Speaking at an industry conference on September 4, EOG Resources' (NYSE:EOG) CEO Mark Papa provided the company's operating and strategy update and shared his macro views on the industry. His comments with regard to the natural gas and NGL markets reflect some of the concerns within the industry and among investors regarding the structural challenges that the U.S. E&P sector may be facing in the next several years.
EOG sees continued structural issues in North American natural gas. Going into 2013, EOG plans to essentially halt all dry gas drilling. EOG has a strong, low-cost natural gas portfolio (including the Marcellus, Haynesville, Barnett, Uinta, and Horn River) but continues to "have zero interest in growing North American gas volumes at these miserable prices." Mark Papa commented:
"Don't expect the philosophy to change there unless we have the coldest winter in the history, or something that changes the structural configuration of North American gas."
EOG has been one of several U.S. independents who have completely shifted away from natural gas towards oil. While the company will spend about $700 million or about 10% of its 2012 budget on dry gas, the management has been very explicit that the capital allocation is driven solely by the need to HBP (Held by Production) acreage (primarily in the Haynesville, but also in the Marcellus and the Horn River plays).
"Over the last two years we've spent a significant amount of money locking down … acreage, and we are now putting that dry gas acreage in a vault. And we are locking it away until a better time shows up for dry gas drilling. And it may sit in that vault for two years, or it may sit in that vault for seven or eight years. We don't know. But the important thing is as we move into 2013, we are not going to be spending $700 million to HBP dry gas acreage. In fact, what we are planning to spend next year is $100 to $150 million, and that's primarily for our Bradford County Marcellus acreage."
Mark Papa commented that it would probably take a gas price of $5-$5.50/MMBtu for EOG to resume dry gas drilling. More importantly, EOG would have to believe that the gas price would be sustainable at that level.
"Let's just say we had a bitter cold winter and gas prices spiked to $5 or so. Our issue would be, is that a temporary spike that would just stimulate a whole bunch of drilling and within a year gas prices will be within $4 or $3.50? To us, we need to see a structural change in gas demand that would have to be something like significant permanent reduction in coal-fired power plants. So we are not at all sanguine about the gas market until we see a major structural change."
EOG's comments appear to reflect a fundamental view that the U.S. natural gas market has problems that are structural in nature and therefore unlikely to go away once the injection season is over. The approach diverges radically from fundamental views expressed by Chesapeake Energy's (NYSE:CHK) CEO Aubrey McLendon and Ultra Petroleum's (NYSE:UPL) CEO Michael Watford, who have supported the thesis of an imminent improvement in natural gas fundamentals and pricing.
EOG sees potential NGL price challenges in 2013. Mark Papa indicated that going into 2013, EOG may be re-directing capital from their "combo" plays, including the Permian and the Barnett Combo, toward the Eagle Ford and the Bakken. This is new and a noticeable change from EOG's recent strategy which reflects the company's concern over NGL prices. A year ago, strong NGL and reasonable natural gas prices made the economics of liquids-rich plays like the Wolfcamp or the Barnett Combo highly attractive. As of today, EOG is "not as sanguine about what's going to happen in 2013 for NGL prices."
"Given the choice, our strategy is that we are going to continue to optimize the Wolfcamp play, but it is not a play that gives us an economic return as good as the Bakken or the Eagle Ford, particularly when we can get LLS prices for both of those products."
EOG's prioritization of the higher return crude oil assets is understandable, particularly given the exceptional quality of the company's "sweet spot" assets both in the Eagle Ford and the Bakken. However the comments reveal a potentially bigger problem for the industry as a whole: substantially reduced profitability of "liquids-rich" plays. Mark Papa was forceful pointing out that many of the horizontal oil plays, including the Permian Basin's Wolfcamp, Leonard and Cline, are really "combo" plays comprised of one third NGLs, one third dry gas, and one third oil, unlike the Bakken and Eagle Ford which are comprised of primarily oil in the range of 80% to 90%, with the rest being dry gas and NGLs. With dry gas prices depressed, and the NGL market facing potential oversupply, particularly in select regional markets, the economics for many recently-hot liquids plays may prove to be less attractive compared to a year ago, particularly when upfront costs of entry in a new operating area are taken into account.
Mark Papa commented:
"… Some of these Permian basin plays will [have] decent economics, but to some degree they will be captive to what happens to the NGL prices."
Kitimat LNG project facing uncertainties. Kitimat LNG project jointly owned by EOG, Apache Corp. (NYSE:APA) (the operator) and EnCana Corp. (NYSE:ECA) is apparently still in search of off-take arrangements. The project will not go ahead until the consortium gets an oil-indexed contract with a Far-Eastern buyer for the majority of the off-take. According to Mark Papa, the discussions with potential buyers have "gone certainly slower than any of us expected" and he "wouldn't even hazard to guess as to the time frame and as to how it is going to move forward."
The data point may indicate increasing competition for multi-year off-take arrangements with buyers among the myriad of new LNG projects that vitally depend on firm contracts to receive project financing. The growing book of potential projects combined with the overhang of the LNG volumes initially designated for the U.S. market that now have to be permanently diverted to other regions may make LNG consumers more picky about the pricing and structure of new contracts. Could this data point signify the beginning of a trend towards a breakdown to the LNG and crude oil price link in the Far East markets? Certainly something to watch.
EOG's comments have potential relevance for natural gas focused stocks: in search of better fundamentals, many gas producers seek shelter in liquids-rich plays; the softening NGL price environment and high entry costs into new plays may make a sizable dent in the all-in returns on new strategic initiatives. My natural gas producer index includes: Chesapeake Energy, Encana Corporation, Devon Energy (NYSE:DVN), Southwestern Energy (NYSE:SWN), Ultra Petroleum, EXCO Resources (NYSE:XCO), WPX Energy (NYSE:WPX), Cabot Oil & Gas (NYSE:COG), Range Resources (NYSE:RRC), QEP Resources (NYSE:QEP), Quicksilver Resources (NYSE:KWK), and Forest Oil (NYSE:FST).