Apache Corporation: Earnings Growth, Free Cash Flows Ahead (NASDAQ:APA)

Apache Corp. (APA) posted a large loss but moving forward, the company’s earnings should improve as it capitalizes on the increase in oil prices and low costs. Moreover, I expect the Houston, Texas-based oil producer to start generating free cash flows. Its production mix will likely get tilted towards the international assets as its US production continues to decline. Apache Corp.’s international assets are looking even better now as it makes a third major discovery in offshore Suriname, which may prompt acceleration of the project’s development.

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Earnings Recap and Review

Apache Corp. reported a drop in production and an increase in losses in its second quarter results. The company also burned cash flows in this period. Although Apache struggled in the second quarter, this performance was widely anticipated, as I discussed in my previous article. The highlight of the quarter, however, was that the company announced a major discovery at Kwaskwasi-1 after it successfully drilled a well in Block 58 located in offshore Suriname.

Apache released its pricing data for the second quarter ahead of the earnings release which showed that the company realized oil prices of just $23 per barrel in the US and $27.50 in the international markets, down around 50% and 45% respectively from the first quarter. The company also confirmed that it curtailed 28,000 boe per day of production in the second quarter to minimize the negative cash flow impact of weak liquid (crude oil and NGL) prices and an additional 7,000 boe per day in the Alpine High play due to unscheduled pipeline downtime.

The company also reduced drilling activity in all regions, particularly in the US where Apache stopped all drilling work by mid-May. Its production, after adjusting for Egypt’s non-controlling interest and tax barrels, fell by 7% from the first quarter to 394,000 boe per day in the second quarter. The decline was led by an 11% decrease in US production to 250,500 boe per day and a 16% decrease in output from the North Sea to 57,500 boe per day, partly offset by a 20% increase in volumes from Egypt to 86,000 boe per day.

The weak oil prices and low production pushed Apache to an adjusted loss of $0.74 per share from a loss of $0.14 per share in the first quarter. Previously, I wrote that Apache’s cash flows will also come under pressure since it didn’t have robust hedge coverage at decent prices. But I still expected the company to generate enough cash flows to fund most or all of its upstream capital. The results showed that Apache’s cash flows (ahead of changes in working capital) plunged by 71% on a sequential basis to $150 million. Its upstream capital expenditures, on the other hand, clocked in at $216 million, which translates into negative free cash flows of $66 million ($150Mn-$216Mn). In my view, the cash flow deficit was modest and manageable for a company as large as Apache which entered the second quarter with ample liquidity of more than $3 billion, including more than $400 million of cash reserves.

Moreover, Apache also announced a “major discovery” at Kwaskwasi in Block 58, which it is developing through a 50-50 joint venture with Total SA (TOT). The company didn’t provide a detailed reserve estimate but said that this was its best well to date “with the highest net pay in the best quality reservoirs.” This follows two Block 58 discoveries – Maka Central and Sapakara West – announced earlier this year.

Looking Ahead

The oil prices have improved substantially since the second quarter. The spot price of the US benchmark WTI, which averaged below $28 per barrel in Q2-2020, has been hovering near $40 since early-June. The commodity was at $42 at the time of this writing. Similarly, Brent oil prices have also improved significantly in the corresponding period and are currently at $45.

Moreover, Apache sold its crude oil in the international markets at an unusually high discount of $5.50 per barrel below the benchmark. This was attributed to the extraordinary pressure on prices in the second quarter due to the excess supply in the region. But following the improvement in market conditions, Apache confirmed that the international prices have now reconnected with the benchmark which means this discount will also normalize from the third quarter. With the rising prices and shrinking discount, Apache will likely realize substantially higher crude oil prices from the third quarter. That’s going to give a boost to the company’s earnings.

Apache’s ongoing cost-cutting efforts will also give support to the company’s earnings. The company was originally targeting around $150 million of annualized cost savings by curtailing overhead costs and lease operating expenses. But it has doubled this target to $300 million, with two-thirds of the cost cuts coming from lower overheads and the remainder from LOE reductions. The company will realize around $225 million of the cost savings in 2020 and the remaining in the future. The great thing is that most of these cost savings are sustainable. This means that Apache will continue to capitalize on these savings in the long run as well when the business environment improves and some of the costs, such as the service costs, increase.

The cost cuts, combined with low levels of capital expenditures, have also put Apache in a good position to generate free cash flows moving forward. The large reduction in drilling activity has allowed Apache to cut this year’s upstream capital budget by 55% to the range of $1-$1.2 billion, with the majority of the cuts earmarked for the US. That’s pushed the company’s cash flow break-even level down to around $30 per barrel for H2-2020. This means that in the current oil price environment of $40s per barrel, Apache will likely generate strong levels of free cash flows.

I think Apache’s future cash flows and CapEx outlook also points towards robust free cash flows for the rest of the year at $40 oil. That’s because the company’s cash flow from operations will get a boost from the increase in oil prices. It has previously said that every $1 per barrel move in oil prices impacts its cash flows by $50-$60 million. From this, we can estimate that the $12 per barrel increase in oil prices [WTI] from an average of $28 in Q2 to $40 in Q3 might lift its cash flows by $500 million to $720 million. On the other hand, I expect the company’s cash outflows as upstream capital expenditures to decline sharply from $658 million in H1-2020 to $342 million in H2-2020, as per my estimate. The increasing cash flow from operations and decreasing capital expenditures should push the company to free cash flows.

Apache’s output, however, will continue to decline as the company keeps drilling activity low. The company shut-in a total of 35,000 boe per day of production in Q2-2020, including 7,000 boe per day at Alpine High due to unscheduled pipeline downtime. Following the improvement in oil prices, Apache has returned its curtailed production. But its future drilling program will continue to focus on international assets, with five rigs running in Egypt, one floating and one platform rig in the North Sea, and one exploratory rig in Suriname. All drilling activity will remain suspended in the Permian Basin in the US in 2020. The company doesn’t plan on completing the drilled but uncompleted wells in the Permian Basin either.

Based on the management’s comments, I don’t expect Apache to resume E&P work and grow production from the US onshore shale plays until the oil market’s demand and supply fundamentals improve substantially and prices stabilize in the $50s a barrel range. As a result, Apache’s US production may decline further in the coming quarters which will push its total production lower. Its high-margin international production from Egypt and the North Sea, on the other hand, will hold steady. The contribution of the international assets to the company’s total production mix climbed from 33% in Q2-2019 to 36% in Q2-2020 and will likely keep moving higher in a sub-$50 a barrel oil price environment.

Meanwhile, the Suriname project is getting closer to full-scale development. Although Apache still hasn’t disclosed anything other than that it has encountered a hydrocarbon reservoir, it has made multiple discoveries so far, which lays the foundation for additional exploration and appraisal work. Moreover, Apache has been encouraged by the latest discovery and believes that it can now consider the option of “accelerated first production.”

Following the success at Kwaskwasi-1, Apache will start exploring work at the fourth prospect, called Keskesi East-1. Thereafter, Block 58’s operatorship will transfer to Total SA. Meanwhile, Apache will carry delineation work at the three discoveries announced so far. It has submitted appraisal plans for the first discovery and will devise plans for the remaining two discoveries shortly. Next year, the company will continue with the exploration as well as the appraisal work. For a project of this magnitude, it could take around four to five years before the first production starts to flow. I think we will likely get a reserve estimate in the coming months and the company might layout a detailed development plan thereafter.

Apache Corp. stock has risen by 47% in the last three months, easily outperforming its peers, as measured by the SPDR S&P Oil & Gas E&P ETF (XOP), whose shares rose by 17% in the same period. The earnings growth, free cash flows, and positive updates from Block 58 might continue pushing the shares higher. But the stock is not cheap, currently trading at 8.6x in terms of EV/EBITDA (forward) multiple, above a sector median of 7.6x, and Apache’s five-year average of 6.9x, as per data from Seeking Alpha Essential. At this price, I’d rate the stock as a hold.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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