Anadarko Revised To $85 As Tronox Liabilities Weigh On A Strong Operational Outlook

Anadarko Corp. (NYSE:APC) primarily operates in three segments: oil & gas exploration and production, midstream and marketing. Its asset portfolio includes positions in onshore resource plays in the Rocky Mountains region, the southern United States, and the Appalachian basin. The company is also an independent producer in the Deepwater Gulf of Mexico, and has production and exploration activities globally, including positions in high potential basins located in East and West Africa, Algeria, China, Alaska and New Zealand. At the end of 2013, Anadarko had proven reserves of almost 2.8 billion barrels of oil equivalent.

We believe that a robust portfolio of onshore and offshore assets in the U.S. as well as internationally, relatively stable commodity prices due to growing supplies from non-OPEC countries and improving profitability due to lower development and processing costs will be the key factors driving future growth for Anadarko. However, higher capital investments required for funding the ongoing development of the U.S. onshore assets as well as other growth projects along with the uncertainties associated with Tronox liabilities continue to weigh on the company’s valuation.

Based on these factors, we recently updated our valuation estimate for Anadarko to $85 a share.

See Our Full Analysis For Anadarko

Key Business

According to our estimates, Anadarko’s crude oil and condensates business, which contributes around two-thirds to its annual revenues, makes up almost 63% of the company’s total value. The division sells oil produced from its production and development activities to refineries and other chemical companies that use crude oil and condensates as raw materials for the production of gasoline, diesel, jet fuel and other petrochemical products. According to the company’s latest annual report, the U.S.-based oil fields contributed almost 64% to the total sales volume last year. Anadarko’s onshore fields in the U.S. are located in Colorado, Utah, Wyoming, Texas, Pennsylvania, Louisiana, Kansas and Ohio. It also owns an average 64% working interest in 479 blocks in the Gulf of Mexico. ^[1]

Anadarko’s international oil production and development projects are primarily located in Algeria, Ghana and China. The company started production from the El Merk project in Algeria last year. It also holds 18% non-operating interest in the Jubilee offshore oil field located in Ghana, which recorded gross production output of 110,000 barrels per day in 2012. In China, the company restarted production from an offshore site in Bohai Bay in 2012, which was shut down after an oil leak in 2011. ^[1]

Proven Reserves

Proven reserves is a closely watched metric for all oil and gas companies. It is a term given to the amount of technically and economically recoverable oil and gas reserves owned by a company. As of December 31, 2013, Anadarko’s total proven reserves of crude oil and condensates stood at almost 2.8 billion barrels of oil equivalent. Almost 70% of these proven reserves are located in the U.S., while the percentage of undeveloped reserves is 28%. Proven reserves are classified as developed or undeveloped, depending upon whether additional capital investment is required or not in order to bring the underlying oil to the surface. ^[1]

Growing Sales Volume

Our outlook for Anadarko’s hydrocarbon production is quite positive primarily due to improving production output from its U.S. onshore assets, especially the Wattenberg field. In 2013, increased horizontal drilling in the Wattenberg field helped the company shore up its total hydrocarbon sales volume by 34,000 barrels of oil equivalent per day over 2012. Sales volumes were also helped by increased horizontal drilling and infrastructure expansions in the Eagleford shale formation in the Southern and Appalachia region. ^[1]

We believe production volumes will grow further in the coming years as the company gains traction on its plan for expanding the existing midstream infrastructure such as oil gathering pipelines and gas processing capacity. The company expects to more than double its oil takeaway capacity from the Wattenberg field to almost 90,000 barrels of oil per day by the end of this year. ^[2] Furthermore, the recent asset swap deal signed by the company in the Wattenberg field will allow it to leverage this midstream infrastructure even better over the coming years as its development efforts in the region will be more concentrated around the supporting infrastructure. This is expected to result in lower development and processing costs for Anadarko. ^[3]

Our forecast of ~6% CAGR for crude oil sales volume in the long run also takes into account rising production from Anadarko’s Caesar/Tonga and Lucius fields in the Gulf of Mexico as well as its El Merk project in Algeria. Anadarko holds 35% stake in the Lucius oil field, which is estimated to contain reserves of more than 300 million barrels of oil equivalent. Other projects such as the Heidelberg in the Gulf of Mexico are also expected to drive higher production volumes in the long run. Total crude oil and condensates sales volume at 91 million barrels of oil equivalent (MMBOE) grew by almost 6% y-o-y in 2013. ^[1]

Higher Capital Expenditure

Anadarko’s annual capital expenditure has increased from just over $5 billion in 2010 to $7.7 billion in 2013 on increased investments in development and exploration activities. As the company continues to develop the U.S. onshore plays and supporting midstream infrastructure, we expect 2014 capital expenditure to be north of $8.5 billion. However, proceeds from the recent 10% stake sale in the Mozambique gas project will partly offset capital expenditures this year. (See: Anadarko Rakes In $2.6 billion from African Asset Sale)

In the long run, new projects in the Gulf of Mexico and Mozambique are expected to drive higher capital expenditures for Anadarko. The company estimates the gross cost of building the first two LNG (liquefied natural gas) trains in Mozambique along with the wells and supporting subsea infrastructure to be around $15 billion. However, it has been observed in the past that large-scale LNG projects are generally marred with start-up delays and cost escalations. This poses a downward risk to the company’s rate of return on invested capital in the long run.

Tronox Liabilities

Tronox was formed as a result of the spin-off of Kerr-McGee’s chemicals business in 2006. Just three months after the transaction, Anadarko acquired Kerr-McGee for $18 billion. Now, Tronox inherited huge environmental liabilities from its parent that forced it into bankruptcy in 2009. Soon after filing for bankruptcy, the company filed a lawsuit against Kerr-McGee accusing it of deliberately setting it up for a failure.

When Tronox emerged from bankruptcy in 2011, a litigation trust was formed to pursue the lawsuit against Anadarko and Kerr-McGee. Tronox transferred 88% of its interest in the lawsuit to the federal government. December last year, the judge announced his opinion on the case. He said that Kerr-McGee acted improperly during the Tronox spin-off and that Anadarko might have to pay anywhere between $5 and $14 billion in damages. He also gave the companies a couple of months to respond to his stand. We believe that after these briefings are over, there could potentially be another round of hearing before the final judgment, which could again be challenged in the court. So the case is still far form over. ^[4]

During the fourth quarter earnings call, Anadarko officials said that according to their estimates, liabilities arising from the case should fall between $850 million to $4 billion. ^[5] In our analysis, we have accounted for $4 billion as a potential net payout amount related to the Tronox case, based on the probability-weighted average of the various possible outcomes. However, it should be noted that for every $1 billion increase in the actual payout amount over and above this estimate would result in a $2 per share negative impact on our current price estimate for the company.

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1. Anadarko SEC Filings, sec.gov, sec.gov [↩] [↩] [↩] [↩] [↩]
2. Johnson Rice Energy Conference, anadarko.com [↩]
3. Anadarko Announces Wattenberg Property Exchange, wsj.com [↩]
4. Tronox, Anadarko fight over cleanup costs may be just getting started, reuters.com [↩]
5. Anadarko’s CEO Discusses Q4 2013 Results – Earnings Call Transcript, seekingalpha.com [↩]