A comparison of three large-cap exploration and production companies

Today I have started to review the 10k reports from exploration and production companies with an eye on their year end reserves.  This is a nice time of year to compare various companies because they all disclose so much information in their annual reports.  I also thought it would be interesting to show how “quality” can be analyzed by the historical data presented in their 10k reports.  I’ve focused on three large cap diversified companies .

EOG- Originally spun out of Enron Corporation as “Enron Oil and Gas”, EOG is widely considered the highest quality shale company, and for very good reason.  They have proved adept at discovering new plays (we can give them credit for both Bakken and Eagleford), but also for recognizing an important macro trend in the industry and shifting away from gas drilling early on.  They also have very good cost control and operational performance and have managed to build land positions through leasing rather than expensive purchases from other oil companies. 

Anadarko- this is a well-managed company, though probably a tier below EOG.  They are experts at offshore exploration and have made very large discoveries in East Africa (Mozambique gas), West Africa, and in the Gulf of Mexico.  They boast an incredible 65% success rate with offshore exploration and appraisal wells.   A large part of their business model is discovering new offshore fields then selling an interest to a larger partner, and they have sold $12.5b of assets in the past 5 year period.   They also have a large presence on-shore in the US in the Marcellus, Eagleford, and Watenberg (Colorado/PRB).  They may be the best at deepwater exploration, but I think deepwater is a more challenged business model than the best of onshore tight-oil.

Apache- Apache is not a well run company.  I have owned it in the past based on low valuation, but management has not performed well at all over the past few years.  Their original specialty was to buy up older fields from the majors and milk them with careful investment and good financial management.  In recent years they have tried to make a shift toward shale by buying up US assets in the Midcontinent and Permian regions and plowing billions of capex into development drilling.  Apache’s MO in recent years has been to take free cash flow from their highly profitable Egyptian operations and plow it into marginal or money-losing onshore projects in the USA (and to a lesser extent over budget LNG projects in Australia).

Looking at earnings and PE ratios can be dangerous when analyzing oil and gas companies, unless they have relatively flat production.  PE ratios are more reasonable to use for oil majors, since production and reserves change little from one year to the next.  Their capex and depreciation tend to be more in-line with each other.  In the recent years of the oil boom here in the US, the exploration and production companies are often growing production quite quickly.  It is possible to have a company that is showing little or no profit, but is in fact making very profitable investments.  One thing that I like to do is look at both production and cash-flow growth over time, and then look at free cash flow.   Oil companies don’t need to be free cash flow positive to be a good investment.  They also don’t need to be growing to be a good investment (look at Exxon over time).  But if they are neither producing free cash flow nor growing then there is a major problem.  I find that this is a good starting point when trying to understand a company.   There have been an incredible number of methods at determining capital efficiency of exploration and production companies based on various operation statistics, but to me this approach should be first.

First let’s look at how production has changed at these companies over the past several years

So from this view we can see that both EOG and Anadarko have been successful at increasing their production since 2012, while Apache’s production has declined.  But one thing to be careful of here is that the metric of “MBOE/D”, or thousands of barrels of oil-equivelent production per day, lumps low value gas with high value oil.  NYMEX oil trades at $49 per barrel.  1mmbtu of gas trades at $2.71.  To get to oil equivelant price, multiply $2.71x 5.8 (or 6) and get $16 since one barrel of oil is abotu 5.8mmbtu of energy content.  So 1 "barrel" of gas is only $16 and a barrel of oil is $49.  So a company may be investing mainly in oil and letting gas production decline, and their overall production in terms of MBOE/d might be in decline, but the value of that production may actually be increasing.  So for that reason it is useful to look at their % of oil in their production mix.

All of the companies have been shifting towards greater oil production, but Anadarko’s shift has been quite moderate, while EOG’s has been very dramatic.

The next thing to look out for is whether the reserves are being maintained.  One thing that the oil majors like Exxon, Chevron, Shell, and BP have been doing for years is under-replacing their production.  In other words, if they produce 2 million barrels of oil per day, they add less than that quantity of reserves, so that at the end of the year they show lower levels of reserves than they had the year before.  The other thing they do is replace expensive and valuable oil reserves with less expensive and less valuable gas reserves, and claim to have been successful at maintaining their reserves.  Reserve life ratio, is the number of years it would take to produce out the current reserves at the current annual rate of production.  So for this chart, I have divided 2012 reserves by 2012 average production, then 2013 reserves by 2013 average production and so on.

  

EOG has been growing their reserve life ratio and Apache has shown the most notable decline, but in this particular case all the reserves are at a healthy level.  10x is quite healthy, but significantly lower levels can be a big red flag.  Sometimes if you see very high levels of reserve life, that can also be indicative of a major operational problem.  For instance it is common for gas producers in the Marcellus, who are constrained on capacity to get their gas to market.

Next we must look at their spending pattern.  I have seen people totally ignore free cashflow in their analysis, and I’ve seen others fairly obsessed with it.  I have even heard someone say, “If a company is not generating free cash flow than what good is it to the investor?”  Well if a company is growing quickly, or if they are a commodity producer in a time of heavily depressed prices, then negative free cash flow is not necessarily any cause for concern.  On the other hand, if two companies have similar production growth profiles, but one is outspending their cashflow and the other is generating free cashflow, then this is certainly an important thing to understand.  Free cash flow can be calculated in several ways, but for oil companies I prefer to just take cash flow from operations and subtract cash flow from investing.  

This is a bit of a hard chart to look at because of the volatile nature of it.  Apache’s free cash flow has been volatile because of major acquisitions (in 2012) and big asset sales in other years.  APC’s free cash flow was impacted by the $4b payment to BP in 2011 to indemnify themselves from any liability in the Gulf Horizon spill, for which they were a non-operator/minority investor.    But other than that incident, they have maintained very healthy levels of free cash flow.

Conclusion:

The overall picture is that APA has outspent cashflow by $1.2b in the period, while both their production and reserves have been in decline, a very poor result for a period with historically high oil prices.  EOG on the other hand has generated a small amount of free cash flow ($91mm) as they have grown production, reserves, and quite dramatically increased their weighting to higher value oil from lower value gas.  Anadarko Petroleum also has an overall positive record.  They have generated a nice sum of total free cash flow over the four years ($666mm) while growing production, maintaining reserve life, and slightly increasing their oil weighting. 

But having made this determination, there is a subsequent step that is just as important, and that is valuation.  EOG and APC both deserve a higher valuation multiple than APA, because they are higher quality companies.  But indeed these companies already trade at a higher multiple.  EOG is now trading at about 12x consensus 2015 EBITDA.   Anadarko is at 11.5x.  Apache is at 6.7x.  How can we compare low quality APA trading at a cheap multiple to high quality EOG and APC trading at a high multiple?   I really don’t have any satisfactory methodology for making a selection between two companies that are so different.  It is much easier to pick between two companies valued at similar multiples.  For instance there is little question in my mind that EOG is a much higher quality company than Pioneer, and Pioneer trades at a higher multiple at 15x 2015 EV/EBITDA.  I have owned EOG, APA, and APC each at one time, and was fully aware of the quality gap between these companies.  APA turned out to be the best investment of the three, but this was largely because I owned during a period when pretty much all oil stocks were going up.