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EOG Resources (EOG) is a well-managed company that has a long history of operational excellence and has generally been ahead of the market with its strategy, pivoting to oil before gas prices crashed and now increasing gas production to capitalize on LNG export opportunities. They have a large inventory of premium acreage and are well placed, independent of the path of oil prices. While EOG appears inexpensive based on current profits, a recession or an end to the war in Ukraine would make the stock look expensive.

Figure 1: EOG Historical Production (source: EOG )

In 2016 EOG began to focus on what they refer to as premium drilling, which is acreage that offers a minimum 30% after tax rate of return with 40 USD/bbl oil and 2.5 USD/mcf natural gas. Through reinvestment, EOG has been able to grow their premium inventory by more than 3.5 times since the metric was introduced in 2016. Last year EOG doubled this hurdle rate to 60% and is now focusing exploration efforts on finding better reserves rather than increasing reserves or production. While these numbers are extremely impressive, it also points towards the unsustainability of the current situation. EOG believes they can generate 60% returns with 40 USD oil and yet expect investors to believe oil companies will remain disciplined with 120 USD oil.

EOG has a stated focus on returning capital to shareholders and their dividends have grown 28% annually since 2016. They have also committed to returning a minimum of 60% of free cash flow to shareholders. EOG does not really have much choice about returning capital to investors though, with current oil prices if they were to reinvest all cash flows into the business it would spike service costs and in time swamp the market with production. While EOG is remaining disciplined with CapEx, a number of peers are raising investment expectations.

Figure 2: EOG Hiring Trends (source: Revealera.com)

EOG has stated in the past that their longer-term production growth target is approximately 8-10% per annum. In the current environment this is acceptable, but longer term if every company tries to increase production at this rate it will likely result in an oversupply.

As one of the larger shale producers, EOG has limited scope to meaningfully increase production without negatively impacting prices. As a result, their best strategy is focus on capital efficiency while maintaining or modestly increasing production. Many larger operators are doing this by returning capital to shareholders, rather than investing to increase production.

Current prices are unlikely to be sustainable in the long-run as producers only need to invest a fraction of operating cash flow to increase production. A very different situation to the early 2010s when most companies were highly reliant on outside financing. Smaller producers could stand to benefit significantly by investing aggressively, and larger producers may be forced to cede market share to avoid a price crash.

When the costs of achieving a common goal are shared, there is a tendency for the exploitation of the great by the small. Unless the group is small or there is a coordination mechanism, rational self-interested agents will not act to achieve their common interests. There are likely too many E&P companies in North America to maintain an equilibrium at such high prices for any length of time and further consolidation in the industry is necessary before a stable equilibrium becomes likely.

Even if producers can maintain discipline, support for higher prices must also be weighed against the attitudes of the public and government. Despite struggling to stay afloat for years, the moment oil companies have started to generate reasonable profits there has been accusations of price gouging. If high prices are ongoing, there is likely to be mounting pressure to either force an increase in production or a reduction in profits.

High prices may remain for a relatively long period of time if drilling and service companies are unable to respond to increased demand. After being burnt badly in the last downturn, service companies are likely to be reluctant to increase capacity until pricing makes the business case compelling. In many cases equipment utilization already appears to be approaching 100% and companies are likely weighing the benefits of higher prices versus increased activity. Similar to the situation faced by E&P companies, larger service companies are likely to be more focused on margins while smaller service companies may be the most likely to increase capacity.

EOG has been exploring unconventional assets in North America for nearly two decades, which has allowed them to assemble a multi-basin portfolio of high-quality acreage across oil, dry gas and condensate. This portfolio continues to expand, as exemplified by the Dorado play in Texas, which EOG announced 18 months ago and now provides 21 Tcf of resource potential. This is a dry gas play across stacked zones in the Austin Chalk and Eagle Ford formations. EOG estimates their breakeven cost in the Dorado is less than 1.25 USD per Mcf and it is now contributing 140 MMcf per day. The Dorado play is positioned near the Agua Dolce Hub, providing EOG with potential access to large export markets.

Figure 3: EOG Production by Geographical Area (source: EOG )

Figure 4: EOG's Marketing Strategy (source: EOG )

In addition to a large inventory of premium drilling locations, EOG also has a track record of operational excellence which has led to continued improvements in productivity and costs. For example, EOG has an in-house downhole tools program (motors, drill bits) which can optimize for specific formations. EOG's drilling times in the Eagle Ford continue to improve, decreasing 28% in the last five years, and the average well is now drilled in less than five days.

On the completion side, EOG has increased the amount of treated lateral per day by around 10% over the last year, utilizing the super zipper technique. This process involves fracking 4 well pads, where two wells are fracked simultaneously while wireline operations are performed on the other two. EOG is now using this technique on more than half of their wells and expects to increase its use going forward. The super zipper technique has helped EOG realize savings of up to 300,000 USD per well.

EOG sources their own sand, which helps to reduce costs and should somewhat insulate them from price inflation. They are also increasing their use of reused water, which helps to reduce costs and provides an environmental benefit. In the Delaware basin approximately 90% of all their water is reused. Cost inflation is hitting EOG though, such as increased steel and fuel prices due to the war in Ukraine. Despite this they remain confident they can deliver on their volume and CapEx targets for the year.

Figure 5: EOG Operational Improvements (source: EOG )

EOG also highlights cost declines, but it is not clear how much of these "improvements" come from high-grading resources and depressed drilling and service pricing. For example, industry wide the percentage of tier-1 wells drilled relative to the total number of wells drilled in liquid plays increased from 18% in 2010 to 42% in 2019. Increased drilling outside of core areas and a normalization of service costs would likely result in a significant increase in costs.

Figure 6: EOG Cost Improvements (source: EOG )

EOG potentially still offers significant upside in the near term, particularly if geopolitical tensions rise further and global economic growth holds up. Over a longer investment horizon EOG is probably not anywhere near as cheap as it appears. Oil prices are unlikely to remain at current levels and service pricing is likely to increase substantially. Approximately 50% of EOG’s well costs for this year are secured with contracts though, which will insulate them somewhat in the short-term. This includes contracts with 90% of their drilling fleet and 60% of their frac fleet, and not all of those service contracts are set to expire at the end of this year.

EOG has a large inventory of premium wells (19 years at 2022 drilling rate) and around half of that inventory is double premium. They are also confident that they can replace double premium inventory faster than they can drill it. EOG should therefore be able to generate reasonable free cash flows going forward, even if service costs move higher and oil prices move lower.

Figure 7: EOG Premium Well Inventory (source: EOG )

EOG’s forward PE ratio is only 8.6 and their dividend yield is 2.1%, although they are likely to return significantly more capital to shareholders. These metrics make EOG look like a compelling investment opportunity, but this assumes that 40+% margins will not attract substantial investment.

Investors had a multi-year period to invest in shale producers at reasonable prices. Most overlooked this opportunity due to a mistaken belief that they were all terribly managed and incinerating capital. It should now be clear that better quality producers focused on operational excellence and low-cost reserves have sustainable businesses. The window to make compelling returns on investments in these companies is closed for now though. Oil prices are likely to remain elevated in the short term and the potential for escalating geopolitical tensions could provide further upside, but prices are unlikely to remain at current levels in the long run.

This article was written by

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.