Drilling in All The Right Places

(From BARRON'S), Sept. 7, 2009

While oil has rallied smartly this year after plummeting last fall, there has been no corresponding comeback for its cousin, natural gas. To the contrary, gas prices have sunk to seven-year lows as supply threatens to exceed storage capacity and overwhelms demand.

At first blush, that sounds like miserable news for EOG Resources, a Houston-based natural-gas producer spun out of Enron in 1999. But EOG's three-year effort to pump up its production of crude oil -- inpart by using the same horizontal-drilling technology that has made it one of the largest independent gas producers in the U.S. -- looks expertly timed.

The diversification could help EOG boost revenue and income, especially if, as expected, oil prices continue to rise. It also could attract more investors. EOG shares have fallen more than 30%, to below 70, from an August 2008 high. They could rally to 80, a gain of 15%, in the coming year.

EOG boasts 8,689 billion cubic-feet equivalent of energy reserves. The vast majority is natural gas, which accounts for about 80% of annual production. Management is aiming for a 50/50 North American production split by 2013 between oil and natural-gas liquids, on the one hand, and natural gas. That's a smart move, since oil likely will continue to trade at a significant premium to gas. "Over the long term, oil's run should be more consistent," says Chairman and Chief Executive Mark Papa.

The shifting emphasis is helping to prop up slowing production growth this year. EOG is looking to increase oil production by 5%, or close to 350,000 barrels a day, after several years of double-digit annual growth. In the second quarter, U.S. crude-oil production jumped by 21% and production of natural-gas liquids by 56%, helping the company beat profit estimates. Production of natural gas was flat. Oil now accounts for 35% of total revenue of about $TK billion, up from 25% three years ago.

Canaccord Adams analyst Irene Haas repeated her Buy rating on EOG following the latest quarterly report, encouraged by the company's success in increasing its "oilier" assets. "Once they pick a niche, they become one of the better players there," she says.

In addition to a greater focus on oil, EOG boasts what management calls "a powerful arsenal of gas assets," with stakes in most major North American fields. It is the leading driller in the largest producing field in the U.S., Barnett Shale, near Forth Worth, Texas, and expanded production there 50% last year. EOG's portfolio also boasts promising long-term growth plays in North Dakota's Bakken Shale and in British Columbia.

Papa has worked for EOG or its predecessors for more than 20 years, and champions a conservative growth strategy. Unlike his former Enron colleagues, he has built a pristine balance sheet and controls operating and capital costs. And, unlike many other gas executives, he strives to build production internally, eschewing pricey acquisitions. Consequently, EOG's net debt-to-capital ratio of 17% is the lowest among its large-capitalization peers, while its 20% average return on invested capital employed in the past 10 years is among the highest.

Rivals such as Chesapeake Energy (CHK) and Devon Energy (DVN) are growing faster, but EOG is extracting oil and gas from its wells more efficiently. Investor Steven Roge of Roge Partners Fund notes that EOG spends $2.60 per million cubic feet to replace reserves, compared with $5.36 for rivals.

EOG remains solidly profitable, in part because of higher oil volume and its hedging strategy. Analysts expect it to earn $682 million, or $2.63 a share, on revenue of $4.5 billion this year, compared with $1.9 billion, or $7.50 a share, on $7 billion of sales in 2008. Canaccord analyst Haas estimates free cash flow of $13.10 a share, based on oil at $60 a barrel and gas at $4.25 per million cubic feet.

EOG is fairly inexpensive at six times that estimate, in line with the group's median price-to-cash-flow ratio but below its 6.7 historical average. Haas thinks the stock deserves a multiple of at least a 6.5, or $85 a share.

In 2004, EOG was the first public company to apply horizontal drilling to extract gas from Barnett Shale. Other natural-gas drillers eventually caught up, as they will in oil production. Even so, it's good to be a leader.  

Copyright (c) 2009 Dow Jones & Company, Inc.