Apache Corp.: The Bear Case From a Bull

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Last fall, Apache (NYSE: APA) unveiled a monster new oil and gas discovery in Texas. The company found the play, which it dubbed Alpine High, in a sleepy portion of the Permian Basin and estimated that it contains 3 billion barrels of oil and 75 trillion cubic feet of natural gas, and that was just in two of the five shale layers it had tested. Even better, it secured this massive find for an unbelievably low investment of around $400 million, leasing up more than 300,000 net acres for around $1,300 apiece. That's a pittance considering that rivals like Concho Resources (NYSE: CXO) spent more than $30,000 an acre to lock up land just north of Alpine High.

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That said, many analysts remain skeptical of the play's potential, which isn't something bulls should ignore. Here's a look at their arguments so bullish investors have a better grasp on what could go wrong.

We've tried this one before and failed

When Apache first announced the location of its Alpine High discovery, an analyst from energy research firm IHS Markit said that the announcement came "out of left field." That's because the region was a known commodity to the industry. Unfortunately, it was a known dud since several others tried drilling there in the past and failed at producing economically viable wells. Those past failures led the industry to believe that the region had too much clay content and natural gas, which made it a technically challenging area to drill, causing the industry to abandon the area. That's why Apache was able to lease land for such a low price while Conoco Resources and others were bidding up acreage in other sections of the basin, where the industry had been successfully drilling wells for years.

Apache, however, started probing the area during the oil market downturn and its engineers found a geological formation that it believed held a tremendous amount of oil and gas. It drilled nearly two dozen test wells to prove its theory that the conventional wisdom on the region was wrong. That's exactly what those wells seemed to indicate since Apache discovered a treasure trove of natural gas liquids and oil while encountering minimal clay. The company has gone on to drill several more wells since that initial announcement, some of which were good and some that underperformed expectations. Because of that variability, many in the analyst community, including IHS Markit, remain skeptical that the play will pay off.

Even if Apache is right, it faces an uphill battle

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While Apache has confirmed that there's oil in the hills of western Texas, it hasn't proved that wells can earn high returns in the current market environment. That's because it first needs to make a massive up-front investment of about $1 billion over the next two years just to build the infrastructure necessary to support the development of the play. This investment includes laying gas pipelines, building tank batteries, and constructing other midstream assets that would then enable Apache to turn new wells into sales quickly. 

After factoring in this investment, Apache estimates that it can earn a 55% rate of return on new wells at $50 oil under its low assumption, which falls to 30% at $40 oil. Even at lower oil prices, that's a more than acceptable return. In fact, it matches what rival EOG Resources (NYSE: EOG) can earn on its premium drilling locations at that oil price. 

However, Apache's return projection assumes that new wells meet expectations and deliver roughly 1.1 million barrels of oil equivalent over their lifetime, including 120,000 barrels of oil. The concern here is that some of Apache's recent wells produced 25% less oil than previously drilled wells, which could lead to lower returns if that trend continues since a higher oil content is a key to earning better returns. Contrast that possible variability with the certainty EOG Resources has on its drilling inventory since it has a tremendous amount of historical data from offset wells that reduce the risk that its new wells will underperform expectations. Because of this, bears think that Apache might end up investing a boatload of money into the play only to discover that the wells aren't as predictable and profitable as expected. That could cause its returns on capital to suffer and hamper its ability to create value for investors, especially in a low oil and gas price environment.  

Investor takeaway

Apache believes it's sitting on a gusher of oil and gas in an area of Texas that the industry had avoided due to previous disappointments. It's a resource position that could fuel high-return growth for investors in the decades to come. Bears, though, aren't so sure that Apache can get those resources out economically, which could impact its ability to deliver high return growth. While it's a valid concern, Apache has been steadily winning over bears as it releases new well data, which while lumpy, does seem to suggest that the company has indeed discovered a game-changing new oil play in a sleepy part of Texas.

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Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of EOG Resources. The Motley Fool has a disclosure policy.