Apache (NYSE:APA)

Apache (NYSE:APA) has underperformed the market significantly over the past year due to the dramatic political uncertainty in Egypt; accounting for 20% of Apache’s worldwide production in 2012. The decline triggered by these events has been far in excess of any loss that might result from, in the worst case, a total expropriation of Egyptian assets. A recent sale of a 33% interest in these assets “validated” their worth. In addition, Apache is aggressively allocating capital towards unconventional drilling in North America. The company has operated in these regions for decades and production here can be ramped up quickly achieving high rates of return. The speed of this move naturally creates questions but the value of the company is in excess of the current price.

Background

Apache’s strategy has been to invest heavily in growth over the past ten years. Every dollar of cash flow has been pushed back into the business to pursue more growth. Cumulative operating cash flows over the past ten years amount to $56b but over the same period $66b has been reinvested into the business.

The majority of this expenditure has been capex, spending on current properties. However, the company’s “acquire and exploit” strategy has relied on opportunistic acquisitions to provide the raw material for capital expenditures.

In the mid-1990s, substantially all production was domestic. After this point, the company began to pursue international resources. “Low-risk” domestic operations would fund more speculative international projects. At this point, the U.S. appeared to be a largely mature market, this switch was essential to the company’s long record of reserve and production increases. Not all of these projects would work – projects in Indonesia, Congo, and China failed, for example – but eventually one would. Egypt, Australia, and, later, Canada and Argentina have been important successes.

On the scorecard of increasing reserves and production this strategy has been highly successful. Reserves increased in 23 out of the last 27 years, production increased in 32 out of the past 34. Some of this record appears to be due to Apache’s operational expertise. For example, Apache has operated in the North Sea since 2003. Through the use of 4-D surveying and cost/production efficiencies the company has managed to keep production at roughly the same level. As in Egypt, the company has continued to make acquisitions in the North Sea as other operators have exited.

The past three years saw the acceleration of this strategy as ~$35bn was invested back into the business. $13.5bn of this was acquisitions with the remainder being exploration and development costs (although the company does incur capex on storage/distribution assets and takes significant asset retirement costs annually).

Acquisitions

Looking first at the acquisitions, Apache has generally stuck to the regions it operated in before. The $3.25bn acquisition of some BP’s Canadian assets was a fairly significant expansion but apart from this Apache has been fairly conservative. However, it has recently announced the sale of some Gulf of Mexico shelf assets, some of which were only acquired back in 2010. This change of course seems to relate more to the investment opportunities it sees in the Central and Permian regions rather than indecisiveness on the part of management. The past record of capital expenditure does suggest it is tremendously expensive to operate in this region so this does appear to be a justified move.

Capital Expenditures & North America

Apache’s change of strategy is far more apparent if we consider capital expenditures. In 2010, the Central and Permian regions were projected to receive just under $1.4bn in capex in aggregate (due to acquisitions, they probably received much less). In 2013, Central alone has been allocated the same amount. Permian has been allocated $2.4bn bringing the combined aggregate to $3.8bn. The Gulf of Mexico shelf, a central part of the company’s operations since the 1990s, has been sacrificed to fund this push.

Compared to YTD last year, combined Permian and Central production is up 41% (quickest in the former at 90%) against a 57% increase in combined capex.  In the second quarter earnings call, the company stated that rates of return in the Permian were 20%. The company expects this to rise at achieves cost efficiencies which have improved the rate of return significantly at Tonkawa and Anadarko (both Central, 40% and 30% rates of return respectively). Current capex plans suggests combined spending this year of $3.8bn boosting production further. As the company continues to make divestments further capex can be reallocated. As these two regions account for 27% of total world production, growth will be highly significant, in line with 6-9% production growth target set by the company. In both these locations, Apache is a major landowner and has a lot of opportunities left. The company estimates ~96,000 future drilling locations.

The company is also developing LNG export facilities in Australia and Canada. The former is the most advanced and whilst it is unable to absorb the same level of investment as U.S. region, at roughly $4bn of total investment it is certainly not irrelevant in the longer-term.

International

Unfortunately, domestic gains have been offset by poor international performance. Falling production in Egypt is significant but marginal returns on investment are still good and the company still has a lot of acreage left to explore. Depletion in Australia has been more dramatic and operations are far more expensive. In Argentina, the company has also experienced significant depletion but has also suffered from a low local price. Finally, the North Sea appears to be fairly expensive and depletion has been significant. The only mitigating factor is the high local oil price. Going forward, investors should be most concerned about Australia and Argentina.

Apache has taken action to deal with its problem but these have focused more on repairing its share price than building value. The recent sale of a 33% interest in Egypt to Sinopec for $3.1b helped to allay investor concerns about the Egyptian operation and the effect of recent political turmoil. However, Egypt is the most valuable international asset with a lot of scope for future production and excellent marginal returns on investment. The recent share buyback should lead investors to ask the same questions. The company is about to embark on a huge capital expenditure program and has sold off key divisions to fund this but is wasting money on trying to prop up its share price. If the investment opportunities were so good in North America, why would Apache do this?

Unsurprisingly, management compensation is linked to total shareholder return. Apache is still cheap at this price, despite the boost from Sinopec announcement, but the long-term picture is slightly more unclear. Further alterations in its international portfolio are clearly necessary, if North America is the goldmine that management suggests. A sale of part of its interest in Argentina, perhaps raising as much as $1bn, is an idea that has been discussed. Management should bring other ideas onto the table that take a longer perspective than measures currently enacted.

Summary

At the current price, Apache provides a significant margin of safety for investors. The current situation in Egypt has been badly misinterpreted. Not only was the company unaffected by the recent turmoil but other investors, China-based ones most prominently, have little qualms about investing in such politically contentious contexts. Chinese involvement may expose Apache to new risks but the boost in the share price shows that the move basically did what it was supposed to.

The move away from international towards domestic investment appears to be wise. Other companies, for example Occidental, are in the process of exploring opportunities here too but Apache has moved fastest. I would suspect that on this basis, Apache may be worth more than $100. As already mentioned, it is hard be specific as questions build about international performance. The recent decline has clearly put pressure on management and whilst their actions have been fairly weak, short-term reactions to the market the moves are in the right direction. The company now appears to be torn between two directions and I expect further changes to the portfolio which should add more value.