Data disclosed by EOG Resources (NYSE:EOG) on its "premium" drilling locations offer a unique opportunity to quantify the value of hydrocarbons underneath the company's acreage. Some in the investment community are of the opinion that high-flying shale oil producers such as EOG and Pioneer Natural Resources (NYSE:PXD) are currently overpriced. This is evident from the comments posted in response to, for example, this article. I will show that, despite the overvaluation viewpoint having distinct merits, the run-up in shares was counter-intuitively accompanied by shares becoming less overvalued than they were early in the year.
The utility of data on premium locations
The value of a company engaged in exploration and production arises from its proved reserves, both developed and undeveloped and from its potential resources. It has been recognized, at least since David Einhorn's well-known bearish call on Pioneer that proved reserves are only a part and, in case of EOG and Pioneer, only a minor part of the company's valuation. Data on EOG's "premium" drilling locations give us insights into the value of its potential resources.
The company's Q3 2016 earnings presentation includes the counts of premium locations by basin and/or formation. For example, the firm identified 1,275 such locations in the Wolfcamp formation of Delaware basin. We also know the completed well cost (CWC) for each category of premium locations. In the Wolfcamp, the combined cost of "Drilling, Completion, Well-Site Facilities and Flowback" amounted to $8.5 million per location, with $7.8 million being the eventual target. This is the amount of initial investment in a location.
A "premium" location is defined as one offering a 30% after-tax rate of return (ATROR) assuming WTI flat at $40. This definition is inflexible with respect to changes in oil prices. However, the profitability of a premium location is expected to vary. In the scenario of WTI at $30, EOG estimates that a premium location would earn a 10% ATROR. At higher oil prices, the expected return rises quickly and somewhat super-linearly, to 60% at $50 and to 100% or above at WTI of $60 per barrel.
The following chart presents ATROR versus flat WTI. The lines linking the four data points allow rough estimation of ATROR at intermediate WTI levels.
Source: data from EOG Resources' Q3 2016 earnings presentation
A premium Wolfcamp location, costing $8.5 million initially would, by definition of "premium", earn a 30% ATROR if WTI is at $40, meaning that after tax, one location would contribute $2.55 million to income. The total value of EOG resource potential is then obtained as a sum of such amounts for all premium locations in all basins and formations.
The value of EOG's premium locations today
The output of a shale well drops rapidly once the well starts to flow. As an approximation, let's assume that the flat WTI level needed to estimate ATROR is the average of the 2-year strip of NYMEX WTI futures. With the front month at $52.04 on December 19, the 12th month future at $55.73 and the 24th month future in a slight backwardation at $54.98, the average stood at about $55. Hence a premium location could be expected to yield ATROR of 80%, resulting in the estimate of about $31 billion for the value of premium locations.
The value of hydrocarbons underneath EOG's acreage
To obtain a closer approximation to the enterprise value of the whole company, we need to add the present value of its proved reserves.
The standardized measure of all proved reserves, both developed and undeveloped, stood at $9.621 billion at year-end 2015. This amount was computed assuming WTI flat at $49.58. If a similar but forward-looking calculation were to be done as of December 19, using the average of a two year WTI futures strip would yield a higher price of about $55 (as pointed out above) and hence about $5.50 higher. One way to adjust for the difference in the value of proved reserves would be to add the change in WTI, multiplied by the volume of the oil part of reserves, 1,097 MMBbl consisting of 445 MMBbl of proved developed reserves and 652 MMBbl of undeveloped reserves. This would yield a current estimate of the value of EOG proved reserves of about $15.7 billion. As this manner of adjusting for higher oil prices does not account for the time value of money, this estimate is probably biased upwards.
To summarize, EOG's proved reserves are worth about $15.7 billion at $55 recent average WTI price, whereas the value of its potential resources, represented by the inventory of premium drilling locations, is estimated at about $31 billion, yielding the total of $46.7 billion. The following exhibit illustrates in greater detail how this total value of hydrocarbons was obtained.
Source: EOG Resources' Q3 2016 earnings presentation and author's analysis
On December 19, with shares at $103.48 EOG's enterprise value (EV) stood at $62.979 billion. This amount exceeds by 35% the above estimate $46.7 billion of after-tax income that could be earned from all hydrocarbons, proved reserves and potential resources the company claims to exist underneath its acreage. Further, EV would equal the value of hydrocarbons at the share price of about $74. In other words, EOG appears to be overvalued, with net asset value (NAV) of only $74 per share compared to shares at well above $100.
Is the current overvaluation a big deal? A historical perspective
Looking back to February 25, 2016 when EOG discussed its FY 2015 results and disclosed the total count of 3,175 premium drilling locations, two developments are worthy of attention. EOG organically identified 1,110 locations and added 1,740 locations as a result of Yates transaction in September. It was probably smart to use, for the most part, the firm's own richly-priced stock to pay for the Yates transaction.
If shares currently trade at a premium to NAV, a natural question concerns their valuation in February. This is also covered in the above exhibit. At the end of February, longer-term WTI futures were hardly higher than $45, with the futures strip exhibiting a steep contango. For example, on February 25, the front month WTI stood at $30.60, 12th month at $40.90 and 24th month at $43.70, while EOG shares closed at $67.70. EV stood at $43.6 billion, as compared to premium locations worth $8.5 billion and proved reserves at perhaps around $7 billion.
In other words, EOG traded at a much greater premium of 182% to NAV in February than it does now.
A firm being valued at a premium to NAV is nothing unusual, even though it would be a negative from the perspective of trying to find buying opportunities. What is surprising is how much EOG's premium to NAV has shrunk since February, despite shares gaining over 50% in the same period.
EOG's current enterprise value is well in excess of the value of its premium locations. The market has clearly bought into the premium location narrative, in contrast to not buying the production growth story.
Given the significance of oil prices to E&P companies, it is always important to try to see the impact of oil prices separately from relative valuation. Relative to NAV, EOG trading currently above $100 does not appear to be a better reason to sell than it was at below $70 in February - the real point being that to ride oil prices up since their winter lows, it would have been better to own oil itself in some form, rather than shares of EOG. If one believes that oil prices are headed lower, being short oil itself would probably be a better idea than shorting EOG.
EOG is unlikely to benefit proportionately from showing growth of its premium location count at the same blistering pace as it did earlier this year. I believe it would be better to demonstrate how large and positive ATROR figures can translate into profits at the corporate level. If the premium location story is true, then raising production would help EOG's profits.
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