In 2020, energy investors will sharpen their focus on drilling inventory and balance sheet. Those oil producers who have a low-quality asset base or a weak balance sheet might struggle, but EOG Resources (EOG) will likely perform well this year. The company has a massive inventory of drilling locations which can generate solid returns in a weak oil price environment. EOG Resources is also in great financial health. The company has an under-levered balance sheet, which will likely get even better in 2020. I think EOG Resources is entering 2020 on solid footing and its shares could outperform this year.
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EOG Resources is one of the largest independent shale oil producers which produced 807,100 boe per day in the first nine months of 2019, primarily from the US. The company has a diversified portfolio of oil assets. It operates in four major shale oil basins in the US – the Eagle Ford, Permian Basin (mainly Delaware Basin), Rocky Mountain Area (Powder River Basin, Wyoming DJ Basin, and Bakken), and the Mid-Continent region (Woodford Oil Window). A majority of the company’s production comes from the Eagle Ford and Permian Basin.
EOG Resources has grown production this year, but like most oil producers, the company has reported a drop in profits due to the weakness in commodity prices. EOG Resources posted a 15% increase in production in the first nine months of 2019 but it reported dips in average crude oil, natural gas liquids, and natural gas prices of 14%, 42%, and 14% respectively. As a result, the company’s adjusted profits fell by 16% to $3.62 per share. The company realized an average crude oil price of $57.95 per barrel in the US in 9M-2019. But EOG Resources still generated strong levels of cash flows and ended the period with $744 million of free cash flows.
Oil prices rose substantially in recent past, with the US benchmark WTI crude climbing from $55 a barrel in late-November to above $63 earlier this month. The gains were driven in large part by OPEC and its allies who decided to deepen production cuts from early-2020, reduction in trade tensions between the US and China after two of the world’s largest economies agreed to sign a preliminary deal, and the US-Iran crisis triggered by the killing of a top Iranian general and threatened to push the entire region towards a major conflict. But oil prices cooled quickly after the threat of war and the risk of supply-side disruptions in the Middle East receded as both the US and Iran backed away from an open conflict. The WTI was at $59 a barrel at the time of this writing.
As the geopolitical tensions in the Middle East subside, the markets will once again re-focus on the US-China trade negotiations, OPEC’s future actions, and crude oil’s supply-demand fundamentals. In this environment, the energy investors will likely exercise caution and focus on buying shares of those oil producers who have a high-quality asset base, marked by a large inventory of low-cost drilling locations, and a strong balance sheet. In my view, the market will likely sharpen its concentration on inventory and balance sheet in 2020, particularly if oil prices remain in the high-$50s to low-$60s a barrel range instead of climbing to $70. In my view, EOG Resources is one of the highest quality shale oil drillers in the US.
Overall, the shale oil production growth is widely expected to slow down this year as oil producers scale back capital expenditures, leading to a reduction in drilling activity, in order to lift free cash flows and boost shareholder returns. The US Energy Information Administration has forecast a 900,000 bpd increase in US crude oil production in 2020, down from 1.3 million bpd in 2019, which was lower than 1.6 million bpd in 2020. However, several industry experts, including Pioneer Natural Resources (NYSE:PXD) CEO Scott Sheffield and the former EOG Resources CEO and the current head of Centennial Resource Development (CDEV) Mark Papa, are expecting bigger drops in production. Papa has forecast roughly 400,000 bpd increase in US oil production in 2020. This deceleration can also be attributed to the fact that shale oil producers are now facing a shortage of low-cost drilling locations that can generate high returns in a weak oil price environment.
The oil prices have been weak for five years now. In this period, virtually all exploration and production companies have concentrated on producing oil from some of their best wells, which has allowed many shale drillers to churn profits and, in some cases, free cash flows. But the oil producers are now running out of tier-1 locations, forcing some companies, such as Laredo Petroleum (LPI), to acquire additional tier-1 acreage while others have to shift to the low-return tier-2 and tier-3 properties. This could raise concerns about the ability of the E&P companies to continue growing their production over the long-term. In this environment, however, EOG Resources could stand out.
EOG Resources has amassed a massive portfolio of “premium” inventory that can generate a 30% after-tax rate of return in low commodity prices of $40 oil and $2.50 natural gas. Its undrilled premium wells are located in every major oil basin. The company owns 6,500 net undrilled premium locations in the Permian Basin (Delaware Basin), 1,900 in Eagle Ford, 1,655 in the Powder River Basin, and hundreds more in other areas. Overall, EOG Resources has 10,500 undrilled high-return drilling locations which can power the company’s production for 14 years. Furthermore, I believe the company could further expand its inventory in the future.
EOG Resources has done an impressive job of growing its premium drilling inventory through acquisitions, exploration work, and converting non-premium locations into premium wells by analyzing data and integrating it with its models to improve well performance. The company has been adding premium locations twice as fast as its drilling pace. EOG resources added 1,700 premium locations in the third quarter which was substantially higher than the 640 wells it drilled in 9M-2019. Its premium inventory has grown substantially from 8,000 locations in Feb-2018 to 9,500 in Feb-2019 to 10,500 by Nov-2019. EOG Resources, therefore, is well-positioned to continue growing its low-cost and high-margin production in the next several years.
This low-cost asset base also helps EOG Resources in generating free cash flows, even with weak oil prices. In the third quarter, for instance, when EOG Resources realized crude oil price of $56.66 a barrel, down 19% from a year earlier, it still ended the period with free cash flows of $337 million. In the current oil price environment of around $60 a barrel, and with the expected increase in oil production, the company could report even higher levels of free cash flows in the future. It has been growing its production at a strong double-digit pace and I expect the company to record mid-teens growth if oil stays within $55 to $60 a barrel. I believe EOG Resources will maintain the current drilling pace in 2020 by working with around 36 rigs and carrying most of the drilling work in the Delaware Basin and Eagle Ford regions. The free cash flows can help further strengthen the company’s financial health, which is already in good shape.
In 2020, energy investors will also likely closely monitor the financial health of oil producer, considering dozens of energy companies including Legacy Reserves (LGCY), Halcon Resources (OTCPK:HKRS), and Sanchez Energy (OTCPK:SNEC) went bankrupt last year and more companies may go under in 2020 if oil prices stay low. But EOG Resources isn’t facing any bankruptcy risks, thanks to a rock-solid balance sheet. At the end of the third quarter, the company had $5.18 billion of debt which translates into a debt-to-equity ratio of 24.5%. That leverage ratio is one of the lowest among all large-to-mid-cap oil producers and below the large-cap peer median of 55%, as per my calculation.
Investors should expect further improvement in EOG Resources’ leverage metrics as the company has been working on a $3 billion debt reduction program. The company benefits from having robust liquidity, including $1.6 billion of cash reserves. Its free cash flows can further increase the company’s liquidity and help it in repaying debt. EOG Resources has also been selling some non-core assets which can aid its debt reduction efforts.
For these reasons, I believe EOG Resources is in great shape entering 2020. The company’s shares held up well last year in a weak and volatile oil price environment. The company’s shares fell by a little less than 4%, easily outperforming the broader exploration and production space (XOP) which dropped by 11% in 2019. In my opinion, EOG Resources stock will do well in 2020, barring any unexpected dip in oil prices. The company’s shares are trading 7x EV/EBITDA (fwd) multiple, lower than the sector’s median of 7.14x. I suggest investors consider buying EOG Resources stock.
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.