Why We're Buying This Energy Stock

Oil and gas production is a capital-intensive business in which the underlying commodities are extremely volatile and the companies are essentially price-takers, at the whims of their customers. Moreover, there is the constant inflow of young upstarts looking to establish themselves. Two of the few enduring competitive advantages in this tough space are strong capital allocation and technical expertise. The stock I'm buying today, Apache (NYSE: APA  ) , excels in both areas.

Built to last
Apache's long-term principles are focused on portfolio balance, rate of return, maintaining a strong balance sheet, and independent thinking. This approach has allowed Apache to shine when others have withered. Despite a terribly challenging North American environment in which the shale gas boom has flooded the market and hurt companies' earnings power, Apache has performed admirably thanks to its focus on protecting its balance sheet and its portfolio diversity.

That diversity includes domestic and international oil and gas, both onshore and offshore operations, and upcoming liquefied natural gas projects. Thanks to its overseas operations, a significant amount of its oil production is exposed to Brent pricing, which trades at a premium to oil indexed to the West Texas intermediate. Apache's gas portfolio outside of North America also receives the same benefit of higher pricing, as gas prices are higher in other parts of the world. Thus, while pure play North American peers are struggling today, Apache is actually thriving.

Today, Apache finds itself with proven reserves of 3 billion barrels of oil equivalent, or BOE. The main driver of success in the next five years is likely to be its commanding positions in the Permian and Anadarko basins. The company has identified 67,000 drilling locations between the two plays, which likely hold 9.2 billion BOE. Just within these two plays, Apache has identified enough drilling locations that could potentially replace its proven reserves three times over.

Bolstering these two plays is its global exploration portfolio, which includes 8.8 billion BOE that have been discovered already. Total exploration upside is equal to five times the 2011 reserves of 3 billion BOE, a number that includes virtually none of the upside from the Permian, Anadarko, or global exploration portfolio.

It takes a lot of work to convert exploratory projects into proven reserves, and not all of them get there. However, it's no secret that more projects lead to more successes. Apache has a strong base of production, short-term growth led by its onshore North American assets, and long-term growth led by its exploratory pipeline. The next phase of this growth story will be led by execution, which is one of Apache's strong suits.

Finally, if one looks at Apache's divestitures on its cash flow statement, they are almost nonexistent. That's because Apache takes a measured approach to acquisitions and enters a new play only after assessing the economics and being sure that it can commit to a region long term. Whereas most other oil and gas producers constantly high-grade their portfolios in order to build up their core portfolio and get rid of non-core assets, Apache finds no need -- it gets it right the first time.

It's cheap
In Apache, we have a flourishing company trading at a cheap multiple. In fact, last quarter's 774,000 BOE of average daily production represented the ninth consecutive quarter of production growth. Trailing-12-month operating cash flow adds up to $9.6 billion, compared to a market cap of just $33 billion. That means this high-performer is trading at just 3.4 times operating cash flow. A casual observer might suspect a cyclical high in earnings for this company, but that couldn't be further from the truth.

Thanks to its vast portfolio of onshore U.S. opportunities and future exploratory projects led by its Permian and Anadarko basin acreage, Apache is poised to deliver strong production growth for the next five years and beyond. What's more, it's going to further increase the liquids component of its already balanced oil and gas production mix. Apache is striving to increase its liquids mix from an already-impressive 50% in 2011 to a whopping 58% in 2016.

On the heels of the increasing liquids mix, I expect today's strong cash flow base to strengthen even more over the next five years and beyond.

Risks
Apache's balanced global production profile has allowed it to thrive despite low natural gas prices. However, its greatest strength is also its greatest weakness -- its two main risks have long been Argentina and Egypt. Earlier this year, Argentina nationalized YPF, the country's biggest oil company that was majority held by Spain's Repsol (OTC: REPYY.PK). The reasoning given was that YPF was underinvesting in production growth.

Recently, Argentina declared that oil companies operating within its borders will have to submit annual investment plans. This is actually a positive development for Apache, which treats each region as its own separate business unit. Each region's cash flows are reinvested into its own operations, rather than being siphoned off to other countries. This is exactly the type of business philosophy Argentina wants. What the government is trying to avoid is companies' cash flows from Argentine production flowing out to fund projects in other countries -- they want the reinvestment to stay inside Argentina.

Meanwhile, Egypt is in the process of setting up a democracy after the ouster of Hosni Mubarak last year. Very little time has lapsed since President Mohammed Morsi was sworn in, so it's hard to tell if this development will negatively affect Apache. However, as with its operations in Argentina, Apache enters regions to stay. Energy-hungry countries are in favor of strong operators that help fuel these energy needs by aiming for long-term production growth, and Egypt is no exception.

Foolish bottom line
Apache is in the early stages of its growth, and I expect many more years of production increases ahead thanks to its vast portfolio of assets. It's very rare to find a company operating superbly yet trading at such a large discount. That's why I'm going to buy shares in the Street Fighter Real-Money Portfolio, which I co-manage with Matthew Argersinger.

Looking for more ideas? The Motley Fool has created a new special report titled "The Only Energy Stock You'll Ever Need," which you can download today, absolutely free.

Paul Chi is an analyst on the Fool's Alpha service. He owns no shares of any companies mentioned. You can follow him on Twitter to stay up-to-date on his latest market commentary. Paul and Matt Argersinger co-manage the Street Fighter portfolio, where they look for cheap, unloved stocks with home run potential.

The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


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