EOG Resources Delivers On Promises

About: EOG Resources, Inc. (EOG)
by: Sarfaraz A. Khan

EOG Resources ended the first three months of 2019 with a decent profit, strong cash flows that covered not only CapEx but also dividends, and a dividend hike announcement.

Increase in oil prices and double-digit production growth will push EOG Resources’ operating cash flows higher in the future, which will drive FCF expansion.

Although EOG currently offers a below-average dividend yield, it could become more appealing for dividend investors in the future as it continues to grow payouts at a brisk pace.

EOG Resources (EOG) is quickly turning into a great dividend stock. The shale oil driller is widely known for rapidly growing production, but it is now increasing its focus on spending cash on shareholder-friendly measures. EOG Resources will continue generating strong levels of free cash flows in the future as it gets support from improvement in oil prices and other factors. The company has increased shareholder payouts by 72% since 2017 and will likely continue growing dividends in the future on the back of solid cash flow growth. I believe EOG Resources is an emerging dividend stock that income-seeking investors should closely follow.

Image courtesy of Pixabay

EOG Resources promised to grow dividends faster than its 19% historical average. In my previous article, I wrote that EOG Resources will achieve this target as it generates strong levels of free cash flows which will fuel dividend growth. The company has recently released its quarterly results in which it delivered on its promise by reporting solid free cash flows and announcing a 31% dividend hike. This marks the second consecutive year of 31% dividend growth. Its quarterly dividends have climbed from $0.168 per share in 2017 to $0.288 per share currently while its dividend yield, which averaged just 0.76% in the last five years, has climbed to 1.22%.

I believe EOG Resources managed to record an impressive performance in the first quarter, even though the company operated in a tough oil price environment. The company reported a 17.2% increase in total production to 773,600 boe per day from the corresponding period last year as output from the US climbed by 19.8% to 722,000 boe per day. Its crude oil production from the US increased by 21% from last year to 435,100 bpd, beating the top-end of the company’s guidance of 426,600-434,200 bpd.

However, the first quarter of 2019 was a tough period for oil producers as the commodity’s price dropped significantly. EOG Resources booked average price of $56 a barrel for crude oil and condensates for the first quarter, down from $64 a barrel a year earlier. The impact of lower prices, however, was offset by higher production, and the company ended the period with an adjusted profit of $689 million, or $1.19 per share, roughly flat from last year.

EOG Resources’ discretionary cash flows, on the other hand, actually increased by 3% to $1.91 billion. This fully covered the cash capital expenditures of $1.73 billion. As a result, the company ended the quarter with free cash flows, or operating cash flows in excess of capital expenditure, of $182.3 million ($1.91Bn-$1.73Bn). The free cash flows were enough to fully fund dividends of $127.5 million and EOG Resources ended the first three months on a strong note with $54.76 million of cash flows in excess of capital expenditure and dividends.

I believe a closer look at the company’s free cash flows shows that the dividend hike was justified. The first quarter free cash flows were of $1.26 per share when taken on an annualized basis. This reflects as a FCF yield of 1.34%. The company’s dividend yield prior to the latest hike, on the hand, was 0.93%. The lower dividend yield as compared to the FCF yield shows that the company had ample room to grow dividends without putting any strain on its cash flows. The 31% dividend growth takes the yield to 1.22% which is still below the FCF yield but that’s sensible which shows that although EOG Resources is focusing on returning capital to shareholders, it will keep some spare free cash flows with itself to strengthen its liquidity.

Moving forward, however, I believe EOG Resources will likely generate even higher levels of free cash flows. That’s because unlike the first quarter, the company will benefit from higher realized oil prices. The spot price of the US benchmark WTI crude has climbed from the first quarter average of $54.83 a barrel to $61 at the time of this writing, driven in large part by weakness in global supplies. The Organization of the Petroleum Exporting Countries and its partners, including Russia, have been keeping a lid on volumes, Iranian oil exports have plunged following the US sanctions, output from Venezuela could decline further, while production from non-OPEC producers (ex. North America) such as China has also remained soft due to a lack of investment in the oil sector in the last few years. The fact that oil has remained above $60 a barrel since the end of March, despite growing production from the US and the escalating trade war jitters between the US and China, shows how tight global supplies are. The strength in oil prices should give a boost to EOG Resources’ earnings and operating cash flows.

EOG Resources also typically realizes higher prices for its barrels than other oil producers, which can be attributed to its successful marketing strategy which gives it flow assurance as well as access to lucrative export markets where oil trades at a premium over WTI. This was evident from the first quarter when EOG Resources’ average US price was $1.21 per barrel above WTI and $2.84 per barrel above the peer average. I believe the company could continue enjoying a pricing advantage in the long run since it has signed agreements which will increase its export capacity from 100,000 bpd in 2020 to 250,000 bpd in 2022.

Meanwhile, I believe EOG Resources will continue growing its production at a double-digit pace well into the future. The company plans to grow its US oil production and total US production by around 14% each in 2019. But what I particularly like about EOG Resources is that it has tons of high-quality drilling locations which can fuel its growth for several years. In Eagle Ford alone, located in South Texas, which has historically been EOG’s primary asset, the company has amassed enough drilling locations to sustain high-return growth for at least 10 years. The company has identified 2,300 net undrilled premium drilling locations at Eagle Ford but it also has 4,815 locations at the Permian Basin, 1,630 at the Powder River Basin, and more than 700 in other regions. These are all low-cost assets that can generate a minimum of 30% rate of return in a low commodity price environment ($40 Oil, $2.50 Natural Gas). Moreover, I believe EOG Resources can significantly grow the size of its premium inventory as it continues to upgrade ordinary acreage into premium status.

The higher levels of realized oil prices combined with production growth will push EOG Resources’ operating cash flows higher. The company won’t increase its capital budget of $6.3 billion for 2019. I believe growing operating cash flows combined with flat CapEx will likely push the company’s free cash flows meaningfully higher from $182.3 million in the first quarter. This could put the company in a solid position heading into 2020 when continued growth in free cash flows will justify another major dividend increase.

EOG Resources still offers just 1.22% dividend yield which is lower than the industry’s average of 1.35% and the S&P-500’s average of 1.86%. However, EOG Resources has reported superior dividend growth in the last few years. The company has certainly come a long way and it likely won’t be long before it starts giving an above-average yield. Another 30% increase in dividends in 2019 will take its yield to 1.58%, which exceeds the industry’s average, and with additional hikes, EOG Resources can surpass the S&P 500 in the next few years.

Shares of EOG Resources have climbed by 7.4% this year, underperforming independent oil producers that have posted gains of 10.2% in the same period as measured by SPDR S&P Oil & Gas Exploration & Production ETF (XOP). But I believe EOG Resources stock should deliver a better performance in the future on the back of robust free cash flow growth. The company’s shares are reasonably priced at 14.4-times next year’s earnings estimates, as per data from Thomson Reuters. That valuation is in-line with the average of large-cap independent oil producers, as per my calculations. I believe this might be a good time to buy EOG stock following the year-to-date underperformance, but value hunters should wait for further weakness.

Note: Discretionary cash flows is a non-GAAP measure of operating cash flows that is used by EOG Resources. EOG Resources calculated free cash flows as discretionary cash flows minus cash CapEx minus dividend payments whereas I've used the more traditional formula in the article of calculating free cash flows as discretionary cash flows minus cash CapEx.

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.

Additional disclosure: The article is for information purposes only. It is not intended to be investment advice. The performance of EOG Resources stock is heavily influenced by movements in oil prices and other factors. Weakness in oil prices may drag EOG Resources shares. Carefully consider your investment objectives, level of experience, and risk appetite before buying the company's shares. Always perform your own research before making any investment decisions.