needed to move capital from acquisitions to producing more oil today rather than buying future output in the form of acreage. Apparently hidden from analysts' view, Apache management cannot make new acquisitions without risking a credit downgrade. This gives me confidence that the firm will not make significant new acquisitions and instead invest the bulk of its cash flows into new production.
- Consistency from low cost production – You know you have good management in a commodity company when the words “lowest-cost producer” are repeated over and over in every conference call. Apache knows that it cannot influence prices for its output. Instead, the only way to have bigger margins or generate larger and more consistent profits is to be the oil and gas firm that can generate a profit even when oil and gas prices fall. Apache manages to be the lowest cost producer by buying older oil fields and smaller assets that are not as interesting to larger oil companies. Also, lower financial leverage gives it an absolute advantage.
- Realized opportunity – Wall Street seems to enjoy pricing this company as if it is primarily in the US gas business. The reality is that Apache's domestic production is tilted toward oil, not gas. As more oil production comes on line, I think we'll see a shift in thinking toward Apache's liquids-heavy business model, which will justify a premium to its current market price.
Ride the Cash Flow Explosion
Apache executives are ready to “drill, baby, drill!” In 2010-2011, Apache burned through nearly $30 billion in capital expenditures. Some $16 billion of that capex was for land acquisitions.
In the same period, Apache generated nearly $17 billion in operating cash flows. Going forward, Apache is in position to use its strong operating cash flows to lock in land rigs for further domestic development.
Apache rarely makes big moves. Low natural gas prices plus BP’s Gulf of Mexico disaster made the well-capitalized firm an opportunist in securing low-cost, liquid-heavy assets from distressed sellers. The future brings massive opportunity to exploit those newly-acquired resources for impressive cash flow growth. As these assets are digested, Apache will be in position to return more cash flow to shareholders. A higher dividend would allow for Wall Street to realize the company's potential, as I do not think this particular firm is an acquisition target for any other firm in the space. It is certainly a company that could (and should, just on the basis of valuation) be taken private, however.
Apache executives want annual production and cash flow growth of 6-9% per year going forward. Given that it trades at a forward PE of under 7, I think it's significantly undervalued. An earnings yield of 14% is hard to come by, especially in a company that can reasonably grow cash flows at 6-9% per year for the next 4-5 years.
Disclosure: I am currently long APA, and intend to average into new positions over time as opportunities to low my cost basis come into view.
What are your thoughts on the energy sector right now?