EOG Resources' (NYSE:EOG) CEO Mark Papa had some interesting things to say at the 2012 Barclays CEO Energy/Power Conference about his company and the energy industry in general. His remarks provided insight into some of the concerns that investors have about the industry and the structural issues that need to be addressed. Moving into 2013, the company plans to stop all dry gas drilling in the U.S., despite its relatively cheap portfolio of gas assets, which includes the Marcellus, Haynesville, Barnett, Uinta, and Horn River. He categorically said that his company continues to "have zero interest in growing North American gas volumes at these miserable prices".
Mr. Papa went on to say, "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 is one of several independent energy producers in the U.S. that are shifting focus completely from dry gas to oil and gas liquids. Though $700 million (10% of EOG's 2012 budget) will be spent on dry gas, this expenditure is being incurred entirely by the necessity for HBP (Held by Production) acreage (primarily in the Haynesville, but also in the Marcellus and the Horn River plays). A lot of money has been spent in acquiring dry gas acreage, which is now being locked away until there is an upturn in market prices. Only $100 million will be spent in 2013, mainly for Bradford County Marcellus acreage. It will take a sustainable price of $5 to $5.50/MMBtu for the company to resume dry gas drilling.
Mr. Papa added that even if there is a very cold winter, temporary developments would not influence the company to change its mind. Unless there is a major structural transformation such as a long-term reduction in coal-fired power generation, he continues to be pessimistic about the U.S. natural gas market. This view differs drastically from the opinions already expressed by Chesapeake Energy's (NYSE:CHK) CEO Aubrey McLendon and Ultra Petroleum's (NYSE:UPL) CEO Michael Watford, who believe that a rebound in prices is imminent. It is easy to understand the company's shift in focus because of the high quality of its assets in the Eagle Ford and the Bakken. Significantly for the industry, he emphasized the reduced profitability of "liquids-rich" plays like the Permian Basin's Wolfcamp, Leonard and Cline, which are one-third dry gas, one-third natural gas liquids, and one-third oil. This is unlike the Bakken and Eagle Ford, which are primarily oil assets.
EOG reported strong results for the second quarter of 2012. The company reported net income of $395.8 million, or $1.47 per share, compared to second quarter 2011 net income of $295.6 million, or $1.10 per share. EOG is capitalizing on the fact that it was one of the first producers to shift focus on shale from gas to crude oil and gas liquids. As a result, EOG has some of the best onshore oil assets in the country and the technical prowess to maximize extraction. EOG is the largest crude oil producer in the South Texas Eagle Ford and North Dakota Bakken. The company also realizes the best possible prices because of its transportation arrangements. Net income was $395.8 million (EPS of $1.47 per share), compared to $295.6 million (EPS of $1.10 per share) in the same quarter of 2011. The consensus EPS estimate was $.93 per share, according to Forbes. The results include gains on asset disposals of $75 million and a non-cash net gain of $173.2 million arising out of marking financial commodity contracts to market. Total production of crude oil, gas liquids and condensates increased by 49% on a year-on-year basis. This has encouraged the company to increase its crude oil and condensates production target for the year from 33% to 37 %, and its total liquids production target from 33% to 35%. Overall, the full production target has been increased from 7% to 9% without any increase in capital expenditure. But, the results were negatively affected by a 19% drop in natural gas realizations and a 41% drop in dry natural gas realizations.
The asset impairment charge of $1.5 million was small when compared to $243 million for Chesapeake. Other companies with natural gas exposure are expected to follow suit. The main reason EOG is outperforming its peers is due to its farsightedness in shifting from gas to oil before many of its competitors even began to realize the necessity. This early move also meant that it was easier to finance the shift when natural gas prices were still profitable. Take the example of one laggard, Encana (NYSE:ECA). It reported a loss of $1.5 billion in the second quarter and its capital spending will outstrip its cash flow as it desperately tries to diversify production. In the West Texas Wolfcamp formation, EOG has deployed five rigs and the results have prompted the company to increase its production growth forecast. The formation is becoming a favorite play and, once again, EOG foresaw this nearly one year ago. Other leading players include Pioneer Natural Resources (NYSE:PXD) and Apache (NYSE:APA).
Analysts at Raymond James have recently upgraded EOG from market perform to outperform after analysts at Miller Tabak upgraded the stock from neutral to buy. This reflects the growth prospects of the company, and I am inclined to agree. Crude oil prices remain strong and the company no longer has the encumbrance of unprofitable natural gas production. But, unlike Chesapeake, the company has retained its natural gas assets which it can exploit quickly when natural gas prices rebound. I am extremely impressed with the quality and the foresight of company management and regard this company as a top pick of the energy producers. EOG is currently trading around $114, between a 52-week range of $66.81 and $119.97. I see considerable upside in the stock price in the coming weeks and months, and recommend that investors buy today.