2 Compelling Reasons Why the EOG Resources Gravy Train Will Keep Chugging

With strong industry catalysts and distinct competitive advantages, EOG Resources' spirited rally is not going to slow anytime soon.

Jun 14, 2014 at 2:06PM

Watch out! The EOG Resources (NYSE:EOG) gravy train is rolling through. This oil producer's 186% stock spike since 2009 has been a testimonial to the transformative force that the U.S. shale revolution has had on the market. In contrast, integrated oil majors, which were slow to cash in on the shale boom, have not performed remotely as well over the same five-year period. For example, ExxonMobil (NYSE:XOM)shares have risen about 36% in that time.

While EOG Resources has outperformed the industry and the broader stock market, speculation that it is trending toward flatter growth in the years ahead cannot be ruled out entirely. Stocks are inherently wired to decline after years of successive gains, especially when the gains are as immense as those of EOG Resources.

EOG Resources, however, still has more upside potential. There are two compelling reasons why investors should hold on to this stock, not only for near-term capital gains, but for more solid long-term growth.

Reason No. 1: It's time for producers to eat
In Africa, where I come from, there is a popular saying among the political class that "it is time for us to eat," which is used to justify politicians' and constituents' claims to a bigger piece of the national pie -- jobs, infrastructure, resource allocation, etc.

There is a similar arrangement of sorts in the U.S. oil and gas sector. In the years following the nation's shale boom, fortunes have largely been tilted in favor of refiners, with producers getting the shorter end of the stick. Relatively high volumes of crude oil output have allowed refiners to access their feedstock at deflated prices, lowering their costs and improving their margins. Meanwhile, the declines in price levels have compelled producers to cut back on costs and/or face slower profitability.

Now, however, the roles appear to have shifted, and top producer EOG Resources is in a position to gain.

Projections from one study by the Energy Information Administration point toward years of relatively leaner production volumes. The chart below offers greater clarity.

Production Growth

 Source: EIA.

The overall expectation is that production will slow after 2018, suggesting that the shale boom, which has largely been responsible for the production uptick in the recent past, is slowing. Although projections are in essence speculation backed by informed conviction, they become increasingly believable if they are shared by more than one party. EOG Resources management, too, is convinced that there will be no other North American shale oil plays with quality comparable to the Eagle Ford or Bakken, adding that production will steadily decelerate going forward.

Lower production will mean that supply will be limited for refiners, compelling them to pay a premium for domestic crude oil. This means that refiners will essentially pass on the profitability baton to producers, such as EOG Resources, which will thereafter enjoy "their turn to eat" after years of slowed profitability due to suppressed crude oil prices in the U.S.

Reason No. 2: Reassuring capital structure
Ambitious shale exploration plans by many upstarts looking to capitalize on the boom have led to relatively high interest payouts, squeezing profit margins and slowing growth. A recent Bloomberg survey of about 61 energy companies found that more than a dozen of them have interest payments of more than 10% of their total sales. This distress, according to Fool energy contributor Tyler Crowe, could prompt Big Oil to swoop in and acquire these start-ups.

While most Big Oil players are currently committed to shareholder returns and not bombastic growth, their continually slowing profitability suggests they will need higher return on capital in order to sustain continued buybacks and dividends. As shown below, higher exposure to shale plays suggests higher gains in return on capital going forward, heightening the probability that Big Oil could start looking to smaller shale players.

Return On Capital Eog

EOG Resources, which largely focuses on shale plays, posted the highest gain in return on capital between 2012 and 2013. Moreover, its return on capital now closely rivals that of Big Oil players, suggesting this will be the prevailing trend for shale players going forward.

Unlike the many upstarts with disproportionate amounts of debt, EOG Resources' capital structure signals a healthy debt and equity mix. It will survive the distress that other smaller players with higher debt are facing.

Eog Capital Structure

Source: Morningstar

As seen in the above chart, EOG Resources' capital structure signals low debt levels. In fact, it has reduced the percentage of overall capital that is debt, though marginally, from a historical standpoint. Moreover, the company has no preferred debt and relatively low dividend payouts of $0.50 a share that yield only 0.5%. While this is not exactly great news for income investors, it is good for the company because a lesser portion of its revenue goes to financing its capital.

Going forward, EOG will continue banking on the overwhelming demand for its stock and raise capital through the equity markets. This will enable the company to support continued drilling and production, producing higher sales while at the same time limiting interest and dividend payouts. Assuming this is the case, EOG Resources should grow profit at a higher pace than other players with less favorable capital structures, enabling it to reinvest even further and giving investors a chance to earn more gains on their capital.

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Lennox Yieke has no position in any stocks mentioned. The Motley Fool owns shares of EOG Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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