EOG Resources Continues To Be The Safe And Rewarding Shale Bet For Investors

Nov. 11, 2021 4:08 AM ETEOG Resources, Inc. (EOG)9 Comments11 Likes
Zoltan Ban profile picture
Zoltan Ban
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Summary

  • The early success of EOG in securing first-tier shale liquids acreage helped to get it past hard times for the industry. It quickly matured into a stable, relatively large company.
  • EOG, along with the entire shale industry, will be helped by the end of low natural gas prices. Natural gas production and reserves are set to become valuable assets.
  • EOG is not likely to return to a high production growth strategy. There will be moderate growth and continued solid financial results which will help sustain its increasingly generous dividend.
  • Biggest challenge of this decade will be dealing with environmentalist pressures that can potentially put pressure on financial results going forward.

Drilling Fracking Rig at Night

grandriver/E+ via Getty Images

Investment thesis: For much of the past decade, EOG Resource (NYSE:EOG) has been mostly thought of as the shale giant that matured early on, thus becoming among the first shale drillers to also focus on profitability issues, not just growth. The first indications emerged in the immediate aftermath of the 2014 oil price crash that EOG will be among the shale producers that will be left standing, even as it was becoming clear for the first time that there will be many shale insolvencies. Since then, it navigated most of the typical shale industry problems rather well, and it is now arguably the safest shale bet available if one is looking to invest in the space. There are however challenges, such as having to tackle methane and CO2 emissions from its operations, as well as an overall political and social situation that is less than favorable to the US or Western oil & gas producers.

EOG demonstrates great ability in producing healthy profit margins, paying down debt, and increasing its dividend. It is not eager to chase production growth.

For the third quarter of this year, EOG recorded an adjusted net profit of $1.3 billion, on revenues of $4.8 billion, showing a net profit margin of almost 27%. Long-term debt declined by $.6 billion, to $5.1 billion, compared with the same quarter from a year ago. Given current profits, the current long-term debt is the equivalent of five quarters worth of profits. It is not a bad situation by any means. EOG also announced a dividend of $3/share, which is an 82% increase compared with the previous dividend.

In terms of production, 237,000 b/d of oil equivalent was natural gas, which amounts to 28% of total production volumes of 844,400 b/d of oil equivalent. EOG is therefore still a mostly oil company, which continues to be perceived as a bonus in the shale patch, based on last decade's experience that investors had with shale investments. Overall production increased by 18% compared with the third quarter of last year. Production is set to more or less stagnate going forward, based on its own forecasts, with only low single-digit percentage production increases expected going forward. The jump in production compared with last year has more to do with the post-COVID crisis recovery than with actual production gains. Compared with 2019, production is up only marginally, by about 3.5%. It seems that EOG will follow the shale industry trend of focusing more on financial discipline and offering investors returns, than it will on increasing production.

There is absolutely no reason to rush into drilling more and more wells. By EOG's estimates, it is sitting on 11,500 premium drilling locations, and it is set to complete about 500 wells this year.

EOG net drilling locationsSource: EOG.

At current drilling and completion rates, it has 23 years' worth of drilling locations left. If it were to opt to hypothetically increase that completion rate to 700 wells/year, its reserve life would drop to just 16 years in that scenario. In other words, half a decade from now investors would start to worry in regards to how much longer it will be worth sticking with the stock, because that drilling inventory will be depleted to a level that will not feel very comfortable. The shale industry reality is that beyond the drilling locations that companies are currently claiming as viable, there is precious little left that can still be considered to be economical, even if oil & gas prices were to rise further from here.

Natural gas is no longer a liability for shale producers. EOG's returns should be bolstered in the future by stronger natural gas prices.

For most of the last decade, it was perceived that first-tier, mostly liquids-yielding acreage was the key to shale drillers surviving and even thriving. Natural gas prices fell to very low levels as shale drillers, mostly competing in production growth, even as they were losing money, just kept on drilling themselves and their peers towards insolvency. They did the same in regards to oil and other liquids, but given the global nature of the oil market, the effect was never as severe, which is why it was safer to be in shale liquids than it was in natural gas.

EOG was one of the lucky winners of the prime oil & liquids acreage lottery when in the early days, drillers were just starting to find out what they were sitting on, after rushing in to secure shale acreage. It was mostly anchored in Eagle Ford, where now EOG has a shorter prime drilling locations lifespan compared with its acreage in other shale plays, after many years of intense drilling of its prime acreage in that field. Its production from top counties like Karnes, mostly in the oil window is what got EOG through the tough times when by the second half of last decade shale producers started going bust.

As of right now, it is still sitting on some decent oil-producing acreage, but it also has some decent natural gas plays which should no longer be discounted as being money losers going forward. After a decade of very low natural gas prices, it looks like the market is firming up in a sustained manner. The reason why it is likely to be sustained is that it does not look like the higher prices we are seeing are stimulating a great deal of new shale drilling activity.

US natural gas rig countSource: YCharts.

As we can see from the chart, even as natural gas prices are now the highest they have been since 2014, there is no corresponding bounce in US rigs drilling for natural gas. What we are seeing currently is a partial recovery after the collapse in drilling in 2020 due to the COVID crisis. We are not yet recovered to the pre-crisis levels. Furthermore, there has been a significant decline in drilling for gas that started a year before the COVID crisis began. The levels of drilling that we are currently seeing are not even enough to keep DUC levels steady. In other words, we are working down the inventory of drilled but uncompleted wells. On the demand side, there is a growing global appetite for LNG and there are new export capacities being added in the US in that regard. There are environmental objections associated with substituting natural gas with coal, even if coal may be cheaper, so there seem to be some limits on how much natural gas demand destruction we may see as a result of higher prices. It looks therefore like natural gas prices are set to remain at elevated levels for a long time to come.

EOG's acreage portfolio includes opportunities to expand natural gas production, which will be profitable this decade.

Old perceptions tend to die hard, and currently, we may still suffer from the aftermath of last decade's decimated shale gas producers. EOG even now tends to focus its presentations on highlighting the fact that its acreage is mostly in the oil window, as is the case with its Eagle Ford play.

EOG Eagle Ford acreage mapSource: EOG.

Such efforts may be simply an attempt to acquiesce investors and some of their set perceptions that became entrenched last decade. EOG does have significant opportunities to produce more natural gas, not only from its Trinidad operations but also from its shale plays. The Delaware Basin play tends to produce a mix of liquids and gas. The Powder River Basin also has been known to produce significant volumes of natural gas. About three-quarters of EOG's remaining drilling locations are located in those areas.

EOG already working to meet environmental concerns, but it may not be enough to meet expectations. Further efforts may weigh on future financial performance.

We are just starting to come to terms with new realities just in the past few years, where we have to increasingly factor in costs related to emissions reduction efforts for most Western oil & gas producers. EOG, like many other Western World oil & gas companies, is already allocating funds to efforts meant to mitigate emissions issues. At the moment, methane is the big focus, but CO2 emissions mitigation efforts will become important as well.

EOG capital spendingSource: EOG.

As of right now, environmental projects are only taking up 2% of EOG's capital spending. That number is likely to rise dramatically going forward. As we see based on the comparison of this year compared with last year, the effort has been already doubled. It is still of little financial consequence, given the very small percentage of capital spending that is currently being allocated to such efforts. Those efforts are however likely to increase. It will involve not just methane capture, but also ways to cut overall emissions from its operations.

EOG flaring reduction sketchSource: EOG.

The sketch above illustrates how EOG is set to tackle the gas flaring issue. It involves pushing the natural gas back to the producing wells, potentially improving recovery. It remains to be seen to what extent the recovery benefits will compensate for the extra costs involved in looping the gas back to the wells. It is possible that this may in fact be a measure that might not increase net costs of oil & gas production all that much. There will be however other additional that will lead to higher production costs, given the growing political and social pressure we are seeing on the industry as a whole.

While EOG's environmental footprint mitigation efforts may rank as being perhaps the most significant cost risk in years to come and perhaps this decade, we should keep in mind that it is not a challenge that is unique to EOG. Most companies producing oil & gas in the Western hemisphere are faced with a similar problem. EOG does have one advantage in this regard, namely its relative obscurity in relation to public awareness of its very existence. The famous oil majors may find themselves in the first line of fire as public pressures for them to transition to less oil & gas and more renewable energy will be directed at them, first and foremost, since they are the most public face of the industry. Even so, EOG and its smaller peers will not be able to escape environmentalist pressures, ranging from public policy, public shaming, to ESG investment trends.

While green pressures are set to weigh on EOG's future financial performance, there are also plenty of factors that are positive, which should more than offset the negatives that emanate from EOG's efforts to conform to environmentalist expectations. Higher oil & gas prices will come with higher exploration costs because the higher price of oil & gas itself tends to push the costs up. The overall picture is nevertheless a decent one for EOG going forward. It should continue posting solid financial results going forward, which will help in sustaining its increasingly generous dividend. Those who still look for a robust growth story will be disappointed, but that does not mean that we might not see some modest but steady annual increases in oil & gas production going forward. There might also be a very gradual decline in its financial performance as the average quality of the acreage it will be drilling will decline, but I expect it will be gradual and if oil & gas prices will continue to increase, it might not even be detected in financial results. While EOG is still mostly shale, investors will feel like they are riding on an oil major stock. It will not be overly wild and exciting, but it will most likely provide investors with steady rewards in the form of dividends and some stock price appreciation over time.

This article was written by

Zoltan Ban profile picture
6.47K Followers
My name is Zoltan Ban,  I have a BA in economics. I am a personal investor with over a decade and a half of active trading experience.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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