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FreezeFrames/iStock via Getty Images
APA Corporation (NASDAQ:APA ) is a global independent exploration and production company that was previously known as Apache Corporation, which is now its largest subsidiary. As is the case with many upstream firms, APA's stock has delivered a stellar performance over the past year, with the stock up 62.67% over the trailing twelve-month period. This was largely due to today's high energy prices, which might be expected.
The high energy prices have also allowed APA Corporation to grow its free cash flow significantly, which has allowed it to buy back a large portion of its outstanding common stock and raise its dividend. These things will be discussed over the course of this article. Despite the incredible capital appreciation that investors have already been rewarded with though, APA Corporation still appears to be tremendously undervalued at the current price, which could make it a worthy addition to a portfolio today.
As stated in the introduction, APA Corporation is an international exploration and production company, boasting operations in the United States, the North Sea, Egypt, and Suriname:
Many of these locations will likely be familiar to most long-time investors in the energy industry. After all, the North Sea has been a very dominant entity in the exploration and production world for many years, and the production credentials of the United States hardly need any introduction considering the shale energy boom that the nation has been experiencing over the past decade or so.
Egypt is not as well-known as a producer, although it was the location of many major finds over the past several years. The most prominent of these is the Zohr Field, which was discovered by Italy's Eni (E) in 2015 and is estimated to contain approximately 30 trillion cubic feet of economically recoverable natural gas. Unfortunately, APA Corporation does not actually own a stake in the Zohr Field, but there are other fields in the nation that are fairly mineral-rich. Suriname, meanwhile, is an emerging nation in the energy space. APA Corporation owns a 50% stake in the offshore Block 58, where the company has seen five exploration discoveries since January 2020. As such, APA Corporation may have a great deal of potential in this area.
Despite the company's global operations, the majority of APA Corporation's production is in the United States. Indeed, about 52% of the company's first-quarter 2022 production and 49% of its capital spending during the quarter was due to its operations in the United States. Interestingly, though, its cash flow during the quarter was much more balanced. In fact, Egypt was responsible for a bit more of the company's first-quarter 2022 cash flow than the United States was:
This might be because it is considerably cheaper to produce in Egypt than in the United States. I have touched on this before. One of the biggest problems with American shale plays is that the wells have an incredibly high decline rate (see here for more information). This, unfortunately, forces shale operators to continually drill new wells if they simply with to maintain, let alone grow, production, which is a very expensive proposition.
It is quite a different situation in onshore Egypt, where APA Corporation's operations in the country are. The cheaper cost of operations in Europe allows APA Corporation to have higher margins. During the first quarter of 2022, APA Corporation had a profit of $56 per barrel of oil equivalent that it produced in the country compared to $38 per barrel of oil equivalent produced in the United States. This higher margin was more than able to offset the impact of the higher production in the United States and thus caused the company's cash flow sourced from that nation to be higher.
One of the prevailing trends that we have been seeing around the energy industry is that today's high energy prices have finally allowed many independent exploration and production companies to generate positive free cash flow. This is particularly important for shale operators, who have historically failed to generate free cash flow in aggregate. APA Corporation is no exception to this, as the company posted a free cash flow of $675 million in the first quarter of 2022, although it is worth noting that the company was one of the few energy companies to be free cash flow positive in both the first quarter of 2021 and the full-year 2020:
This is something that is quite nice to see, because free cash flow is the money that can be used to reward the shareholders. This is because free cash flow is the money that is left over after the company pays all of its bills and makes all necessary capital expenditures. Thus, it is the amount that can be used for things such as paying down debt, buying back stock, or paying a dividend.
APA Corporation is doing exactly this, although it is opting to use share buybacks as opposed to a variable dividend program like some of its peers. The company has stated that it will return at least 60% of its free cash flow to the shareholders through both dividends and buybacks. In the first quarter of 2022, the company only paid out a dividend of $43 million, which was obviously an insignificant proportion of its $675 million free cash flow. However, it also bought back $261 million worth of its own stock, bringing the total to $304 million returned to shareholders during the quarter.
This was admittedly only 45.04% of the firm's first-quarter cash flow, so the company did not manage to achieve its own goal. We can likely expect the company to make up for this later in the year.
APA Corporation is dedicated to generating growth over the next few years, which it intends to accomplish by boosting its production. The company has guided to produce an average of 408,000 barrels of oil equivalent per day over the course of 2022, which is an increase over the 386,000 barrels of oil equivalent per day that the company produced on average in the fourth quarter of 2021. It plans to do the same in 2023 and 2024, ultimately giving the company a 5% compound annual growth rate over the 2021 to 2024 period:
This growth will be driven primarily by the company's operations in Egypt, although its shale energy operations also are seeing a slight production increase from the four rigs that it currently has operating on the acreage. One method that APA Corporation is using to accomplish its planned production increase is to reduce flaring activity.
As some people reading this are well aware, it has been something of a common practice for energy producers to ignite the natural gas byproducts that come out of a well because there was insufficient infrastructure to take the natural gas to the market and it was not worth it to actually take the gas to a point of sale. However, natural gas prices have risen considerably and environmental concerns have resulted in a change of this policy. APA Corporation has now completely eliminated all flaring at its North American operations and plans to reduce flaring by 40% at its Egyptian operations by the end of this year.
It should be easy to see how this will result in production growth. After all, the company can now sell the natural gas that was formerly flared off. This obviously gives the company more products to sell and produce revenue from. All else being equal, this means that more money is available to cover the company's expenses and make its way down to free cash flow.
As the company continues to reduce its flaring activity in Egypt over the coming years and increases drilling activities on its Egyptian properties, we can see how its production and by extension free cash flow should grow over the next few years. Naturally, this would require that energy prices remain at today's elevated levels, but as we will see in just a few moments, this is likely to be the case.
As APA Corporation is a producer of crude oil and natural gas, it would be a good idea to have a look at the fundamentals of these products. APA Corporation's production is quite well-balanced between the two products:
This is quite nice because the fundamentals of the two products are quite different. In particular, natural gas has much stronger growth prospects going forward. This is one reason why I prefer natural gas-heavy producers to crude oil ones, which is a fairly far cry from the situation that existed a decade ago when natural gas was almost worthless. It has appreciated by 82.53% over the past twelve months compared to a much more meager 42.69% increase in West Texas Intermediate crude oil.
It appears likely that natural gas will continue to perform well, as will crude oil, due to the laws of economics. In particular, the demand growth for both products will likely exceed the supply growth of both products. This may be surprising but according to the International Energy Agency, the global demand for crude oil will increase by 7% and the global demand for natural gas will increase by 29% over the next twenty years:
Pembina Pipeline/Data from IEA 2021 World Energy Outlook
Pembina Pipeline/Data from IEA 2021 World Energy Outlook
This is something that may perhaps be shocking, but the demand growth for natural gas is primarily being driven by global concerns about climate change. These concerns have induced governments all over the world to impose a variety of incentives and mandates that are intended to reduce the carbon emissions of their respective nations.
One of the most common methods being used to accomplish this is to encourage the retirement of old coal-fired power plants, which are then replaced with renewables and natural gas-fired turbines. The reason for the natural gas turbines is that renewables alone are not reliable enough to support a modern electric grid on their own. Natural gas is reliable enough to do this and it burns much cleaner than any other fossil fuel. As such, it works quite well to supplement renewables and ensure overall reliability until renewable technology is sufficient to support the grid on its own.
The case for crude oil demand growth is much harder to understand, particularly considering that many politicians in Western nations have been working incredibly hard to reduce the crude oil consumption of their respective nations. This situation is quite different if we look at the various emerging nations around the world. These countries are expected to see tremendous economic growth over the projection period, which will naturally have the effect of lifting the populations of these nations out of poverty and putting them securely into the middle class.
These people will naturally want to live a lifestyle that is much closer to what their counterparts in the developed nations enjoy than what they have now. This will require increased consumption of energy, including energy derived from crude oil. As these nations have considerably higher populations than the various developed nations, the rising consumption here will more than offset the stagnant to declining consumption in the various emerging countries around the world.
The global production of fossil fuels is unlikely to increase to the degree needed to satisfy this demand. In fact, according to Moody's, the oil and gas industry must immediately increase upstream spending by $542 billion annually in order to avoid a supply shock. This high cost is because the energy industry has been chronically underinvesting in production capacity and infrastructure since the 2015 oil bear market. This is one reason why the offshore drilling industry never recovered from that event. It is highly unlikely that the industry will actually increase spending to that degree. Energy companies are currently under tremendous pressure from politicians and environmental activists to improve the sustainability of their operations as well as from investors to improve returns.
Thus, it seems likely that the demand for fossil fuels will grow much faster than the supply of said fuels. According to the laws of economics, this situation will result in rising prices. This would, of course, be beneficial for APA Corporation since it should allow the company to continue to enjoy relatively high free cash flow that will allow it to continue to reward the shareholders.
It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate a suboptimal return on that asset. In the case of an independent exploration and production company like APA Corporation, one method that we can use to value it is the price-to-earnings growth ratio. This is a modified version of the familiar price-to-earnings ratio that takes a company's forward earnings per share growth into account. Generally, a price-to-earnings growth ratio of less than 1.0 is a sign that the stock may be undervalued relative to its earnings per share growth and vice versa.
According to Zacks Investment Research, APA Corporation will grow its earnings per share at a 23.56% rate over the next three to five years. This gives the stock a price-to-earnings growth ratio of 0.15 at the current price. Thus, the stock is currently looking incredibly cheap relative to the company's forward earnings growth. However, as I have pointed out before, pretty much the entire traditional energy industry looks remarkably cheap so let us see how APA Corporation compares to some of its peers:
As we can indeed see, the entire industry looks remarkably cheap based on its forward earnings growth. However, APA Corporation compares reasonably well here as it boasts a more attractive valuation than any peer except for Continental Resources. Thus, it certainly appears that APA Corporation is presenting investors with an attractive value proposition right now.
In conclusion, APA Corporation appears to offer a lot to investors. While it does not offer the high annualized yields of some other energy companies, the company is still returning a significant proportion of its free cash flow back to investors. The fact that it is doing it through share buybacks as opposed to dividends may prove appealing to those investors wishing to purchase the stock in a taxable account. APA Corporation also provides international exposure and reasonable growth prospects that could allow it to increase its share buybacks if oil and gas prices stay elevated. Finally, the company's incredibly attractive valuation is something that should appeal to any investor.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
Additional disclosure: I am long various energy-focused mutual funds that may include any stock mentioned in this article. I exercise no control over the contents of these funds.