EOG Resources Can Face The Tough Market
Summary
- EOG Resources reported an increase in profits and strong levels of cash flows for Q4-2019, but the dip in oil prices will push its earnings and cash flows lower.
- EOG Resources, however, is a high-margin operator that can generate decent returns in a low oil price environment.
- EOG Resources has a flexible CapEx plan, allowing the company to quickly adjust its operations and spending levels in light of oil price swings.
EOG Resources (NYSE:EOG) delivered strong levels of free cash flows in the fourth quarter, but the company is facing a tough environment as oil prices plunge to less than $40 a barrel. But a low-cost asset base, its ability to capture premium oil prices, and a flexible spending plan have put EOG Resources in a better position to handle weak and volatile oil prices than most oil producers.
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Earnings Recap
EOG Resources has recently released its fourth-quarter results in which the company posted an 8.9% increase in adjusted profits to $1.35 per share. The company benefited from an 8% increase in oil production from high-return operating areas in the US to 468,900 bpd. Its total oil equivalent production climbed 11% to 850,300 boe per day led by a 12% increase in US production to 803,600 boe per day. The company's operating costs on a per-unit basis also declined which contributed to the earnings growth.
The earnings growth was impressive considering EOG Resources experienced weak levels of commodity prices in the fourth quarter. The company realized an average price of $57.13 per barrel for crude oil, $16.23 per barrel for NGL, and $2.36 per thousand cf for natural gas in the fourth quarter, which were down 4%, 31%, and 31%, respectively, on a year-over-year basis.
EOG Resources also generated strong levels of free cash flows in the fourth quarter, enough to fully fund its capital expenditures and dividends. The company generated $2.1 billion of discretionary cash flow while its total cash capital expenditures before acquisitions came in at $1.4 billion. The company ended the period with a free cash flow of $723 million ($2.1 billion-$1.4 billion). The free cash flows covered the dividend expenditures of $167.35 million, allowing the company to end the period with more than $555 million of cash flows in excess of CapEx and dividends.
Looking Ahead
The oil price environment, however, has gotten worse since the fourth quarter. The US benchmark WTI crude has tumbled from more than $60 a barrel at the start of the year to just $32 at the time of this writing. The latest plunge came after Russia shot down OPEC's proposal to cut oil production by an additional 1.5 million bpd which prompted Saudi Arabia, the OPEC's kingpin, to launch a price war. The prices were already weak due to the mounting fears related to the spread of coronavirus from China to other parts of the world which triggered a reduction in economic activity. As per some reports, the crude oil demand in China has fallen by 3 million bpd, which is roughly equivalent to a third of the country's total demand. We don't know how the virus will impact oil demand in other key markets, particularly the rest of Asia, Europe, and the US. The demand could pick up in the summer months, but I think the commodity's future is currently levered to the trajectory of the coronavirus and OPEC's actions.
The weakness in oil prices is going to push EOG Resources' profits and cash flows lower. The company posted an adjusted profit of $2.9 billion, or $4.98 per share, and free cash flows of $1.89 billion in 2019 while operating in a $57 a barrel oil price environment. Both of these key metrics will likely decline if oil prices continue to stay low.
But I think EOG Resources is better prepared than most to handle the weak oil prices. That's because EOG Resources benefits from having a massive inventory of what it calls premium wells that can generate solid returns at low oil prices. The size of its drilling inventory has also been growing for the last few years and now it has amassed enough premium wells that can power its production for around 13 years. The company has 10,500 drilling locations, with a resource potential of 10.2 billion boe, which can generate at least 30% returns at $40 oil and $2.50 natural gas. Its median well can yield more than 55% direct after-tax rate of return at $40 WTI. At $50 a barrel, this return surges to more than 80%. Therefore, I think it is reasonable to assume that the company might struggle at $30 oil, but in the oil price window of around $40 to $50 a barrel, EOG Resources' wells can generate decent returns.
EOG Resources has further solidified its position as a low-cost operator by cutting its operating costs and improving capital efficiencies by 15%. The company reduced its well costs by 7% and cash operating costs by 6% in 2019. At the same time, the company got better at producing oil as well productivity improved. Investors should expect further gains in capital efficiencies in 2020 as the company continues to push its well costs and lease operating expenses lower. The company will also likely experience service cost reduction which will help improve its cost structure.
EOG Resources produces low-cost barrels but what makes it a high-margin operator is its ability to sell its output at an attractive price. The company's marketing team has been successful in securing access to lucrative markets, such as the US Gulf Coast where oil prices are linked with the international benchmark Brent crude which typically trades at a premium over WTI. As a result, the company has been capturing an above-average crude oil and condensate price. In the fourth quarter, for instance, EOG Resources realized crude oil price of $57.14 per barrel which was higher than the peer average price of $55.33 per barrel for the same period.
The above-mentioned factors have put EOG Resources in a good position to handle weak oil prices. As indicated earlier, the company generated $1.9 billion of free cash flows last year which funded dividend payments of $588 million and debt retirement of $900 million, while operating in a low oil price environment of $57 a barrel. This clearly indicates that the company's cash flow breakeven level is well below $57 a barrel. The company has said that at $50 oil, it can generate enough cash flows to fully fund its CapEx of $6.5 billion budgeted for this year as well as the increased dividend of almost $800 million. The CapEx will drive around a 12% increase in US oil production, which I expect to be led by an increase in volumes from the Delaware Basin and the Eagle Ford regions. Here, the company will work with a total of 25 rigs (18 in Delaware and 7 in Eagle Ford) which will help in bringing 650 net wells online.
I don't expect EOG Resources to increase CapEx if the oil price environment improves considerably. In this case, the company will likely generate strong levels of free cash flows which it will use to reward shareholders by increasing dividends. The company increased dividends by 31% in 2018 and another 31% last year. If the company gets support from oil prices, then I think it will hike dividends by 30% or higher in 2020.
What makes EOG Resources resilient to this volatile oil price environment is that the company has a flexible CapEx plan. If oil stays at $40 a barrel or lower for an extended period, the company can make downward revisions to its spending plans. It can bring the spending down to as low as $4.1 billion, which is what the company requires to keep production flat. It can cut the Capex down to maintenance levels and generate around $4.9 billion in operating cash flows at $40 oil. That will show a large drop in operating cash flows of almost 40% from last year. But the cash flows will still be enough to cover all of the CapEx as well as dividends.
Even at $40 oil, EOG Resources can self-fund fund its operations from internally generated cash flows. At $30 oil, the company will likely face a cash flow deficit. But thanks to an under-levered balance sheet, I believe EOG Resources can use debt to finance the deficit without damaging its financial health. At the end of last year, the company had a debt-to-equity ratio of 24%, which is substantially lower than the large-cap peer median of 57%, as per my calculation.
Therefore, in my view, EOG Resources is well prepared to face the current weak and volatile oil price environment. Although the company's earnings and cash flows will come under pressure as oil hovers within the $30s to $40s a barrel range, it can still generate decent returns and cash flows. If oil prices improve, then EOG Resources will generate tons of excess cash which the company will return to shareholders as dividends. The company's shares have tumbled by 34% this year, but it has outperformed the industry's benchmark fund - the SPDR S&P Oil & Gas E&P ETF (XOP) - which is down 46% in the same period. The company's shares are trading 4.3x in terms of EV/EBITDA(fwd) multiple, below sector median of 5.4x, as per data from Seeking Alpha Essential. EOG Resources' stock could drop further if oil remains under pressure. But I believe it is one of the highest quality oil producers that will likely outperform in a tough market. Those investors who can stomach oil price swings should consider buying this stock on weakness.
This article was written by
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