There are opposing views on oil price bottoming out. While I am in the camp of those who believe that oil has bottomed out, there are analysts who believe that there is still more downside. The bottom line, however, is that it’s difficult to time the markets, and the best strategy is to invest gradually in stocks that offer value. With this strategy in mind, I have been looking for oil and gas stocks that are trading at attractive valuations, have sound fundamentals and have attractive long-term assets. EOG Resources (EOG, Financial) fits in all these criteria well, and this article discusses the factors to be bullish on the stock with an investment horizon of 3-5 years.
I will start with the company’s balance sheet health as EOG Resources has $6.4 billion in debt as of 2Q15. For 1H15, EOG Resources reported EBITDA of $1.8 billion and the company’s debt servicing cost was $102 million. This implies EBITDA interest coverage of 17.9 and underscores the point that the company’s debt is not a matter of concern. Further, interest coverage of 17.9 and debt to capitalization of 26.9% also implies that EOG Resources has significant room for leveraging for investments.
From a cash flow perspective, EOG Resources reported operating cash flow of $1.8 billion for 1H15 and during the same period, the company incurred capital expenditure of $2.6 billion. While the free cash flow is negative, I don’t see this as a concern considering the first point discussed. For FY15, EOG Resources has target capital expenditure of $4.8 billion (mid-range of guidance) and this implies investment of $2.2 billion in the second half of 2015. I believe the company would have negative free cash flow of $400 to $600 million for 2H15.
This is not a concern as EOG Resources had $1.4 billion in cash and $2.0 billion in undrawn credit facility as of 2Q15. Even if $500 million of facility is utilized in 2H15, EOG Resources will still have $2.9 billion in liquidity for investments in FY16. If EOG Resources generates the same level of operating cash flow in FY16 as it is likely to generate in FY15, the company will be fully funded for capital expenditure in excess of $5.0 billion. Therefore, liquidity is not a problem for the company even if the investment target remains significant.
From a long-term perspective, EOG Resources has quality assets and the company’s Bakken Resources estimates have recently been estimated at 1 billion barrels of oil equivalent. Further, the company’s top plays are generating an IRR of greater than 35% even at $50 per barrel oil. From a drilling inventory perspective, EOG Resources has 1,540 net drilling locations and this will ensure that the company’s drilling program remains robust over the next 5-10 years. A lot will depend on oil price recovery, but this article has the basis that oil will start trending higher in FY16.
In addition to a sound financial profile and quality assets at Bakken, Eagle Ford, Delaware Basin and Midland Basin Wolfcamp, EOG Resources has increased dividends to $0.67 per share in FY14 as compared to $0.38 per share in FY13. While dividend remains at $0.67 on an annualized basis in FY15, I see dividends sustaining through FY16 and potentially increasing in FY17. This is yet another reason to consider exposure to EOG Resources. Cash flow will be robust when oil trends high considering the IRR even at $50 per barrel oil. This implies meaningfully higher dividends once there is sustained recovery in the energy industry.
In conclusion, EOG Resources is a good investment at current levels and I see minimal downside risk to the stock, but significant upside potential. I am not expecting the stock to surge anytime soon, but these levels are good for gradual accumulation. The long-term fundamentals for the energy industry are robust with significant upside expected in per capita consumption of oil in emerging countries.
