Analyst Note| by Stephen EllisUpdated Aug 31, 2023
We have adjusted our valuation methodology for U.S. exploration and production companies. Our multistage DCF valuation incorporates five years of explicit projections for a fixed period, typically five years. Terminal values are derived by assuming firms eventually earn their cost of capital in perpetuity. This contrasts with our previous methodology, which modeled the harvesting of all company assets over a 30-year timeframe. The change brings our E&P valuations in line with Morningstar’s standard equity research methodology.
For an industry facing secular decline, it might seem counterintuitive to switch to a perpetuity method. However, we maintain our long-held view that oil and gas demand will keep growing in the short run before slowly declining over a multidecade horizon. We agree that electric vehicles and renewables are effective substitutes for oil and gas, respectively, but light-duty vehicles account for less than half of crude consumption and there are no viable alternatives for the remainder (aviation, shipping, and petrochemicals). And natural gas will remain a core part of the energy mix for many years yet, initially taking share from coal that is still widely used for electric power generation. As production from existing wells declines quickly, the industry will have to keep developing oil and gas reserves to meet this persistent demand, and firms should receive credit for the ability to continue generating returns as a result (even when their current inventories are exhausted). Because our multistage DCF now implicitly incorporates this, the fair value estimate impact is typically positive (with an average increase of 5%-10%).
Even after the increases, bargains in the industry are scarce. Our top picks are low-cost leader Diamondback and APA, which appears to have strong growth potential in as-yet undeveloped Suriname. Price/fair value ratios for the two are 0.89 and 0.78, respectively.
Business Strategy and Outlook| by Stephen EllisUpdated Aug 31, 2023
APA is an upstream oil and natural gas producer with assets in the United States and overseas. The vast majority of its domestic production is derived from the Permian Basin. The firm's footprint of 500,000 net acres extends across several subbasins and mainly focuses on the same reservoirs that competitors are targeting (the Spraberry and Wolfcamp intervals in the Midland Basin and the Bone Spring and Wolfcamp formations in the Delaware). However, APA also has its own discovery in the Permian region, the Alpine High play. Alpine High wells are characterized by very strong initial production rates but with a much higher gas and natural gas liquids content than we'd expect elsewhere in the Permian. This gives the firm optionality: When natural gas prices compare favorably with oil prices, APA can allocate more capital to its gassier assets.
APA also holds a large acreage position in Egypt, where it has operated for nearly a quarter of a century. After it modernized its contract with the government there, the asset has come back to the front of the queue for capital, and the firm expects to deliver 1% year-on-year production growth in 2023. Reported volumes could fluctuate, however, as APA's revenue and profits in Egypt are governed by production-sharing contracts (due to cost-recovery provisions in these contracts, lower crude prices translate to higher reported volumes, creating a natural hedge in weak commodity environments, and vice versa). North Sea volumes are no longer a priority after the local government implemented a windfall tax on oil and gas companies, and production will probably peak in 2023.
The company's focus has widened to include Suriname following a string of exploration successes in Block 58 (which APA is appraising with its 50/50 partner, TotalEnergies). The evidence to date suggests a very large petroleum system that could be transformative for the company. At this point, we think it is very likely that one or more of the discoveries will progress to the development stage, though none have been officially sanctioned yet.
Economic Moat| by Stephen EllisUpdated Aug 31, 2023
APA has historically struggled to meet the threshold for a moat rating by consistently failing to earn its cost of capital. However, it apparently turned the corner in 2021, and our projections now show modest excess returns on invested capital over the next decade. But there's a catch. Commodity prices soared in 2021 and 2022, providing a temporary advantage, and it will be a lot harder for APA to squeeze economic profits from its legacy assets under midcycle conditions ($55/barrel West Texas Intermediate and $3.30/thousand cubic feet natural gas). It is the contribution from its Suriname position that makes APA look moaty in future years. But this is still a highly speculative asset, with a handful of discoveries but no developments yet sanctioned.
If it works, it could be a massive prize for APA (just like Guyana was for narrow-moat-rated Hess, APA's most comparable competitor). We expect the Suriname government to offer relatively generous fiscal terms to induce more rapid development, making the potential returns for APA competitive with or even better than what it can earn in the Permian or Egypt. But it could be several years before production commences, assuming that one or more of the discoveries can be commercially developed, and the capital requirements will be heavily front-loaded. So if anything, Suriname is more likely to drag on returns for the next few years. And it's still possible that the discoveries to date are deemed uncommercial and are never developed. Accordingly, we need more confidence in the trajectory of APA's Suriname activity before it can support a moat rating.
On a stand-alone basis, APA's other assets also have moaty characteristics. But as with many exploration and production firms, too much capital was invested in prior cycles under the assumption of higher oil prices. After incorporating costs sunk on leasehold, acquisitions, exploration, and infrastructure, APA's capital base inflates to a level that makes high returns on capital difficult.
The Permian Basin is the cheapest source of crude oil in the U.S. and sits below other shale plays, deep-water projects, and other unconventional sources on the global cost curve. But within the Permian, well performance does vary. As a result, some of APA's competitors in the region enjoy lower average unit costs and higher internal rates of return. In addition, APA has recently focused on Alpine High, a portion of the southern Delaware Basin that other firms have overlooked. Alpine High wells typically yield very strong flow rates but with a less favorable oil mix. Altogether, we’d be hesitant to say that the company’s Permian assets have a narrow moat.
APA’s other main producing assets are in Egypt and the North Sea. The conventional projects in Egypt generate a substantial amount of free cash flow, benefit from Brent pricing, and are probably low enough on the cost curve to be considered moatworthy at the asset level. Political risk is a factor, though the company does have a long and productive record in the country (including the turbulent early 2010s). In the North Sea, Brent pricing props up average realized prices, and operating costs are reasonably low, but production is likely to trend sideways or even decline modestly in the next few years, especially now that the U.K. government has installed a windfall tax on oil and gas operations that makes capital allocation there less attractive. At the corporate level, we don’t think steady cash flows from these assets will be enough to pull returns above the weighted average cost of capital.
Like all E&P firms, APA is exposed to a range of potential environmental, social, and governance issues that could hurt its ability to generate strong returns. The most significant ESG exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills).
Greenhouse gas emissions are the biggest threat, and these are unavoidable for oil producers. Firms can clean up their operations in the field as much as possible by avoiding unnecessary flaring and using technologies like electric fracking and carbon capture to reduce carbon dioxide volumes being released into the atmosphere during the extraction process. APA has started working on a project that eliminates at least 1 million tons of CO2 emissions annually by year-end 2024. However, downstream emissions—at the refinery and beyond—are beyond its control, and these account for the vast majority of total emissions. As consumers grow more averse to fossil fuels, the reputational risk rises for producers and the probability of widespread substitution away from fossil fuels increases. This also makes value-destructive regulatory intervention more likely (think fracking restrictions or carbon taxes). These threats are not likely enough to be included in our base-case forecasts, but because the impact would be material, it does further erode the firm’s moat potential.
Because APA operates offshore, in the North Sea, spills are a concern as well. Though the probability is very remote, a devastating accident like the BP Macondo disaster in 2010 could have a material adverse impact on APA (which could be forced to cover cleanup costs and perhaps face other legal repercussions). Spills also occur from time to time during long-haul transit over land, but APA has limited exposure there, as this activity is typically outsourced to midstream firms. So there is no chance that the firm would be on the hook for an event like the Kalamazoo River spill in Michigan, which also occurred in 2010.
Fair Value and Profit Drivers| by Stephen EllisUpdated Aug 31, 2023
We assume oil (West Texas Intermediate) prices in 2023 and 2024 will average $77 a barrel and $76/bbl. In the same periods, natural gas (Henry Hub) prices are expected to average $2.77 per thousand cubic feet and $3.62/mcf. Terminal prices are defined by our long-term midcycle price estimates (currently $60/bbl Brent, $55/bbl WTI, and $3.30/mcf natural gas).
Our fair value estimate is $55 per share. This corresponds to enterprise value/EBITDA multiples of 4 times and 3.9 times for 2023 and 2024, respectively. Our production forecast for 2023 is 409 thousand barrels of oil equivalent per day (this includes tax barrels and a minority interest share associated with the firm's Egypt output). That drives 2023 EBITDA to about $5 billion, and we expect free cash flow to reach about $1.5 billion in the same period. Our 2024 estimates for production, EBITDA, and cash flow per share are approximately 420 mboe/d, $5 billion, and $2.2 billion, respectively.
Risk and Uncertainty| by Stephen EllisUpdated Aug 31, 2023
We assign APA a Very High Morningstar Uncertainty Rating. As with most E&P firms, a deteriorating outlook for oil and natural gas prices would pressure this firm’s profitability, reduce cash flows, and drive up financial leverage. An increase to federal taxes, or a revocation of the intangible drilling deduction that U.S. firms enjoy, could also affect profitability and reduce our fair value estimates. In addition, with operations in Egypt and a production-sharing contract with the Egyptian government, the company is exposed to geopolitical risk in the Middle East. While the Suriname assets are potentially transformative, its too early to tell how big of a contribution they will make and the range of outcomes is massive for this asset, which is large component of our enterprise value estimate.
Material ESG exposures create additional risk for E&P investors. In this industry, the most significant exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills). In addition to the reputational threat, these issues could force climate-conscious consumers away from fossil fuels in greater numbers, resulting in long-term demand erosion. Climate concerns could also trigger regulatory interventions, such as fracking bans, drilling permit suspensions, and perhaps even direct taxes on carbon emissions.
Capital Allocation| by Stephen EllisUpdated May 23, 2023
Our Standard Morningstar Capital Allocation Rating for APA reflects the firm's moderate balance sheet strength, fair investment strategy, and appropriate distributions.
Like many large E&Ps, APA has an acquisitive history and has also sold assets over time as well. Over the years, it has operated in Australia, Argentina, China, and Canada in addition to its key regions today of U.S. onshore, Egypt, the North Sea, and Suriname. This portfolio shuffling has left it with a hefty capital base that has depressed firmwide returns for several years.
However, the firm is back on track with its plans for accelerating share repurchases and dividends, now that the balance sheet is in much better shape after the COVID-19-related downturn in 2020. Management reacted swiftly at the time, making dramatic capital cuts with a steep reduction in the dividend payout. And when it made a potentially game-changing discovery in Suriname, it partnered with TotalEnergies in a deal that will give the latter a 50% stake in exchange for taking on the lion's share of the up-front capital burden (the carry requires TotalEnergies to pay $5 billion of the first $7.5 billion in development capital expenditures and 25% of all investment thereafter).