Will EOG's New Strategy Pay off for Investors?

Jordo is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A recent interview with EOG Resources’ (NYSE: EOG) CEO Mark Papa offered some unique insights on the prospects for natural gas prices in 2013 and beyond. Papa is shifting his company’s focus away from natural gas and towards oil because the profit margins from producing North American crude oil are much larger than the margins from producing North American natural gas.

Papa expects to see depressed natural gas prices for the next three or four years, after which prices will touch an equilibrium that earns a decent profit on natural gas production for the industry. Furthermore, he believes that domestic U.S. gas production will flatten out in 2013 as the momentum from connecting already drilled natural gas wells subsides and the lower rig count begin to take effect.

EOG will drill for natural gas again in the future, but not at the price of $4/mcf to $5/mcf, which he expects to see over the next three or four years. Four years out, he expects prices to rise to $6/mcf, at which point EOG will get back in the natural gas game. Meanwhile, he thinks that in 2013, WTI oil prices will remain stable at around $90 a barrel.

EOG Finishes out 2012

At the end of 2012, energy analysts Joel South and Taylor Muckerman listed the top energy stocks of 2012. Coming in the No. 9 position was EOG. Based on their analysis, the company has been ahead of the curve in terms of innovation. In addition to raising its liquids production by the largest amount by volume among its peers since 2010, EOG has also found ingenious ways to minimize drilling costs, as well as coming up with innovative methods for selling its oil at a premium. The major cost-saving is a result of the sand mill purchase, which is expected to cut costs up to $1 million per well drilled. The premium on sales comes from being a crude-by-rail leader, which provides lots of flexibility when it comes to selling oil. The company can transport its crude from the Bakken to Cushing, Oklahoma, or St. James, Louisiana and, because of the international Brent and U.S WTI price difference, EOG was able to sell its oil at times at a $25 premium compared to other peers operating in the Bakken.

2013 Outlook

The growing emphasis on liquids is reflected in the growth of EOG’s liquids production volume. During the third quarter of 2012, crude oil and condensate production was up approximately 42.4% from the same period in 2011. This was primarily due to significant contributions from the company’s South Texas Eagle Ford, North Dakota Bakken and Three Forks, and Permian Basin Wolfcamp and Leonard plays.

Outstanding drilling results and continued modification of completion techniques across its liquids plays encouraged EOG to increase its full-year crude oil production growth target to 40% from 37%, and liquids production growth target to 38% from 35%. The company has raised its total production growth target for 2013 to 10.6% from 9%.

The company is increasing its interest in major oil and liquids rich plays, such as the South Texas Eagle Ford play and the Fort Worth Barnett Shale Combo, as well as Colorado Niobrara, Oklahoma Marmaton, West Texas WolfcampNeuquen Basin and New Mexico Leonard. This will help EOG achieve its new volume target, which is also likely to facilitate the generation of significant future cash flows. EOG continues to divest assets to concentrate on liquid rich plays and has realized around $1.2 billion in the first nine months of 2012, which is expected to climb to $1.3 billion for the full year. UBS has said that  EOG will realize an estimated $450 million for exiting the Kitimat project in which it had minimal interest in any case.

Natural Gas Producers to Avoid

I do not see any short-term growth catalyst that will help natural gas producers weighed significantly towards gas in 2013. This is going to result in low operating margins as well as significantly reduced cash flows.

Paramount Resources is heavily weighted towards natural gas and produces only 20,000 boepd (85% natural gas), However, it's enterprise value is $3.5 billion and it trades at 58 times its annualized funds from operations (FFO).

Tourmaline Oil had 2012 production at 70,000 boepd with only 9% oil and liquids. With an estimated FFO (annualized) at $300 million and an enterprise value of $5.7 billion, it trades for 19 times the annualized FFO.

Quicksilver Resources (NYSE: KWK) is swamped by a mountain of $2.2 billion in long-term debt, which is unsustainable. Quicksilver Resources’ enterprise value is $2.7 billion while the annualized FFO is only $200 million. After its latest asset disposal in South Louisiana, it has production of 53,000 boepd, which gives an annualized FFO of only $400 million. Quicksilver Resources has been losing money for three consecutive quarters, and it is also expected to show losses in Q4 2012.

Conclusion

Despite its rapid transition to oil, EOG still has considerable natural gas exposure, and more than half of production still comes from natural gas and not oil and liquids. In addition, as of year-end 2011, about 39% of the company’s net proved reserves were crude oil and condensate and natural gas liquids. The remaining 61% was natural gas. The company still has a long way to go to reduce dependence on natural gas. I need to see more concrete developments before recommending this stock to investors.  In the meantime, I am placing a “Neutral” rating on the stock.


jordobivona has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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