Apache part one

I’m going to go over a profile of one of the largest E&P companies by production, if not by market capitalization.  I own this company because of its very low valuation, not because of their great execution.  As I’ve said before, I have a temperamental predisposition to invest in companies with low valuations.  Their execution has been marginal at best over the past few years, especially considering the large opportunity set before them.

Apache describes themselves:

“Over the years our strategy for achieving profitable growth has evolved. Over the most recent decade Apache has been an active acquirer of properties, following up each one with proactive exploitation operations, including workovers, re-completions, and drilling, to increase production and reserves, as well as efforts to reduce costs per unit produced and enhance profitability.”- 2005 10k filing

Apache has been a significant independent company since long before the shale boom days.  They would acquire elderly fields and invest in stimulating further production.

At any given time, oil companies must be either producing free cash flow and return capital to shareholders, or growing production.  Doing both at once is preferred, but rare.  If they can’t do at least one of these, then something is going very wrong.   Apache has tended to err on the side of growth, with minimal FCF although they are currently upping their share buyback program, an uncommon strategy among E&Ps currently.  Until the past few years they have managed to grow production buy an impressive 12% CAGR.  Unfortunately this streak has pretty much ended in the three years since 2011.

 I’ve heard people say (and Apache themselves say) that they are good at taking on the mature fields that the oil majors turn away from.  I do think that this is partly true.  I also think it was partly a difference in philosophy between them and the oil majors.  Because the oil companies had tended to grossly underestimate the long term price of oil, which steadily rose throughout the past two decades, they tended to err on the side of returning capital rather than growing production.  In other words if Shell would only invest on a project that met whatever their threshold internal rate of return, which was based on a too-low estimate for the price of oil, they would tend to divest mature properties, when in retrospect it would have been better to invest in them.

The oil majors would also tend to underestimate their cost for new projects, especially the larger and more technically complex ones.  By way of example, look at the Shell gas-to-liquids plant in Qatar begun in 2003.  This plant takes gas and converts it to liquid petroleum using the Fischer-Tropsch process, the same way Nazi Germany produced gasoline from coal during WW2.  The cost was originally supposed to be $5b, and the original cost model suggested it would be sufficiently profitable at $40 long term oil price.  Well the cost turned out to be $24b when it was all said and done, but they were partly saved by the fact that Brent has now been trading above $100 for years.   This is an egregious example but it is representative of a wider trend for projects by the oil majors.  They go way over budget, but luckily the price of oil turned out to stay higher than was originally projected, salvaging the economics of the projects.  But if oil companies had spent that cash on less glamorous projects like stimulating mature oil fields to coax out a few extra barrels (Apache’s strategy) they would have tended achieve better returns than the complex mega projects that have reliably run behind schedule and over budget.

So I’m not really sure if Apache’s long term success has been due to their unique expertise, or because they were able to gobble up small assets that the oil majors shed because they incorrectly assumed the price of oil would be lower than it turned out to be over the longer term.

 An example that Apache likes to tout as their strength is Permian Basin field they bought from Amoco (now BP) in 1991.  The production curve from the time of purchase is shown below.  They bought a field in decline, and made it decline less fast.

But this chart doesn’t show the extra capex that they invested to achieve this.  Was their technical ability the source of this success, or was it simply their more optimistic (and correct) view of the long term price of oil?  It is a difficult question, but it is the type of question that makes investing in this sector so interesting.

More recently, Apache has stalled.  They have produced basically no free cash flow over the past few years, but this is typical of E&Ps right now in this time of production growth.  Unfortunately, Apache has managed to spend all their cash flow while growing production by only ~3% annually since 2011.  This is an unimpressive record considering the very high price of oil during this period.  In the next installment I’ll talk a bit more about why they’ve done poorly recently and why I own them.