Depending on whom you listen to, the oil market is either getting much better or there is more pain in the forecast. While most oil companies need the former to grow their production going forward, EOG Resources (NYSE:EOG) reset its business so that it can deliver compelling growth at lower oil prices for the long term. What that makes is a great oil stock to buy -- no matter what happens to the price of crude in the future.
The premium transformation
Almost the entire oil industry spent the past two years focused on one single pursuit: survival. For many producers, that meant cutting costs to the bare bone and selling assets just to stay afloat. While EOG Resources focused a good portion of its attention on reducing costs, that pursuit was not about survival. Instead, it was about improving the drilling returns.
Through a combination of innovation and technology, EOG Resources permanently reduced well costs while at the same time enhancing its hydrocarbon recoveries. The net result is that the company developed a large and growing inventory of what it terms "premium wells," which are those it defines as generating at least a 30% direct after-tax rate of return at flat $40 oil. This inventory is a game-changer for the company and will drive its growth going forward.
With roughly 6,000 premium locations in its inventory, EOG Resources is ready to return to growth mode next year. The company currently projects that it can grow its crude production by 10% annually through 2020 at a flat $50 oil price, with that accelerating to 20% compounded annually at flat $60 oil. Furthermore, the company estimates that it will earn an average of 60% per well at $50 oil, with that return rising to more than 100% if oil averages $60 a barrel. In other words, this is very profitable growth.
What sets EOG Resources apart from its peers is the focus on drilling high-returning wells instead of just drilling wells to grow production. While its competitors talk about drilling high-return wells, that is more of a function of a prime location in the major shale plays than a centralized focus on returns-driven growth. For example, Chesapeake Energy (NYSE:CHK) plans to drive 5% to 15% annual production growth through 2020. That said, its drilling returns in the Eagle Ford shale, for example, can range anywhere from 25% to 65%, depending on how long it drills wells. What sets EOG Resources apart from Chesapeake Energy is that EOG Resources' go forward plan would eliminate the lower-return well from its plans and instead only pour its capital dollars on wells that would deliver the higher return.
By drilling only high-return wells, EOG Resources gives itself a much larger margin for error should prices collapse. For example, while its premium wells have a minimum 30% return at $40 oil, they'd still deliver an adequate 10% return at $30 oil. Meanwhile, companies like Chesapeake Energy could lose money on lower-return wells if commodity prices were to dive deeply in the future.
The case for buying EOG Resources is simple: It does not need oil prices to improve to drive growth going forward. Instead, the company has a massive inventory of high-return wells to drive not just production growth but also profit growth for years to come. That sets it apart from peers that are focused more on growing production than driving returns.