How Will Reduced Royalty Rates Benefit EOG Resources In 2020?

With the growing crude oil inventory levels in the U.S., EOG Resources (NYSE: EOG) and other upstream companies have slashed production by nearly 30% during the second quarter to support falling benchmark prices. Due to near-term risks associated with the slump in global energy consumption, EOG’s stock has dropped by 50% since the beginning of the year. However, the lower royalty rates will offset lease & well costs and support operating margins in 2020. Considering the positive impact of the recent reduction in royalty rates by the Bureau of Land Management, Trefis estimates EOG Resources Valuation at $56 per share, which is 25% ahead of the current market price.

Revenues to benefit from sizable hedge positions and stable benchmark prices

In 2019, EOG Resources generated $17.4 billion in total revenues with 818 MBD of total oil & gas production volume. For May and June, the company has a hedge position for 265 MBD (nearly 50% of liquids production) of crude oil at a weighted average price of $51.36 per barrel. Despite a sharp fall in benchmark prices, EOG Resources’ Revenues are expected to contract by 30% to $12 billion in 2020 supported by its sizable hedge positions until September. Per EIA’s STEO (short-term energy outlook), the WTI benchmark is expected to remain under $40 per barrel in 2020 as inventory draws are expected to offset production curtailments during the latter half of the year. Declining wellhead revenues, which account for 70% of EOG’s top line, are not only a key concern for investors but also regulators as royalty charges are determined as a percentage of production value. Per Q1 filings, the company plans to add 485 new wells to its 9,297 net productive well count in 2020, nearly 40% lower than estimated earlier.

Lowering of royalty rates to have a positive impact on margins and cash flow

Apart from well maintenance and administrative costs (Lease & Well), the company incurs production and property taxes, primarily royalty costs, as a percentage of wellhead revenues. In 2019, EOG Resources incurred $800 million of direct taxes on $11.58 billion of wellhead revenues (at an effective rate of 6.91%). Recently, the Bureau of Land Management lowered royalty rates for certain regions from the stipulated 12.5% to 5%. While the company is likely to observe sizable depreciation & impairment charges, a relaxation in royalty rates is expected to offset lease & well costs (In 2019, lease & well costs accounted for 12% of wellhead revenues).

Considering the combined effect of sizable hedge position and lower royalty rates, we estimate EOG’s stock valuation at $56 per share, which is 25% above the current market price by using an appropriate P/S (price-to-sales) multiple of 2.7

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