By Charles LaPorta, CFA
Established in 1954 with $250,000 from investors, Apache (APA ; recent price, $53) has grown to become one of the world's top independent oil-and-gas exploration and production companies, with $12.4 billion in assets. Standard & Poor's Equity Research Services believes that over its 50-year history, Apache has demonstrated a strong ability to find, develop, and produce hydrocarbons more efficiently than its peers.
Apache's core competency in exploiting domestic resources -- often acquired from major oil concerns -- combined with its exploration success internationally, has allowed it to secure substantial reserves on very economical terms. For the three years ending in 2003, its finding and development costs have averaged $8.33 per barrel of oil equivalent (BOE), and it has replaced 266% of its reserves at a cost of $6.52 per BOE. This has created a platform from which Apache can aggressively boost its production for the foreseeable future. We believe the business is among the most efficient independent operators of oil and gas fields, with production costs averaging $5.67 per BOE in 2003.
Given our price expectations of $40.25 per barrel in 2004 and $39.33 in 2005 for the West Texas Intermediate (WTI) grade of crude oil, and $5.94 per million BTU for natural gas in both years, we believe Apache will be able to earn historically high returns on capital. The stock carries Standard & Poor's highest investment opinion of 5 STARS, or buy.
Growth in global oil demand, principally in China and India, has all but eliminated surplus oil-production capacity around the world. We believe the market's legitimate concerns about supplies -- especially in light of the potential for disruptions in the Middle East, Russia, Nigeria, and Venezuela -- and demand, based on higher projected U.S. real GDP growth, have led to persistent elevated oil price levels. And the lack of a foreseeable change in this picture should allow the E&P outfits we cover to keep earning superior returns on capital.
The industry has shifted its capital investment dollars toward development projects over the past five years. We view this emphasis on exploitation activity as rational, as the independents appear to be maximizing deliverable quantities of hydrocarbons during a time of perceived shortages.
Apache was one of the first to emphasize an exploitation strategy in the independent E&P universe, and we think it continues to be the most successful at it. The concern's large, diversified operations span all of the major producing regions of North America (except the Rocky Mountains), and internationally it operates in the British North Sea, Western Australia, Western Egypt, Argentina, and China.
Apache's reserve base has a high 71% of proved developed reserves, which is the lowest-risk classification of reserves. Apache's proved undeveloped reserves are mainly in mature regions with readily available infrastructure, which implies relatively low capital spending needed to fully exploit nonproducing reserves. The outfit operates the vast majority of its production, providing substantial control over the timing and magnitude of capital spending.
Apache's growth strategy is to acquire producing properties and add value through cost reductions, aggressive development drilling, and increased exploration activity. The company's three-year average finding and development costs are $8.33 per BOE and its 2003 production costs of $5.67 per BOE are better than peer group averages, though they lag behind the metrics for the major integrated oil companies. Apache is usually a buyer of the integrated oil concerns' relatively mature fields.
MATURING ASSET BASE.
We have conservatively modeled production growth of 10% in 2004 and 4% in 2005. We believe this is conservative because we haven't included the impact of operations from Apache's recently closed joint-venture deal with ExxonMobil (XOM ; 5 STARS; $49), the pending property acquisition of 85 million BOE proved reserves from Anadarko Petroleum (APC ; 3 STARS, hold; $70), and a conservative ramp-up of new Egyptian production.
The biggest challenge in the industry, in our view, is to restrain escalating production costs. Since Apache operates the overwhelming majority of its projects and has a long history of efficient production, we believe it will be successful. We're forecasting earnings before interest, taxes, depreciation, and amortization of 75.2% in 2004 and 74.1% in 2005, with the source of margin erosion coming primarily from slightly lower commodity prices in 2005 and firmer gathering costs, as many pipeline players continue to operate at capacity.
We're modeling higher unit depletion, depreciation, and amortization rates for Apache's properties, reflecting its maturing North American asset base and higher interest expenses associated with the closure of the ExxonMobil transaction. We will increase our interest-expense forecast pending the closure of the Anadarko transaction.
Operating EPS is estimated at $4.70 for 2004 and $4.65 for 2005. This reflects a projected return on invested capital of about 17% and 15%, respectively. Given the current long-term commodity price outlook, we believe that Apache can conservatively increase earnings over 10% annually for the next 10 years.
JUSTIFYING A PREMIUM.
Our estimates of Standard & Poor's Core Earnings are $4.64 per share for 2004 and $4.59 for 2005. These forecasts reflect $20 million in stock-option expenses in each year. Given the shares' performance, we expect this expense level to continue for the foreseeable future. Apache's pension and post-retirement benefits costs are minimal. We believe that our S&P Core EPS estimates' divergence of less than 2% from our operating EPS estimates suggests very high earnings quality.
Given Apache's long history of efficiently finding, developing, and producing hydrocarbons above peer-performance levels, we believe the company should have a premium valuation.
Our 12-month target price of $60 suggests a 2005 p-e multiple of 12.9, while our E&P coverage universe currently trades at 12.7 times 2005 estimates. Apache's enterprise value (defined as stock market value plus debt value, less cash) reflected by our target price is 5.4 times our estimate of cash flow (defined as earnings before interest, taxes depreciation and amortization), while our coverage universe currently trades at 4.8 times. Our estimated intrinsic value for Apache stock is $61.61.
Potential risks to our recommendation and target price include events that would cause substantial and sustained declines in oil and gas prices. The volatility of energy prices has increased over the last five years, which has increased the unpredictability of earnings and cash flows in the independent oil and gas industry. We believe this unpredictability is further exacerbated by the relatively high capital intensity of the industry and the relatively long project lead times required for the commodity's production. Because, at minimum, the time from approving a new drilling project to commercial production of hydrocarbons can be over two years, the economics of the project can substantially change in the interim.
Independent E&P players must continually find and develop new reserves to maintain themselves as a going concern. If Apache becomes persistently unable to economically discover and develop new reserves, it would materially adversely affect its value.
Analyst LaPorta follows stocks of oil and gas exploration & production companies for Standard & Poor's Equity Research Services