EOG Resources: Delaying Investments For Better Returns
EOG Resources (NYSE:EOG) recently announced its 2015 first-quarter results. As expected, the company’s earnings were significantly impacted by lower price realizations. Its earnings per share (EPS), adjusted for one-time items, declined by almost 98% year-on-year to just $0.03. The impact of lower commodity price realization more than offset higher net production and cost reductions due to productivity improvements. [1] Going forward, EOG Resources expects its net upstream production to decline sequentially in the second and third quarters, primarily because of deferred well completions, and then start picking up pace in the fourth quarter. During the earnings conference call, the company mentioned that if oil prices (WTI) stabilize around $65 per barrel, it can restart its growth engine and clock double-digit growth in net production as soon as next year. EOG Resources also reaffirmed its gross capital expenditure target for the year and expects the figure to decline by around 40% year-on-year to $5 billion. The company stated that in view of the changed crude oil price environment, it is prioritizing the highest-return profile development plans with approximately 85% of the capital targeted at the development of its acreage in the Eagle Ford, Delaware Basin, and the Bakken shale plays. [2]
EOG Resources is an independent oil and gas exploration and production company that explores, develops, produces, and markets crude oil, natural gas liquids, and dry natural gas, from major producing basins in the U.S., Trinidad, Canada, and the U.K. A vast majority (around 94%) of the company’s total net proved reserves are located in the U.S., while the remaining ones are spread across other international markets including Trinidad, U.K., Canada, Argentina, and China. Based on the recent earnings announcement, we have revised our price estimate for EOG Resources to $100 per share, which is around 5% above its current market price.
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Delaying Investment For Better Returns
Lower oil prices result in a sharp decline in operating cash flows of upstream oil and gas companies, which reduces their ability to reinvest in production growth. For example, EOG Resources’ first-quarter cash flow from operating activities was down more than 57% year-on-year to $960.5 million. Therefore, capital expenditure (which is the biggest single cash expense item in this business and the primary driver for future production and earnings growth) plans of independent exploration and production companies largely depend upon the short to medium term outlook for global crude oil prices. During the earnings call presentation, EOG Resources reaffirmed its target to cut capital spending by 40% this year in order to maximize the long-term shareholder value and sustain its balance sheet for potential acquisition opportunities that generally arise in a commodity down cycle such as this one. Bill Thomas, the company’s Chairman and CEO, noted during the call that the current demand-supply imbalance in oil markets is not very large and benchmark oil prices should recover to more sustainable levels soon. He also stressed that it makes sense for his company to deliberately slow down production growth in the current oil price environment, as this strategy maximizes the value of its portfolio. Answering one of the analyst’s questions, Mr. Thomas stated that a $10 per barrel increase in the price of oil, increases the net present value of a typical well by about $300,000, despite a 6-month deferral in its completion.
The chart above reflects EOG Resources’ thought process behind deferring well completions and consequently production growth until oil prices recover to more sustainable levels. It basically quantifies the incremental rate of return that the company can generate by deferring a well completion in the Eagle Ford West to realize a price of $65 per barrel instead of $45. The incremental return diminishes as the deferral time increases because of the time value of money. Overall, EOG Resources believes that its completions-deferral strategy will ultimately pay off — in terms of higher after-tax rates of return (ATROR) — even if oil prices do not recover substantially for more than 2 years. However, based on the current scenario, we do not expect the waiting time for a sustainable $65 per barrel oil price (WTI) to be more than a year from now. [3]
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Notes:- EOG Resources Reports First Quarter 2015 Results and Provides Operational Update, eogresources.com [↩]
- EOG Resources 1Q 2015 Earnings Call Presentation, eogresources.com [↩]
- EOG Resources 1Q 2015 Earnings Call Transcript, seekingalpha.com [↩]