The Future is in Rocks!
James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As the adage goes, you cannot squeeze blood from a stone; but you can squeeze oil and natural gas from rocks. This process is made possible through hydraulic fracturing, which as of late has become a hot button issue. Hydraulic fracturing, or “fracking,” has been utilized for 60 years by the energy industry, but more recently has a played a pivotal role in accessing extremely abundant reserves in shale formations in the U.S. EOG Resources (NYSE: EOG) is a leader in identifying, acquiring, and successfully using hydraulic fracturing.
Hydraulic fracturing is a process in which water and chemical additives are pumped into a well that often extends 1,000 feet below the surface into geologic formations; that's where the pressure exceeds the strength of the shale rock, resulting in cracks that can extend several hundred feet from the well. Subsequently, a supporting agent (sand and liquid) is employed to keep the cracks open, allowing the oil/gas to rise to the surface.
EOG is one of the largest independent (non-integrated) crude and natural gas producers in the U.S. with proved reserves in the U.S., Canada, Trinidad, the United Kingdom, and China. It is a compelling growth story that is a combination of vision, operational ability, technical expertise, and most importantly high quality crude and natural gas assets that will play a role in making the U.S. energy independent.
Competitive Advantages
EOG is a first mover and fastidious cost control enforcer. While the company has begun to expand internationally, many of its domestic reserves are largely untapped, and they maintain that the U.S. has significant fields that have yet to be discovered. They are also technically proficient; EOG has been drilling wells with denser spacing, and has begun using secondary methods to get max ROI from their shale assets that by nature have low recovery rates.
One of EOG’s core competencies is vertical cost integration. In 2008, in an effort to lower costs, they opened a sand processing plant in Hood County, TX. They followed with 2 additional plants and began shipments from a wholly-owned sand mine in Wisconsin. EOG also utilizes a proprietary rail off-loading facility in St. James, LA, that supplies the recently completed Enterprise Product Pipeline. This pipeline is significant, as it connects Eagle Ford Shale in Texas with the refining operations in Houston.
Natural Gas represents a big part of the company's future, and EOG has invested accordingly. In March 2011, EOG purchased a 24.5% interest in Pacific Trail Pipelines intended to link West Canada’s Nat Gas assets to a planned Kitmat LNG terminal in British Columbia. Ownership in the Kitmat terminal is split between top LNG producers Apache (NYSE: APA) (40%), EOG (30%), and Encana (NYSE: ECA) (30%), which will allow for export of Natural Gas to Eastern emerging market countries.
Strategic Assets
EOG ended 2011 with net proved reserves of 2,054 million barrels oil equivalent (MMBOE), which breaks down to 517 million barrels of crude/condensate reserves, 228 Nat Gas liquids and 7851 billion cubic feet, or 1309 MMBOE Nat Gas reserves.
The Eagle Ford in Southern Texas, along with the Bakken Shale in North Dakota, represent EOG’s greatest crude assets, and both lie in states that have favorable regulatory policies. Between 2001-2011 EOG had 38% compounded annual growth in crude oil and condensate production, while slowing their production of Nat Gas due to lower prices. They are the largest producer in the South Texas Eagle Ford, with 572,000 net acres, the largest U.S. crude discovery net to any singular company in 40 years.
EOG can afford to be patient with their huge Nat Gas reserves. They have a presence in some of richest Nat Gas shale plays in the U.S., including the Marcellus, Haynesville, Barnett, and Horn River, which does not include the 3.6 million undeveloped acres they own in the U.S. and 749,000 acres in Canada.
EOG executives are serial forward thinkers, which is evident in their international expansion, which includes new production from the UK and Argentina. Their acreage in China’s Nat Gas-rich Sichuan Basin is particularly exciting. China realizes the potential of Nat Gas and their reserves. Westport innovations (NASDAQ: WPRT), a creator of Nat Gas engines, experienced significant growth in sales in China last quarter, and their guidance indicated that it is just the beginning of the story.
The Valuation
EOG’s superior cost management and drilling success have resulted in admirable margins and a strong balance sheet. EOG has a debt to capitalization ratio of 27%, with $280 million in cash as per fiscal ending 2011. Discretionary cash flows increased 29% YOY for the first half of 2011. Despite their focus on investment, EOG raised their annual dividend to $0.68 per share.
In 2011 EOG had net income of $1.091 billion versus 160.7 million in 2010, a 551% earnings increase, although some of that can be attributed to increases in the price of oil. The price per barrel in 2009 was $54.46, $74.29 (2010), and $92.79 in 2011. Performance is not due to just higher oil prices. EOG has increased oil production in spectacular fashion, from 55.2 million barrels in 2009 to 113.4 per year in 2011. Revenues in Q1 & Q2 2012 totaled a 64% increase over the first half of 2011. 2012 Q2 net income was 395.8 million versus 295.6 million in 2011, a 33% increase year over year, despite relatively lower oil prices.
EOG is very efficient, with over $4.2 million in revenue and over $541,000 in net income per employees. The valuation is not cheap, with a PEG ratio 1.32 (5 yr. projected) and a 20.50 P/E on next year’s earnings. However, those numbers are hardly unreasonable in light of their current growth and future prospects.
The Risks
The risks to EOG, and other exploration and production companies, include potential regulatory changes in regards to fracking, oil price sensitivity, and their ability to drill successfully. There have been select industry cases of water contamination due to poorly managed recovery wells, which has created concern for the safety of water sources. However, the process of fracking itself is several hundred feet below the water table. Regulatory control and safety is paramount, but the practice as a whole should not be discounted because of a few bad apples, especially if you consider the alternatives, many of which are more dangerous to the environment. Horizontal drilling offers the possibility to increase crude domestic oil production by 1.5 million barrels by 2015, while Nat Gas reserves are expected to yield 100-plus years of supply in Northern America.
With the economy in pain, and the world in turmoil, a practical approach is necessary. According to the American Petroleum Institute, the American Nat Gas industry supports 9 million jobs and represents 7.5% of U.S. gross domestic product. We do not have viable green energy alternatives to replace our need for oil, and due to low prices, available and lower-emissions Nat Gas makes sense as a bridge fuel.
Opportunity (in) Rocks
Despite European issues, fiscal uncertainty in the U.S., and a slowdown in China, crude demand increased in 2011. EOG estimates worldwide crude demand to increase by 1 million barrels per day per year, with total crude supply, specifically from OPEC countries, only growing marginally, providing a meaningful opportunity for pioneers in hydraulic fracturing and crude assets like EOG.
While EOG expects Nat gas prices to remain relatively low for years, that is not sustainable in perpetuity. Consider not only the push for Nat Gas to replace some Coal plants due to lower emissions, but also the gradual adoption of Nat Gas as a transportation fuel, and even as an export product. EOG is in the sweet spot to support current crude needs, and more importantly, the future of U.S. energy independence.
Hydraulic fracturing has undergone significant controversy, but responsible players improve the process and the safety, with significant upside for our country. Not only does the process access Nat Gas and Crude oil that would otherwise be unrecoverable, it is contributing to our economy and domestic security. Imagine the economic and political implications of a United States that is energy independent. It isn’t a matter of choice between green energy and fossil fuels; it is an all of the above reality, and the transformation has begun with leaders like EOG. Get in on rocks at the ground floor!
James Fantaci owns shares in WPRT & EOG. The Motley Fool owns shares of Apache and Westport Innovations. Motley Fool newsletter services recommend Westport Innovations. 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.If you have questions about this post or the Fool’s blog network, click here for information.
