Company

EOG Resources, explores for, develops, produces, and markets crude oil, natural gas liquids (NGLs) and natural gas primarily in major producing basins in the U.S., as well as Trinidad, China, and Oman. As of December 31, 2020, EOG's total estimated net proved reserves were 3,220 million barrels of oil equivalent (MMBoe), of which 1,514 million barrels (MMBbl) were crude oil and condensate reserves, 813 MMBbl were NGLs reserves and 5,360 billion cubic feet (Bcf), or 893 MMBoe, were natural gas reserves. At such date, approximately 98% of EOG's net proved reserves, on a crude oil equivalent basis, were in the United States (1% in Trinidad and 1% in other international areas).

Thesis

EOG Resources is one of the pioneers of the U.S. shale boom that began twenty years ago and was an early mover in some of the best-known fields including the Barnett shale gas play near Fort Worth, Texas, the Bakken of North Dakota, and the Eagle Ford shale of South Texas. EOG was also among the first of the shale producers to recognize the chronic and building oversupply of natural gas in the U.S. market in 2009 and 2010 and pivot to developing more oil and liquid shale plays. Therefore, we are not surprised that today the company is also among the leaders of the transition from the old shale model of production growth at any cost to a free cash flow centric focus that seeks to generate returns for shareholders at even moderate oil and gas prices.

EOG’s quarterly earnings emphasize management’s progress in that regard. At the beginning of 2020, EOG had outlined a $6.5 billion capital spending plan with nearly three-quarters of that sum aimed at drilling in what it calls “premium” areas including the Eagle Ford and Delaware Basin fields in Texas. Following the oil price crash in the spring, management dramatically cut its capital expenditure plan to $3.5 billion for the year and, in the third quarter of 2020, capital expenditures came in a full 23% below that reduced target. Even better, the company’s progress on cost-cutting is not just a simple matter of demanding discounts from service cost providers amid an industry-wide down-cycle; rather, management estimates that 75% of the cost reductions achieved last year are down to sustainable gains from greater efficiency and innovation in well design.

Amid what was arguably the worst commodity price downturn in history last year, EOG still managed to generate > $1.5 billion in free cash flow – more than enough to cover the company’s dividend. Quarterly dividend rate is currently 41.2 cents, equivalent to 2.3% yield at the current price. However, more important than EOG’s performance in 2020 is the company’s three-year outlook and plan management unveiled at year end. Specifically, the company previously estimated its breakeven oil price at less than $40/barrel West Texas Intermediate (WTI). However, considering recent progress on cost cutting and gains in efficiency, management now estimates a WTI price of $36/barrel in 2021 would be enough to fund the capital budget of $3.4 billion needed to maintain its production at 435,000 to 445,000 barrels-per-day, as well as pay its full regular quarterly dividend.

Management has been very clear that they have no interest in growing production in an already oversupplied global oil market. Oil prices have strongly recovered in 2021 amid optimism of a recovery in demand. However, we would note that the oil market has also seen serious support from the supply side since last spring thanks to an OPEC+ deal to cut production by a record amount, 7.7 million barrels-per-day. In effect, oil prices have risen, and the market appears balanced, but that is only due to serious support from Saudi Arabia and other OPEC countries this year. What EOG’s management indicated in the Q&A is that rising oil prices supported solely by OPEC machinations do not constitute a balanced oil market and that is not an environment that would encourage EOG to increase output. EOG’s CEO also indicated that management is not interested in putting OPEC in a situation where they feel they are losing market share to shale by cutting output. We believe that is a significant shift in sentiment. Just a few years ago, shale producers saw themselves as price-takers rather than companies with production sizable and concentrated enough to have an impact on global oil markets.

However, when oil prices do recover and the market looks balanced without OPEC’s extraordinary support, EOG Resources also offered investors a look at the sort of free cash flow it can generate. Specifically, with WTI oil at $50/barrel and natural gas around $2.50/MMBtu, EOG estimates that it could reinvest approximately 70% to 80% of its free cash flow and generate oil production growth in the 8% to 10% annualized range. At those prices, and at that level of reinvestment, EOG would generate approximately $2 billion in annual free cash flow. Roughly speaking, and based on EOG’s guidance, that implies the company would see roughly an additional $150 million in annualized cash flow per $1/barrel increase in WTI oil prices.

EOG’s management team plans to look at the global oil market to determine their spending plans. At prices down to about $36/barrel WTI, EOG can allocate maintenance capital of $3.4 billion per year to maintain constant production and its regular dividend. At prices below that, management could further reduce capital expenditures, allow output to fall while preserving cash flow. On the other hand, in a recovering oil market – rebalancing supply and demand and prices to over $50/barrel WTI – EOG can grow oil production at a double-digit pace and generate more than $2 billion in annualized free cash flow. EOG already has one of the strongest balance sheets in the sector with $3.1 billion in cash and total debt of $4.9 billion. That means EOG’s net debt to capitalization ratio is around 7.8%. EOG’s net debt to capital is the lowest of any of the sizable producers in the SPDR Oil & Gas fund including giants like ConocoPhillips, Exxon Mobil, and Chevron.

Even with plans to further reduce debt over the next few years, the company is left with significant amounts of free cash flow to be deployed with oil prices around $50/barrel, but in 2021 WTI oil prices have averaged $70/barrel. Management has indicated its priorities remain sustainable growth in its regular quarterly dividend, a payout that’s been rising at a 16% annualized pace over the past five years. 

One possibility is for EOG to declare variable dividends to return some of its free cash flow to shareholders in addition to its existing regular quarterly payout. Variable dividends would allow shareholders to benefit directly from rising cash flow during commodity price upturns while preserving capital during downturns. In fact, on May 6, 2021, following the release of the company’s first quarter earnings, EOG declared a special dividend of $1.00 per share and regular quarterly dividend of $0.4125 per share, an indicated annual total cash return to shareholders of $1.5 billion.

The key to EOG’s low cost production is what it calls premium drilling locations. The company defines premium wells as those that can earn a minimum 30% after-tax rate of return at $40/barrel oil prices and natural gas at $2.50/MMBtu. EOG estimates that it has 11,500 premium drilling locations across its shale plays including more than 6,000 well locations that can earn a 30%+ rate of return even at $30 WTI prices. That’s up from about 8,000 premium locations in February 2018.