EOG Resources (IL/A): Confidence in sustainability of growth and returns advantage key to further relative upside
Goldman Sachs July 27, 2005
We believe EOG Resources has earned its strong stock price performance and much improved valuation relative to the E&P sector, as the company is now delivering top quartile growth and returns and shows no signs of slowing down. In addition to executing on Barnett Shale upside, we believe greater market confidence in EOG's ability to maintain a mid-single-digit annual growth rate in North America ex-Barnett gas production through at least 2010 is the key to further upward revaluation relative to its peers. On an absolute basis we expect the E&P sector overall to perform well; we have a our bullish commodity outlook and Attractive coverage view. We see it as a very close call between the "growthy" E&Ps EnCana (OP/A), XTO Energy (OP/A), and EOG. Our In-Line rating on EOG merely reflects the fact that we missed the opportunity on previous pull-backs to have a higher rating.
WITH LEADING GROWTH, RETURNS, AND NOW VALUATION, SUSTAINABILITY THE KEY TO FURTHER UPSIDE
With 19.5% year-over-year organic volume growth in the first half of 2005 and top quartile returns on capital employed (ROCE), EOG's large-cap E&P sector-leading stock price performance and premium valuation is not a surprise. The question for investors is whether all the good news is priced in relative to its peers. On an absolute basis (and relative to the broader stock market), we expect most of the large-cap E&P sector including EOG to continue to perform well in light of our bullish commodity outlook; hence our Attractive coverage view. For EOG to extend its performance and valuation advantage relative to its peers, we believe it will need to demonstrate that it can extend its growth and returns advantage beyond 2007 potentially through 2010, as we increasingly believe is possible. We have raised our estimate of EOG's 2005-2010 volume CAGR to a top quartile 9% from 7% and we continue to forecast leading ROCE.
From a valuation standpoint, EOG is currently trading at 6.6X 2006E EV/DACF, which is in line with other "growthy" E&Ps like EnCana (6.0X) and XTO Energy (6.5X) and at a premium to the 5.5X where the large-cap E&P sector on average is trading. In our view all three "growthy" large-cap E&Ps face the same issue: the market must gain further confidence in the sustainability of their advantaged growth and returns in order to re-rate their shares even higher relative to the sector. We believe this is possible if not likely for all three. Our Outperform rating on EnCana and XTO Energy and In-Line rating on EOG does not imply that we have greater confidence in the other two versus EOG but is instead a reflection of the timing of when we upgraded the other two, which came after periods of relative weakness. Our increased confidence in EOG's outlook unfortunately for us came after a period of sharp share price outperformance and our style is to not chase stocks after a strong run. The inherent volatility of the sector, we think, will provide more compelling relative buying opportunities from time to time, even for stocks with a favorable fundamental outlook like EOG.
KEY COMPANY-SPECIFIC CATALYSTS
(1) Confidence in sustainability of North America ex-Barnett gas production growth rate. In our view, the primary driver of EOG's significant re-rating over the past year relative to the sector (i.e., above and beyond the benefit of higher commodity prices that impacts most oil and gas companies) has been the market's excitement over the substantial gas resource potential on EOG acreage in the Barnett Shale play of Texas. While additional upside exists in the Barnett (discussed below), we believe a further re-rating will likely also require greater market confidence in the sustainability of a mid-single-digit growth rate in North America gas excluding the Barnett Shale. Gas production in North America ex-Barnett grew 4% in 2004 and we estimate will grow around 5.5% in both 2005 and 2006, and 5% per year from 2007-2010. Prior to 2004, North America gas volumes had not grown meaningfully since the 1990s. Our higher assumed growth rate is driven by the dramatically improved results EOG is showing in a variety of different regions, including the US Rockies, East Texas, the Mid-Continent, and West Texas. While EOG conservatively does not assume growth from "big target" exploration discoveries in its growth forecasts, we view the meaningful upside such plays provide as representing a measure of conservatism in our growth projections.
(2) Barnett Shale: Execution of drilling program moving to forefront. We believe the market increasingly recognizes the significant natural gas resource potential that exists on EOG's near-500,000 acre position in what is referred to as the "non-core" area of the Barnett Shale. While some uncertainty exists as to the commercial viability of some "higher risk" counties toward the western fringes of the play, we see the Barnett for EOG moving more to an "execution" phase from an "exploration" phase in terms of driving EOG shares over the next year or two. We estimate that Barnett production from EOG acreage could rise from negligible volumes in 2004 to in excess of 400 MMcf/d in the 2009-2010 time frame. We believe the market gaining confidence that EOG has both the rigs and pipeline takeaway capacity to cost-effectively meet its Barnett Shale production potential will be important to EOG's share price.
(3) "Big target" exploration program. EOG will be drilling a number of higher-risk/higher potential opportunities over the next 6-12 months. Offshore Trinidad, the Deep Ibis prospect (up to 2 Tcfe of resource potential) and the deep Kiskadee prospect (up to 500 Bcfe of resource potential) are expected to spud in 4Q 2005, with news likely in early 2006. Additional meaningful targets exist onshore North America, in particular in the Uinta Basin and onshore Texas. We believe exploration success on any of EOG's larger exploration-oriented targets could drive the shares higher, as it would enhance confidence in the sustainability of its growth and returns advantage.
2Q 2005 RESULTS BETTER THAN EXPECTED
EOG reported 2Q 2005 EPS of $1.02 (no special items), well ahead of the $0.89 First Call consensus projection and our $0.95 estimate. Most noteworthy was exceptionally strong E&P production growth of 20% (year over year) in 2Q 2005 and 19% y-o-y in 1H 2005. We now expect full-year growth of 16% in 2005 versus 15% before. EOG is on track to generate top-quartile ROCE in 2005 relative to other E&P companies.
UPDATING ESTIMATES
We are raising our 2005 EPS estimate to $4.06 from $3.97 to reflect the positive 2Q variance as well as a slight increase to our 3Q forecast to $1.05 ($1.03 before). 4Q 2005E EPS remains unchanged at $1.14. We are raising our 2006-2010 EPS expectations to primarily reflect our increased volume forecasts. We now project $4.70 ($4.60 before) for 2006E, $2.25 ($2.15 before) for 2007 normalized, $2.55 ($2.35 before) for 2008N, $2.82 ($2.52 before) for 2009N, and $3.07 ($2.71 before) for 2010N. Exhibit 1 shows an updated summary model for EOG.
I, Arjun Murti, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. |
