Apache Sees Opportunity in 2014 and Beyond

Apache (NYSE: APA  ) has made some big changes over the past few years to improve shareholder returns. It has rebalanced its portfolio by divesting noncore assets in order to focus on what it believes are its highest-value opportunities: Texas' Permian Basin and Oklahoma's Anadarko Basin. Let's take a closer look at where the company sees opportunity this year and in the years ahead.

Photo credit: Devon Energy

Where Apache will spend its money this year
Apache announced late last month that it will reduce its exploration and production budget to $8.5 billion this year, down from $10 billion last year. Once again, the bulk of its spending -- about 64% -- will be directed toward its operations in the Permian Basin and the Anadarko Basin, while the remainder will go toward projects in Egypt, the U.K. North Sea, and elsewhere.

Specifically, the single largest portion of Apache's exploration and production budget -- about 31% -- will be directed toward the Permian Basin, while the next largest portion -- 20% -- will be spent in the Anadarko Basin. The remaining 13% of its North American budget will be divided up fairly evenly between Canada (7%) and Gulf Coast Onshore (6%), while international E&P spending will be focused primarily in Egypt (11%), the North Sea (11%), Australia (9%), and the Gulf of Mexico (6%).

Apache also plans to spend an additional $1.4 billion not included in its E&P budget to develop the Chevron-operated (NYSE: CVX) Wheatstone LNG project in Australia. It will also spend money on the Kitimat LNG project, though plans to reduce its 50% stake in the project because it says it can't afford the $1 billion it initially planned to spend on the project this year.

Key drivers of Apache's future growth
In my view, investors should welcome Apache's capital allocation plans for 2014 since they are a perfect reflection of the company's new strategy, which seeks to deliver stronger growth from its U.S. onshore assets in the Permian and Anadarko Basins, while using its international assets primarily for cash flow generation.

Last year, Apache's Apache's Permian and Anadarko assets fueled a 34% year-over-year increase in Apache's onshore North American liquids production, which drove 15% year-over-year growth in operating cash flow. This year, Apache is guiding for 15%-18% growth in North American onshore liquids growth.

Given the highly competitive rates of return Apache is seeing from the Permian and Anadarko basin, currently in excess of 30% after tax, this should drive stronger cash flow growth in the years ahead. Major efficiency gains through greater use of multi-well-pad drilling, which helped the company slash completion costs by more than 25% last year, should also boost returns and cash flow.

Cash flow generation from abroad
While its Permian and Anadarko assets will remain the centerpiece of its growth strategy in the years ahead, Apache's foreign assets will be used mainly for cash flow generation to fund domestic drilling, dividend payments, and share buybacks. The company's assets in Egypt and the North Sea generate free cash flows in excess of $1 billion annually thanks to a large production base and Brent-linked pricing.

Apache's two LNG projects -- Wheatstone and Kitimat -- will also be significant contributors to cash flow when they come online. Because their production will remain constant for an extremely long period of time and is linked to oil prices through long-term contracts, they should be a reliable source of cash flow generation for a long, long time.

For instance, 85% of Wheatstone's capacity has already been contracted out through 20-year contracts at Brent-linked pricing. Assuming $100 per barrel Brent oil prices, the project is expected to generate $1 billion in annual free cash flow for decades to come, while requiring very little capital investment after it comes online in 2016.

Why Apache may be a long-term buy
Though Apache's $8 billion of asset sales over the past year will weigh on its near-term production and profits, likely limiting major share price gains this year, I think the company's long-term outlook is highly promising and may not be fully appreciated by the market, which values its shares at just over 11x forward earnings -- a meaningful discount to its peer group.

Given the company's massive and highly economic inventory of drilling locations in the Permian and Anadarko basins and its consistent track record of execution, I think it should command a higher multiple in line with other major Permian and Anadarko basin-focused operators.

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