EOG Resources: Why You Need To See Beyond Valuation

Oct.14.13 | About: EOG Resources, (EOG)

New oil drilling technology has helped the U.S. exploration and production industry increase its production. Eagle Ford, Bakken and the Permian basin, the leading plays in the U.S. in terms of oil production, are all expected to produce over 1.5 million barrels of oil per day by 2016. The ever-increasing domestic oil production has reduced U.S. dependence on the Middle East for oil. Investors are also looking to benefit from this increasing oil growth by investing in oil producing companies. However, with so many companies to choose from, it can be difficult for an investor to pick the best players. Here, we have chosen EOG Resources (EOG), the leading company in the Eagle Ford shale play. While this stock may be categorized as "one to avoid" by some investors, we argue why it would be a mistake to do so.

Beyond the traditional numbers

One look at EOG's valuation multiple and stock price may discourage some investors. A trailing twelve months P/E multiple of over 40 and stock price well above $170 makes this stock appear expensive, even by the most generous of considerations. Add an annual dividend of $0.75, which translates into a dividend yield of less than 0.5%, and investors may ignore EOG. However, we believe that having this myopic view can lead investors to overlook a great company. EOG is a growth stock, and it's important to look beyond the P/E and dividend yield when analyzing it.

For the second quarter of 2013, EOG reported net income of $659.69 million, which gives a diluted EPS of $2.42 per share. However, the number to look for is the discretionary cash flow. Discretionary cash flow for the second quarter was $1.87 billion. This indicates an increase of over 35% year over year. For the first half of this year, EOG has delivered $3.56 billion of discretionary cash flow. If we project this for the full year, it implies that the company is trading at just 6.62 times its operating cash flow. This presents a completely different picture from what the P/E multiple suggests.

A look at the EV/EBITDA ratio will further substantiate this view. A low EV/EBITDA multiple indicates that a company might be undervalued. EOG competes with Occidental Petroleum (OXY) and Devon Energy (DVN) among the large-cap independent exploration and production players.



EOG Resources


Occidental Petroleum


Devon Energy


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Source: Occidental Petroleum Presentation.

The table suggests that the EV/EBITDA for EOG is in line with its peers. By this consideration, EOG looks fairly valued. However, we are bullish on its production growth because of its assets and its position in the important oil production areas in the U.S. When the growth prospects are factored in, EOG becomes a compelling proposition at the current valuation. Let's take a look at the company's tailwind opportunities highlighted below.

Leading the Eagle Ford shale

The most compelling case for considering EOG is its growing oil production. It is expected to deliver best-in-class crude oil growth through 2017 and beyond. The company has the best horizontal crude oil assets in North America, allowing it to deliver an average annual production growth of 40% since 2010. The company has a target to increase crude oil production by 35% this year.

EOG's leading position in the Eagle Ford shale helps it achieve its targets. Current Eagle Ford oil production estimates vary between 600,000 barrels of oil equivalent, or boe, per day to 800,000 boe per day. Oil production at this facility is expected to exceed 1 million boe per day next year. As the largest oil producer at this facility, EOG remains uniquely positioned to indulge in the growth story. It has 639,000 acres of assets in the Eagle Ford play and produces 173,000 boe per day. Thus, EOG accounts for roughly 25% of the overall production in this area. The company has also increased its reserve estimate from 1.6 billion boe to 2.2 billion boe. Its assets and reserves provide it with a potential to drill oil in the Eagle Ford shale for the next 12 years.

EOG plans to drill approximately 440 wells this year in the Eagle Ford shale play. The use of EOG Sand allows the company to reduce well costs and improve efficiencies. Sand is a principal component used in hydraulic fracturing for drilling oil. EOG has a 105-acre frac sand mine, and it transports the sand to all its oil fracking fields in the country. This makes EOG self-sufficient to fulfill its sand requirement. The well completion cost has reduced from $6.8 million in 2012 to $5.8 million this year. Time required to drill a well has also reduced from 13.4 days in 2012 to 9.9 days per well this year.

Heavy concentration in Eagle Ford, doesn't mean that EOG has missed out on other important plays. It has 90,000 net acres in the Bakken core area and 320,000 acres in the Permian Basin, which is in the Delaware and Midland basins. The importance of Eagle Ford, Bakken and Permian stems from the fact that these areas account for a third of total U.S. oil production currently. These areas are expected to produce half of the U.S. oil in the future.

On the other hand, Devon Energy has a target to achieve an oil production growth rate of 16%-19% in 2013, and it plans to achieve 40% oil production growth in the U.S. Devon derives strength from its strong position in the Permian basin where it has 1.3 million acres of assets. The company plans to drill more than 300 wells in this region in 2013. Additionally, Devon also has operations in Canada, where its expertise in Steam-Assisted Gravity Drainage technique bodes well for improving production in the future. This technique allows the extraction of oil that is too deep or economically inefficient to drill using traditional methods. Devon has a target to achieve CAGR of 17%-20% in its Canadian oil production through 2020.

Occidental Petroleum targets increasing oil and gas production by 5%-8% over the long term. This company is the largest oil producer in the Permian basin, contributing approximately 16% of the overall production in the region. It is also the largest operator in this basin, with 2.5 billion boe of likely recoverable resource. An additional reason for considering this stock is its consistent dividend growth. The company has increased its dividend for 11 consecutive years and has achieved a CAGR of 16% in dividends over this period. The annual dividend of $2.56 implies a dividend yield of 2.7%, which is in line with the yield on a 10-year US treasury bond. So, this compensates investors well, even in the absence of capital appreciation.


It is easy to be skeptical about the stock growth of EOG after looking at its high P/E multiple. However, deeper research and a look beyond the traditional numbers helps investors discover that its valuation is actually in line with its competition. With its leading position in the Eagle Ford shale play, and once its oil production growth prospects are factored in, it deserves to command higher multiples on a relative basis. Hence, with EOG trading in line with its peers, we concluded that this stock is actually cheap. Investors should consider indulging in EOG's growth story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any 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: Fusion Research is a team of equity analysts. This article was written by Madhu Dube, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.