Driven by the drop in realized prices for liquid natural gas due to overproduction, EOG Resources (EOG) is focusing its capital on the Eagle Ford and Bakken plays. The decrease in liquid natural gas prices is incremental but steady, and has more than a few echoes of the decrease in dry natural gas prices that started three years ago during the initial shale drilling boom. EOG was a frontrunner in transitioning to liquids after forecasting today's disastrously low dry gas prices, and after CEO Mark Papa's most recent remarks on price expectations, is now positioning itself as a frontrunner once more by transitioning more heavily to shale oil; Papa is hinting that a precipitous fall in U.S. liquid natural gas prices may be coming in 2013.
Far from a minor reposition, Papa's indication of a new direction in drilling represents a major pivot for EOG, which grew its liquid natural gas production by 31% in the last year alone. I think this was a good strategy for EOG until others, like cash strapped Encana (ECA), followed the same strategy with similar success; it was only a matter of time before the market reacted. EOG now expects future liquids growth to derive from oil, with a plan to limit its debt to market cap to less than 30% through the remainder of this year.
With just $280,374 cash on hand at the close of the second quarter, this is a tough but critical sell for EOG. Since many of its closest competitors are struggling under monumental debt loads, investors are paying close attention to debt to equity and debt to market cap ratios; EOG is so far distinguishing itself by minimizing that burden. But, a second pivot in less than five years will be expensive, and if EOG is not financing through debt acquisition it will be financing at the expense of further growth by siphoning from continued operations on its high value plays. Given this catch 22, I think it is very likely sales of EOG assets will be forthcoming in the next two to three quarters.
Where this puts EOG's expectations for the Kitimat LNG project is unclear, though projections are that Asian demand for the resource will keep export from Canada's western coast economically viable for the foreseeable future. The Alaskan government is also bullish on export to Asia, recently pushing several oil and gas majors to submit plans for a $50 billion gathering, pipeline, and processing package that combined with current infrastructure would put Alaska in front of any export markets across the Pacific.
Aside from EOG's change in position, just months ahead of the previously announced deadline for a final investment decision in the Kitimat LNG project, EOG's partner Apache (APA), is looking to divest 20% of its current 40% stake. This would put EOG and a third partner, Encana into a position as joint leaders of the project, as each currently have a 30% stake in Kitimat. I doubt that EOG would want to step in to the project as a leader given its bearish position on liquid natural gas, especially if better financed Apache is pulling back from the deal. That could mean a negative decision on further financing for the project and yet another acquisition opportunity for firms with a more optimistic near-term outlook for natural gas projects.
Attempting to Keep Costs Low
With the expense of another pivot looming, EOG is forming a media campaign against fracking rules proposed by the U.S. government, claiming that the rules would increase costs to drill per well by 20 times over regulators' estimates, from adding $11,833 to costs per well by regulators' estimates to $253,839 per well by EOG's estimates. If EOG's estimates are the more correct of the pair, the U.S. shale drilling boom could come to a virtual standstill, since for many smaller operators like Kodiak Oil & Gas (KOG) and SandRidge Energy (SD) an additional burden of $253,839 per spud would quickly erode profits at current prices.
One major driver of the disparity between the two cost estimates is the idle time that would be required to confirm to regulators that poured concrete bonded properly. Such confirmation would require an average 72 hours, during which time work on a well would be at a standstill. Since most operators are drilling with rented personnel and equipment, the idle time required to be compensated under existing contracts would come at substantial cost. Exxon Mobil (XOM) is also standing against the new proposals, indicating that the estimated 72 hour idle time could well be higher in practice since regulators would need to evaluate and approve producers' confirmation of appropriate bonding for each individual pour as part of a time consuming and "onerous" process.
EOG is currently trading around $113 per share, with a price to book of 2.3 and a forward price to earnings of 17.7. Encana is trading around $22 per share, with a price to book of 2.4 and a forward price to earnings of 41.4. Kodiak, following a volatile track that outpaces nearly every other competitor in daily swings, is trading around $9 per share, giving it a price to book of 2.5 and a forward price to earnings of 9.3. SandRidge is trading around $7 per share, with a price to book of 1.2 and a forward price to earnings of 16.4.
With healthier balance sheets cushioned in part by multinational operations, Apache and Exxon Mobil are trading at relative discounts. Apache is currently trading around $87 per share, with a price to book of 1.2 and a forward price to earnings of 7.9. Exxon Mobil is trading around $92 with a price to book of 2.6 and a forward price to earnings of 10.6.
It is bold for EOG to come out so early against liquid natural gas, especially in light of international export projects breaking ground everywhere between the Texas Gulf Coast and Australia. The position will either turn out to be prescient or a major mistake. But, since the majority of its production is already in oil, a resource that remains in demand at reasonable prices and is forecast to continue to return revenues above the cost of production, EOG is still a safe investment opportunity.