EOG Resources Could Be Significantly Undervalued If The OPEC Changes Its Stance
Crude oil prices have been extremely volatile of late. After falling sharply by more than 60% in a short period of slightly over six months, oil prices have risen by over 33% from their lows over the past few weeks. In hindsight, the sharp decline in oil prices makes sense because of slowing demand growth and surging tight oil production in the U.S., but the billion dollar question is, what will they do next, and how would that impact the valuation of oil companies. We currently expect oil prices (Brent) to average around $70 per barrel for this year, below the global marginal cost of production due to the current oversupply scenario, and increase gradually towards the $85 per barrel mark over the next two years, as the supply becomes tighter due to the recent cutbacks in capital spending by almost all major oil companies and the growth in demand picks up to more normalized levels. But there could be a much sharper, V-shaped recovery in global oil prices led by higher demand growth in response to lower prices and a decline in tight oil production in the U.S. Or the recent decline in oil prices could also sustain for a much longer period because of a continued slowdown in economic activity in China — the world’s second largest oil consuming nation and the key driver of demand growth over the past few years — and a rapid penetration of alternative fuels due to advancements in biofuels or fuel cell technologies. In this article, we assess the potential impact of a V-shaped recovery in oil prices on our estimate of EOG Resources’ (NYSE:EOG) valuation.
We currently have a $80/share price estimate for EOG Resources, which is around 10% below its current market price.
See Our Complete Analysis For EOG Resources
V-Shaped Recovery In Oil Prices
There could be a V-shaped recovery in global oil prices if the growth in demand for oil products picks up significantly on the back of lower oil prices and simultaneously, tight oil production in the U.S. declines because of a sharp, sustained slowdown in drilling activity. However, we believe that oil prices cannot sustain above the $100 per barrel mark for long under normal geopolitical conditions unless the Organization of Petroleum Exporting Countries (OPEC) decides to sacrifice on some of its market share for better prices. This is because oil production in the U.S. can quickly start growing again at an annual rate of around 1 million barrels per day if oil prices sustain above the $100 mark and that would once again create an oversupply scenario, which will weigh on benchmark oil prices. But if for some reason there is a change in OPEC’s stance and it takes some of its oil off of the market, that would provide an artificial lift to oil prices and EOG Resources, one of the leaders in the shale oil industry, would gain significantly from that. Apart from better price realizations, this would also improve its E&P EBITDA margins and boost production growth. Currently, the company has voluntarily slowed down its tight oil development program in the U.S. by deferring well completions to maximize asset returns. EOG Resources believes that it can sacrifice on production growth now, to generate higher returns in a more favorable commodity price environment, and a sustained V-shaped recovery in oil prices would provide just that. (See: EOG Resources Revised To $80 Per Share On Lower Oil Prices, Slower Production Growth)
We believe that in case the company’s annual average wellhead price realizations for crude oil increases to $100 per barrel by 2017, its E&P EBITDA margins could recover to around 75% and crude oil production could increase to 386 thousand barrels per day, implying a CAGR of just over 10% from 2014 levels, compared to the 40% CAGR it has achieved between 2010 and 2014. As you can see the impact of modifying these key drivers in our analysis, in this scenario, the company could be fairly valued at a price of around $110 per share, implying an upside of more than 20% from current levels. You can check out our detailed analysis of this scenario here.
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