|Shares Out. (in M):||377||P/E||150||19|
|Market Cap (in $M):||23,940||P/FCF||45||10|
|Net Debt (in $M):||8,100||EBIT||700||2,540|
|TEV (in $M):||32,040||TEV/EBIT||46||12.6|
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This discussion (and, we believe, opportunity) isn’t from the lens of an energy expert, but summarizes our view on the dislocation in oil-exposed securities. We don’t have a defined view on the price of oil, but think that uncertainty is near the root of the opportunity – most folks who recommend buying an energy stock will first be asked, by their boss or client: “what is your expectation for the price of oil?” Since we think it’s difficult to respond convincingly, many investors choose to shy away from the opportunity.
There is fear in the markets with many stocks getting thrown out with the bathwater. We believe there is a margin of safety surrounding certain stocks, even without a strong sense of future oil prices. We look forward to hearing why we’re wrong.
We think the Exploration and Production (E&P) sub-industry is a good place to hunt and will discuss Apache (APA), specifically. We think E&P’s are interesting because intuition suggests earnings power is simply tied to the price of oil (or natural gas). It is in the short-term - but there are economic adjustments over the medium-term that benefit the companies during periods of lower commodity prices (i.e. lower drilling expense, lower power costs, less competition for future production, and production-sharing-agreements - where contracts limit upside to E&P profitability, but also dampen downside as oil prices decline).
We also think there is a general misconception when analysts model these companies – the typical model will calculate: number of barrels * (price per barrel less cost per barrel) = operating profit per barrel. When production declines, the simple response in the model is to just cut the number of barrels, which results in lower operating profit and EPS. But, the business works differently – a company will first pull back on its higher cost projects and the future DD&A expense per barrel will decrease. It’s difficult to forecast this change accurately, but the concept is directionally correct and we think often missed by the market.
More importantly, any company with a healthy balance sheet (and guts) to take advantage of distressed opportunities over the next couple years should be rewarded with outsized returns, benefitting longer-term patient investors. We think APA is in this camp and will survive a lower-oil-price environment without raising equity or facing debt maturities.
Within E&P’s, we think many of the companies primarily focused on the high-growth (and quick decline) shale plays were selling at premium, before oil prices dropped, mainly because of the high rate of return offered by these high-growth plays. But, these reserves also have a high decline rate (for example, from Month 2 through Month 14, a well drilled in the Bakken can expect production to decline of nearly 60%). This means they need to continue spending aggressively – often on higher-cost projects, just to keep production flat. That differentiates the oil industry – as fast as the high cost capacity came in, it also could come out, unlike shipping or offshore drilling, where the economic life of the capital is much longer. As industry capex tends to bear a direct relation to its cash flow, excess returns tend to beget excess supply and thus lower returns, and vice-versa. The key is for a company to make it through to the better returns.
In this environment, companies without a concentrated base of fast declining, capital intensive assets should have more ability to spend in the future, potentially at distressed prices. APA fits this mold. Admittedly, they did chase some of the faster declining Permian and Eagle Ford regions, but a significant portion of their production base is still in slower declining fields. And, because of timing (and mostly luck), they are still in the transition of selling assets that has left them with a pile of cash (nearly $4b) and an under-levered balance sheet.
A few comments on the other industries in energy:
Offshore Drillers – we thought the industry was oversupplied, before lower oil prices. With the amount of debt outstanding and potential that many rig day rates fall to cash costs, liquidity is a meaningful risk – we still think that risk isn’t priced appropriately and will wait to possibly participate on any capital raise.
Integrated Oil Companies – these names also seem generally cheap and likely sit on a similar risk/reward curve as the E&P's - less risk, but less reward. We do own RDS, but think the E&P’s are closer to the center of the pain and would rather purchase stocks that have faced indiscriminate selling (both from generalists and industry specialists), not stocks that may have been supported (relative to the sector), by a defensive rotation from investors who need to meet a certain sector benchmark.
APA – What It’s Worth
We think APA is worth $100+.
Three Approaches to Assess Value:
Return on Capital – We believe that over time, E&P’s should earn a return on the capital they commit. Sure, it’s a commoditized, cyclical business, but over a longer period of time, we assume returns should average about 8% after-tax. APA currently has about $53b of capital on its balance sheet (almost all PPE). To start, $53b * 8% (after-tax, using a 40% tax rate), would be ~$7b of operating income. Subtract $400m of interest expense (5% on $8b), tax at 40%, gets you $4b of net income or ~$11 per share of earnings power (after buybacks from LNG asset sale). Put a 10x multiple, gets you $110.
You might argue that a portion of that $53b of capital is impaired – it was poorly allocated in a period of unsustainably high oil prices. We think it’s pretty difficult to sift through all the capital and accurately write it up or down, but we’d make two points: 1) over a long period of time, APA has earned a 10% after-tax return on its book capital, 2) it will take about 7 years for APA to replace that capital, through future capex. Sure, the capital they spent over the past few years may ultimately generate a poor return on capital, but this should be counter-weighted by the potential excess return generated on capital spent over the next few years. The critical factor is that they survive in their current capital structure to see the better environment.
Book Value – As of 3Q14, APA’s BVPS was $87. Some of the book value may be impaired, but it’s trading at 75% of book value and as we suggested above, some of that impairment should be made up by a higher ROE in subsequent years. We think the book value provides some valuation support around current levels.
Cash Earnings – at about $65 oil and $3.50-$4 gas (adjusted for differentials), we think APA can earn about $7b of EBITDA. To continue these production levels, we estimate they need to spend ~$4.5b (over the next few years). Hit them with a 40% tax rate, gets you $1.4b of net income or ~$4 of “Cash-EPS”.
Earnings at $65 Oil
APA should be able to earn ~$7b of EBITDA at $65 oil and $3.75 gas (adjusted for differentials). That assumes 235m BOE and ~$46 per BOE (blend of oil/gas/NGL). For lifting, tax, and transport, we use $14 per BOE. Then subtract ~$500m for G&A.
Looks like the break-even for EBITDA less maintenance capex of $4.5b and interest expense is about $45 oil and $3 gas. They key though is that they would survive and would still be able to maintain production, while others would have to cut back on capex (and shrink). That reduction in supply should support the commodity prices.
Note: the EPS and EBIT figures in the VIC submission-table (above) use the strip prices as of 1/2/15. This is $55 WTI and $3.30 Henry Hub.
APA has a strong balance sheet with $10.9b of debt and $600m of cash as of 3Q14. Apache is also getting $3.1b (after a 600m cash tax payment) from the sale of its LNG assets. At about 1.5x net debt to depressed EBITDA, we think this cash can be used for either buybacks or distressed asset purchases and doesn’t need to be put towards paying down debt. In fact, they’ll be competing for assets (or for oil-related services like drilling) against companies who do need to use cash flow to pay down debt. We’re happy in that position through this volatile period.
From 2011-2014, APA spent $7b, $10b, $11b, and $11.5b in capex, respectively. A large portion of that was in North America (about $7b in each of the past two years).
We estimate maintenance capex of ~$4.5b (our judgment of what they need to spend, to keep production flat over the next few years) as follows:
Permian – is ~30% of production. The following is a rough guess at maintenance capex (and probably is a bit high in the near-term). Production has been 19m, 22m, 26m, and 33m barrels per year from 2011-2014. In 2015, production is estimated to be 38m barrels. In 2013 - 2015, the average capex is about $2.5b. If we assume a natural decline rate of ~25% for the entire base of production, thats 5.5, 6.5, and 8.3m barrels "lost" in 2013-2015 from the depleting wells. Thus, the production growth + the decline was 9.5m, 13.5m, and 13.2m barrels in 2013-2015. On a per barrel figure, thats about $200 of capex per barrel of "growth". So, to keep production flat, a decent guess is ~$1.5b ($200 * 8m barrels of "natural decline"). Looked at another way, if a well does 200 barrels per day for the first year, thats 73,000 barrels for the year. So, you would need 115 wells to get 8.3m barrels. At $5m per well, thats $600m of capex (drilling only). Not all wells are horizontal and the data in APA's presentation is probably the optimum-type wells, so that estimate is likely a bit low. But, nonetheless, you could see maintenance capex around $1 - 1.5b or so in the Permian.
Central US and Other Canada – Permian makes up about 60% of production, so figure another $1b for rest of North America.
Egypt – spending has averaged ~1b over the past 8 years. Figure that stays about the same.
North Sea – also averaged ~1b.
Other – don’t have much else left after selling LNG assets.
In 2009, only 34% of APA production was in onshore North America, compared with 63% by 2014. Most of this increase is from the Permian and Eagle Ford (combined with reduced international production, after asset sales). APA should be in a decent position with these assets, going forward.
In the Permian, APA has the #2 or #3 position and production is fragmented with the largest producer (Pioneer) only having ~10% share. At current oil prices, many of these companies should have difficulty maintaining production growth by late 2015. For example, Pioneer’s EBITDA would be ~1.8b in 2015. If they spent an average of that over the next two years (assume $2.2b in 2015 and 1.3b in 2016), production could start to fall ~5% y/y by 2H15 and 10% y/y by 2016. Smaller producers, with fewer reserves, will likely have calls on their financing, cutting production even more. APA should be able to take advantage of these pullbacks in the region, focusing on higher return drilling. Plus, this should occur as they become more efficient in the Permian, while others need to pull back.
Still a cash cow. Less upside in a higher oil price environment, but less downside to as the production is lower cost. Sure, Egypt is a risk, but that’s well-known.
Egypt is operated under a production-sharing-agreement with the state oil company. The production cost per barrel in Egypt is very low (likely below $20 per barrel) and the drilling operation is very profitable. However, as the price of oil rises, that profitability is disproportionately split, in favor of the Egyptian interests. But, APA’s profits aren’t reduced as much by lower oil prices and we estimate that at $65 per barrel (and $4 gas), APA would still earn pre-tax operating income of nearly $1b (compared with an average of ~2b over the past 10 years).
Buybacks - that are accretive to book value per share.
An acquisition with strong subsequent returns.
Stable or increasing oil prices over the next 18 months.
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