Description

Apache Corporation (NYSE: APA)

This write-up will not mention anything about EUR’s, type curves, IPs, or individual well economics, because those things don’t really matter to me. I look for companies with good management teams and solid balance sheets that are misunderstood by investors and where fear or uncertainty has created a buying opportunity. I believe that Apache checks all of these boxes.

Simplify, simplify. – Henry David Thoreau

Recommendation: Buy APA

• Apache is a high-quality E&P focused on North American onshore drilling with core assets in the Permian Basin. In addition, ~40% of production comes from slower-declining, high-FCF assets in the North Sea and Egypt. Apache is highly levered to an increase in the price of oil and as oil continues to recover to the marginal cost of production (at least $75), APA should outperform.

• As of December 31, 2015, APA had ~1.6 billion BOE of proved reserves. Apache produced 204 mmboe in 2015, of which 52% was oil, 37% was natural gas, and 11% was NGLs.

• New management has implemented a new capital allocation strategy that increases the focus on portfolio-wide returns on capital. In the past, capital was allocated on a regional basis, which resulted in projects with inferior returns being allocated over those with superior returns. The market does not appreciate this new pivot in strategy and misunderstands the company’s future growth profile.

• The company has stated that they could have held 2016 production flat with a $2.5 billion capex budget (2016 production will instead be down ~9% with a $1.6 billion capex budget). The 2016 capex budget was done using $35 oil, and they have stated that every $5 increase in the price of oil generates ~$500 million of additional cash flow. Therefore, if oil averages $50 in 2016, I estimate that the 2017 capex budget could be ~3.1 billion, which would generate 2017 production growth of ~13%. The market currently expects APA’s production to decline 1-2% in 2017.

• Apache has a clean balance sheet that is underlevered relative to several large cap E&P peers, with a history of producing free cash flow and solid returns on capital (shocking for an E&P, I know). The company has been free cash flow positive in 8 of the last 12 years, with cumulative free cash flow over that period of ~$9.5 billion and through-the-cycle ROIC of ~10%. APA currently has net debt/2015 EBITDA of ~2.5x. This number decreases to 1.5x under my 2017 base case. The peer group currently average net debt of ~2.5x 2017E EBITDA.

• We are clearly seeing a much faster drop-off in oil production and a much stronger demand environment than most market participants expected. Just as the market oversold many of these stocks many of these stocks as oil prices were declining, it is likely to do the opposite as oil prices recover. As long as the price of oil remains below what I believe to be fair value (at least $75), I would continue to hold this stock regardless of my estimate of its fair value.

• Perhaps most importantly, good things tend to happen to cheap stocks. In the past 9 months, APA has been the target of take-out rumors by both APC and OXY. In the first instance, APA rejected a low-ball bid, while in the second instance the rumor turned out to be false. Even so, I believe that Apache’s superb acreage and clean balance sheet combined with its cheap valuation and ability to generate free cash flow will continue to make it an attractive target for larger E&Ps.

• As an added bonus, it appears that Apache has a very intriguing asset offshore Suriname that is directly across the Suriname-Guyana border from Exxon’s significant Liza-1 discovery offshore Guyana. Apache has a 45% working interest in Block 53 and a 100% WI in Block 58. Both of these blocks were obtained prior to the Liza well being drilled.

Valuation

• APA currently trades at a discount to the peer group on an EV/EBITDA basis. The group currently trades at an average EV/2017 EBITDA of 10.3 versus APA at 8.3 (using consensus 2017E EBITDA). However, I believe the Street significantly underestimates APA’s 2017 EBITDA and under my base case, APA currently trades at just 5.8x 2017E EBITDA.

• Based on a scenario using $65 oil in 2017, I estimate that APA can generate ~$5.3 billion of EBITDA (versus consensus $3.7 billion). Using APA’s current valuation of 8x 2017E EBITDA, I value APA shares at $91.

Risks

• Oil prices reverse their recent gains and remain in a “lower for longer” scenario.

• The company’s Egypt operations are affected by terrorism or political turmoil.

• Production continues to decline.

Catalyst

• Production growth in 2017.
• Management executing on a more disciplined capital plan.