The Coming FCF Giant Known As EOG Resources

Summary

• Going over EOG Resources' 2017 performance and 2018 expectations.
• A lot of free cash flow at $60 WTI enables debt reduction and strengthens the balance sheet.
• Higher capex budget funded by organic cash flow generation, not debt issuance, will stimulate additional production growth.

EOG Resources, Inc. (NYSE:EOG) is generally considered one of the best unconventional upstream oil & gas players in the business, and its financials back it up. Last year, the firm posted almost $2.6 billion in net income! But that includes the gain from the tax law as its deferred tax liability decreased by a huge amount after the tax cut bill was signed into law. Factor that out and EOG Resources still earned an adjusted $648 million for 2017, $401 million of which was earned in Q4. Let's dig in.

Free Cash Flow

During its Q4 2017 conference call, EOG Resources' management team noted that:

"In 2017, we [EOG Resources Inc] grew high return U.S. oil production 20%, paid the dividend, reduced our debt, and generated over $200 million in free cash flow."

Let's dig into that a little bit. It depends on how you define free cash flow, which for many/most publicly traded oil & gas firms excludes changes in working capital. EOG Resources generated $4.265 billion in net operating cash flow in 2017, but that includes negative working capital effects of $965 million.

That isn't a "normal" build in the sense that EOG needs to invest almost $1 billion a year in working capital to support its operations; the real figure is much lower than that. A growing upstream firm does need to invest in working capital, for instance, by building up an inventory of wellheads, well casings, proppant, and other D&C-related materials in order to bring more wells online per year. Even so, most annual working capital changes are due to timing effects and that won't necessarily show up next year.

When it comes to evaluating upstream firms with numerous big long-cycle projects, working capital builds are material because that cash flow won't return for some time, but small short-cycle projects generally recover working capital quite quickly. For that reason, it is reasonable to remove working capital changes from the operating cash flow streams of unconventional upstream firms in order to get a better gauge of their performance. Adding working capital changes back to EOG Resources' operating cash flow gives you $5.23 billion in organic cash flow generation.

Stacked against $4.124 billion in capital expenditures and $387 million in dividend payments in 2017, it is fair to say EOG Resources was truly cash flow positive. Already being in a free cash flow position heading into 2018 is a great sign.

Attack on Debt

The firm used $600 million of that cash flow to pay off its 5.875% notes due 2017, retiring that debt and removing the interest expenses from its future income statements instead of refinancing that burden with a new debt issuance. EOG also plans to pay off its $350 million October 2018 6.875% notes with cash on hand.

Management expects that at $60 WTI and assuming EOG spends $5.6 billion on its 2018 capital expenditures, the company will generate $1.5 billion in free cash flow. That comes on the heels of a dividend increase, but that will only increase its annual investor payouts by $40 million as EOG's yield remains tiny. The savings from its debt retirements will basically pay for the increase as EOG's annual cash interest payments move $59 million lower.

By the end of 2018, EOG will pay down $1 billion of its debt, bringing it down to $6 billion pro forma. Management made sure to highlight the fact that:

"We [EOG Resources Inc] will not issue new equity or debt to fund capital expenditures or the dividend."

Management intends on "incrementally" reducing EOG's debt load over time. This is a great idea as a better balance sheet will make EOG more attractive to investors and retiring notes removes a major fixed cost. EOG spent almost $275 million on interest expenses last year. Sure, there are tax benefits to consider, but the annual drain on its cash flow is a real problem.

When some market participants saw EOG Resources' capex budget climb year-over-year, they panicked. It's important to note that EOG's capex is being funded with organic cash flow generation, not debt or equity issuances, and will result in material production growth.

Production Growth and Cost Reinflation

EOG Resources' production base climbed from 560,000 BOE/d in 2016 to 608,900 BOE/d in 2017, and its current capex budget will keep the momentum going. Management expects EOG's company-wide output to climb by 16% as the firm's oil production grows by 18% this year. Production growth will compound with higher oil and international gas (behooves EOG's Trinidad & Tobago operations) prices to propel EOG's cash flow generation upwards.

One major concern across the upstream industry is cost reinflation. This is the process of labor costs, oilfield services rates, and other inputs rising on the back of higher demand for those services/products, and to make up for ground lost during the bust. Oilfield service providers aggressively slashed rates to keep winning business in 2015-2017, but now that WTI is over $60, those oilfield service providers want in on those gains. Employees who put up with stagnant or even declining wages during the bust need to be compensated for their hard work and dedication now that times are better (particularly because there is a workforce shortage and wages need to be competitive), and generally, G&A tends to creep up when things are improving.

Cost reinflation was brought up during EOG's conference call, and management noted the firm has a couple of ways to fight back. A lot of its drilling rigs and completion crews were locked under contract at very advantageous prices during the bust, which will help keep a lid on prices in the medium term. Stockpiling well casing materials helped EOG get prices 15-20% below current market rates.

Due to a combination of EOG owning its own sand mining and processing assets, and recently gaining access to a more "diverse" supply of sand (proppant used during the fracking process), management expects sand unit costs to trend 15% lower this year versus 2017. That is on top of each frac crew being able to complete 5-10% more wells this year than last year. Investments in water handling and recycling infrastructure are expected to decrease total well costs by $100,000 in certain locations.

With all that being said, it still doesn't stop the industry-wide trend. Eventually rigs and completion crews under contract will ask for higher rates when the contract expires. Any new equipment or materials EOG buys to support its growth runway will be at current market prices, significantly above where they were last year. Similar story for any new drilling and/or completion crews that sign a contract with EOG, don't expect those new rates to be cheaper than last year's. Something to keep in mind as the industry enters the next stage of the recovery process.

Final Thoughts

EOG Resources was able to generate free cash flow, positive net income, and solid production growth all while paying down its debt burden last year. If that's what it can do when WTI was struggling below $50, imagine what the company can accomplish when WTI is over $60. One day the equities market will wake up and smell this opportunity as well.

Disclosure: I/we 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.