Anadarko’s Earnings Rise On Increased Wattenberg Development Despite Lower Crude Oil Prices

Anadarko (NYSE:APC) posted impressive third quarter earnings growth despite lower crude oil prices, primarily driven by a robust sales volume growth from its U.S. onshore assets. The company’s diluted earnings per share (EPS) adjusted for one-time, non-core items such as the unrealized gains on derivatives, grew almost 3.6% year-on-year to $1.16. Anadarko’s crude oil price realizations fell 11%, compared to the previous year’s quarter on lower benchmark prices. The average West Texas Intermediate (WTI) crude oil spot price declined by almost 8% year-on-year during the third quarter on rising supplies and falling global demand growth estimates. ^[1]

However, Anadarko posted a very impressive sales volume growth from its U.S. onshore assets during the quarter, which more than offset the impact of lower oil prices. Most of this growth came from the ongoing development of its acreage in the Wattenberg field, which is a very lucrative asset for the company because it also holds mineral rights in most of that area. We believe that Anadarko’s Wattenberg operations will continue to drive most of the earnings growth for the company in the short to medium term. ^[1]

Anadarko 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, Alaska and New Zealand. At the end of 2013, Anadarko had proven reserves of almost 2.8 billion barrels of oil equivalent. Based on the recent earnings announcement, we have revised our price estimate for Anadarko to $102/share, which is almost 15% above its current market price.

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Higher Volumes

Currently, most of Anadarko’s total hydrocarbon production (~75%) comes from its onshore assets in the U.S. The company’s net hydrocarbon production from its U.S. onshore assets has grown at more than 13.3% CAGR between 2009 and 2013. This compares to the company’s overall production growth rate of 7% CAGR over the same period. This year, Anadarko plans to grow its U.S. onshore production by 8% over last year by spending around $5.5 billion, which is ~65% of its total capital budget for the year, on the development of its key assets. A large chuck of this capital is being pumped into the Wattenberg field, which forms the centerpiece of Anadarko’s U.S. onshore development plan. ^[2]

The Wattenberg field forms the centerpiece of Anadarko’s U.S. onshore development plan. The Wattenberg field is a liquids-rich area where Anadarko operates over 5,200 wells. Recently, the company’s drilling program in the field has been entirely focused on horizontal development. It drilled 335 horizontal wells last year, which led to a 21% y-o-y jump in sales volume from the field. Anadarko has identified around 4,000 potential drilling locations in the Niobrara and Codell formations of the Wattenberg field that are expected to provide substantial opportunity for continued activity. This year, the company plans to drill over 360 horizontal wells in the field, employing as many as 13 horizontal operated rigs on an average. During the third quarter, Anadarko’s oil equivalent sales volume from the Wattenberg field grew by 88 MBOED*, compared to last year. This made up almost 84% of the total year-on-year hydrocarbon sales volume growth for the whole company. ^[1]

Anadarko expects to grow its hydrocarbon sales volume from the Wattenberg field at 20% CAGR in the long run. We believe that the target is achievable due to a combination of favorable factors. These include rising drilling efficiencies, increased number of operated rigs, and improving midstream infrastructure. The company is working on more than doubling its oil takeaway capacity from the Wattenberg field to almost 90,000 barrels of oil per day by 2015. It also plans to expand the gas processing capacity from around 400 million cubic feet per day (mmcfd) to over 1,000 mmcfd by 2016. ^[3]

Furthermore, the asset swap deal signed by Anadarko in the Wattenberg field will also 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. In October 2013, Anadarko exchanged certain oil and gas properties in the Wattenberg field with a third party. Under the terms of the transaction, each party exchanged approximately 50,000 net acres. The transaction that increased Anadarko’s production growth potential from the field significantly is also expected to drive more than $500 million in cost savings for the company through reduced trucking and water sourcing requirements. ^[1]

Thicker Margins

The growth in Anadarko’s Wattenberg production is also boosting its consolidated exploration and production (E&P) margins. This is because the company generates the highest, more than a 100%, rate of return on the development of its acreage in the Wattenberg field. This can be primarily attributed to its land grant advantage in the region. Anadarko holds fee ownership of mineral rights under approximately 8 million acres in the U.S. Rocky Mountains region. The acreage passes through southern Wyoming and portions of Northeast Colorado and Utah. It is commonly referred to as the land grant.

Before any oil and gas E&P company can start working on the development of a prospective field, it has to have legal rights to extract hydrocarbons from the subject property. The most commonly used instrument to facilitate this arrangement is a mineral rights lease. It allows the E&P company to explore and extract minerals, including crude oil and natural gas from the property. In return, the owner of mineral rights gets a cut from the profits earned by the E&P company on selling minerals produced from the property. The cut, also known as the royalty rate, varies from state to state. However, it is a significant portion of an E&P company’s total production cost.

Therefore, by owning mineral rights, Anadarko not only gains from lower operating costs in the land grant area, but it also earns royalty income from third-party operations in the area. During the 2014 annual investor conference held in March, Anadarko pointed out that for each operated well with an estimated ultimate recovery (EUR) of around 350,000 barrels of oil equivalent, the land grant increases its before-tax net present value (NPV) by $2.2 million or more than 45%. What’s even more significant is the fact that the land grant area covers a large part of Anadarko’s 350,000 net acres in the Wattenberg field, which is the primary growth driver for the company. ^[3]

The contribution of Anadarko’s Wattenberg operations to its total sales volume has grown from around 9.4% in 2010 to 22.3% during the third quarter of this year. Going forward, the company expects to grow its hydrocarbon sales volume from the Wattenberg field at around 3-4 times the company’s total sales volume growth target of 5-7% CAGR. Therefore, the weight of Wattenberg production in Anadarko’s total sales portfolio is expected to increase, which would exert downward pressure on its total unit operating costs resulting in thicker consolidated E&P margins. According to our estimates, Anadarko’s 2014 first nine months adjusted E&P margins improved by around 320 basis points y-o-y. ^[1]

*MBOED: Thousand barrels of oil equivalent per day

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1. Anadarko Announces Third Quarter 2014 Results, anadarko.com [↩] [↩] [↩] [↩] [↩]
2. Anadarko 2013 Annual SEC Filing, sec.gov [↩]
3. Anadarko Investor Conference, anadarko.com [↩] [↩]