EOG Resources (NYSE: EOG)

Key Takeaways:

• EOG Resources blew away the consensus earnings estimate of $256 million, generating second-quarter net income of $395 million.
• Management raises its estimate of 2012 oil production growth to 37 percent from 35 percent and calls for double-digit growth once again in 2013.
• Management is considering a joint venture to develop at least one of its unconventional oil plays, with the proceeds from this deal being funneled into its operations in the Bakken Shale and the Eagle Ford Shale.

In the July 6 issue of The Energy Strategist, we highlighted Growth Portfolio holding EOG Resources as our top pick on Oil’s Value Menu, citing the company’s favorable production mix, high-quality acreage in the best unconventional plays and prescient management team.

Our faith in the firm’s growth story was repaid in the subsequent month and a half, as shares of EOG Resources rallied 20 percent. The company’s impressive second-quarter results drove much of this upside: EOG Resources posted second-quarter net income of $395 million, blowing away the Bloomberg consensus estimate of $256 million.

EOG Resources’ production numbers were even more impressive, with the firm growing crude oil and condensate output by 52 percent from a year ago and its overall liquids output by 49 percent. Crude oil and condensate accounted for 53 percent of the firm’s second-quarter revenue, compared to 42 percent during the same period last year.

By design, the company extracted 7 percent less natural gas than in the second quarter of 2011. With prices for this commodity likely to remain depressed in North America, EOG Resources limited planned expenditures on natural gas drilling to only 10 percent of its total budget. The majority of this investment (roughly $750 million) will go toward drilling in the Haynesville Shale, the Horn River Basin and the Marcellus Shale in order to hold acreage by production.

Although management plans to slash spending on natural gas-focused drilling to a mere 5 percent in 2013, the company’s leaseholds in the aforementioned plays will be premier assets when the price of this commodity eventually recovers.   

In total, EOG Resources grew its second quarter production by 16.5 percent, to a record 480 million barrels of oil equivalent per day. Management now expects the firm’s oil output to surge 37 percent and its liquids production to jump by 35 percent in 2012. Meanwhile, the company’s forecast calls for overall output to increase by 9 percent. We expect EOG Resources to deliver double-digit growth in oil and liquids production once again in 2013.

In an environment where the price of natural gas and natural gas liquids could remain under pressure, EOG Resources’ oil-weighed production profile is a huge advantage.

But the company’s first-mover status in the Eagle Ford Shale and other plays, as well as the quality of its acreage, reduces its cost base and boosts internal rates of return. For example, management estimates that, after taxes and input costs, the company earns a roughly 80 percent rate of return on its average horizontal well in the Eagle Ford Shale.

Operational excellence also continues to lower EOG Resources’ cost of production. For example, the company has reduced the time it takes to drill and case a well in the Eagle Ford Shale to about 13 days, which cuts costs substantially. These improvements prompted the company to cut the number of active rigs in the field without the number of wells planned.

EOG Resources’ drilling expenses should decline even further once the firm’s sand production facility in Wisconsin expands later this year, enabling the firm to self-source this critical input. Shortages of sand for hydraulic fracturing have been a fact of life in the hottest US shale plays. Using its own sand will improve operational efficiency and lower costs by another $500,000 per well.

The company has also tackled midstream challenges in the Bakken Shale and Eagle Ford, partnering with Conservative Portfolio holding NuStar Energy LP (NYSE: NS) to develop a rail offloading terminal in St. James, La., with a maximum capacity of 100,000 barrels of oil per day. Not only will this capacity support EOG Resources’ rising production from these basins, but the company also markets its oil output based on the price of Louisiana Light Sweet crude oil–a varietal that currently commands a higher price than West Texas Intermediate. Management estimates that this arrangement boosts price realizations on its output from the Bakken Shale by about $14 per barrel.

Moreover, EOG Resources continues to refine its production methodologies in its core plays to bolster liquids recovery rates. For example, the firm has found that reducing the spacing between horizontal wells in the Bakken Shale and Eagle Ford Shale not only increased the firm’s drilling inventory substantially but also boosted output from surrounding wells.

Investors looking for upcoming catalysts for the stock should monitor the company’s enhanced oil recovery efforts in the Bakken Shale and the Eagle Ford Shale.

EOG Resources plans to boost output in its core acreage in North Dakota by pumping water into the play to increase well pressure–an enhanced recovery technique that the industry has used extensively in conventional plays. Producers in the Canadian portion of the Bakken Shale have used this strategy with success, but water-flooding has yet to be implemented south of the border. The exploration and production company will also test the efficacy of injecting gas into its Eagle Ford acreage in an effort to boost recovery rates.

During a conference call to discuss EOG Resources’ second-quarter earnings, CEO Mark Papa indicated that the firm would consider inking a joint venture to develop some of its noncore shale oil plays. Papa noted that the company would funnel the proceeds from such a deal into ramping up development and production in the oil-rich Bakken Shale and Eagle Ford Shale.

Upstream in April reported that EOG Resources entered into a joint venture with a subsidiary of Mitsubishi Corp (Tokyo: 8058) on an estimated 120,000 acres in the Tuscaloosa Marine Shale. Papa discussed this transaction at the Citi Global Energy Conference and provided substantially more color about this strategy than he has during conference calls focused on quarterly earnings:

Here was our logic on the Tuscaloosa Marine Shale. That falls under category one on this particular chart, which are kind of some of these green-field plays. And we have a fairly long list of these green-field plays where we’ve accumulated acreage. And what we’ve noticed on…our big-four plays–the Bakken, the Eagle Ford, the Permian stuff, and even the [Barnett] Combo play—is that as we look out in the one to four-year period, we feel that all of our big four oil plays are going to get bigger. And that’s really good news, but it also means that they will be consuming additional capital.

And so the going-in thought was, okay, this list of green-field plays, we would test all those with 100 percent EOG dollars. But now that we’re seeing that likely all of our big four plays are going to grow in terms of size and scope, we said we better high-grade this list of greenfield plays, and the ones we really, really have at the top of our list, let’s keep those at 100 percent and test them at 100 percent. But some of the others that the well costs are more expensive, or that perhaps they’re–[they] have an element of risk in them–let’s look at bringing a partner in on those.

And that was the situation with the Tuscaloosa Marine Shale. So what I’d say on a go-forward basis is, it’s still totally hands-off on the big-four plays. And for some of these green-field plays, there will be a mixture of joint ventures on some of them, and a mixture of 100 percent EOG effort on some of them, on a go-forward basis. And that will be a function also of, is oil $80, $100, or $60 [per barrel] in 2013?

Not only is this strategy in keeping with EOG Resources’ focus on growing oil and liquids production from its most promising and lowest-cost fields, but this approach also aligns with management’s focus on maintaining balance-sheet flexibility. The firm remains committed to maintaining a leverage ratio of no more than 30 percent, a stance that has prompted the firm to raise an estimated $1.2 billion thus far in 2012 by divesting noncore assets.

Critics often point to EOG Resources’ lack of major discoveries over the past few years. However, investors would be foolhardy to overlook the firm’s significant growth potential in its existing leasehold in the Bakken Shale, Eagle Ford Shale and the Permian Basin, positions that the company has the financial wherewithal to exploit without dilutive joint ventures.

Using these transactions to develop marginal plays limits the firm’s financial risk while preserving exposure to any success in these emerging fields.

Investors should note that EOG Resources’ management team went out of its way to warn that oil production growth would moderate in the back half of the year because the firm is ramping up drilling in the western portion of the Eagle Ford Shale, where it has a lower working interest.

One of the best-run independent exploration and production outfits in North America, EOG Resources boasts an enviable production mix and continues to execute. EOG Resources rates a buy up to $125 per share, and investors should snap up the stock whenever it slips to less than $90.

Oasis Petroleum (NYSE: OAS)

Key Takeaways:

• The small-cap exploration and production firm grew second-quarter output by 158 percent from a year ago and 15 percent sequentially.
• Oasis Petroleum raised its full-year production guidance to between 20.5 and 22.5 million barrels of oil equivalent per day from between 18 and 22 million barrels of oil equivalent per day.
• Oasis Petroleum increased its estimate of full-year capital expenditures to $1.062 from $884 million. The bulk of this money will be spent on developing the company’s leasehold.
• Management once again highlighted efforts to reduce completion costs and forecast a 10 percent decline in these expenses.
• With the company shifting to pad drilling in 2013, the company expects completion costs to decline by 5 percent to 10 percent in 2013.

Aggressive Portfolio holding Oasis Petroleum (NYSE: OAS) offers pure-play exposure to the Bakken Shale and boasts about 320,000 net acres that are prospective for Bakken Shale and the Three Forks trend, the majority of which will be held by production by year-end. Crude oil accounts for about 82 percent of the company’s reserves–a favorable mix with natural gas prices likely to remain depressed and volatile for at least the next two to three years.

Management estimates that the company has about 1,300 potential drilling locations in the Bakken Shale alone. Oasis Petroleum operates about 90 percent of these wells and has an average working interest of roughly 70 percent. As efforts to develop and prove the productivity of the Three Forks/Sanish formation progress, the firm could add another 928 low-risk drilling locations to its inventory.

Oasis Petroleum’s test wells targeting the Three Forks formation in South Cottonwood have yielded results that were on par with or superior to similar wells targeting the Bakken Shale. Test wells in the firm’s acreage in the Iron Hills region have flowed at rates equal to between 80 and 90 percent of a comparable well targeting the Bakken Shale. Management expects to report findings from tests in other areas when the firm releases third- and fourth-quarter earnings.

Plans to reduce the spacing between wells could also double the number of potential drilling sites. The company has sunk 35 new wells in the pilot area and continues to evaluate their interaction to ascertain whether upsizing the firm’s drilling inventory to eight wells (four in the Bakken Shale and four in Three Forks) per 1,280 acres. If the results of this infill drilling prove encouraging, the stock price could receive a boost.

Meanwhile, the exploration and production company’s ongoing development efforts enabled the firm to grow its second-quarter output to 20,353 barrels of oil equivalent per day, up 158 percent from a year ago and 15 percent sequentially. Management attributed this upsurge in production, which surpassed the firm’s prior guidance, to a higher average working interest in the wells completed during the quarter. These impressive results prompted the company to revise its full-year production estimate to between 20.5 and 22.5 million barrels of oil equivalent per day from between 18 and 22 million barrels of oil equivalent per day.

During Oasis Petroleum’s conference call to discuss second-quarter results, management once again highlighted how efforts to improve operational efficiency and price reductions for third-party services would enable the firm to lower its average cost per completed well by 10 percent before year-end.

Not only will the company’s in-house fracturing teams transition to a full 24-hour cycle by the end of the year, but the firm’s engineers also continue to hone its completion techniques to maximize recovery rates while reducing costs. To that end, Oasis Petroleum has cut the amount of proppant–a material that props open the hydraulic fracturing-induced cracks in the reservoir rock–in portions of the play where the pay-zone is thinner or areas that feature elevated levels of water saturation.

In particular, the company has sought to decrease the company’s use of ceramic proppant, which tends to cost more than sand and doesn’t necessarily produce superior results. Management estimates that a well with a 36-stage lateral that uses sand as a proppant costs about $0.8 million less to complete than a development than one that relies on a mix of sand and ceramic material. That being said, the firm continues to use a full load of proppant when targeting thicker formations that exhibit relatively low levels of water saturation.

In addition to using less proppant, Oasis Petroleum continues to transition to a drilling pad-based system that enables the firm to sink four wells from a single location, an approach that slashes the downtime between wells and the coast of relocating the rig from one site to the next. Oasis Petroleum plans to use this system on about 35 percent of the wells that the firm drills in 2012 and will move exclusively to pad drilling in 2013. Management expects this transition to cut completion costs by another 5 percent to 10 percent in the coming year.

We also like Oasis Petroleum’s investments in its own saltwater disposal systems, a move that should further reduce expenses in 2013. By the end of 2012, management expects about 80 percent of this water will flow through the firm’s own pipelines. At the end of the first quarter of 2013, 60 percent of this water will flow into company-operated disposal wells.

Although logistical constraints have weighed on operators’ returns in the Bakken Shale, management notes that roughly 800,000 barrels per day of takeaway capacity is in the works. This construction boom, coupled with the gradual improvement of production techniques in the Bakken Shale, bodes well for future price realizations and Oasis Petroleum’s growth.

Mergers and acquisitions activity has slowed in the upstream space–this year, much of the deal flow in the energy sector has been concentrated in the midstream segment–but Oasis Petroleum’s oil-heavy production profile and high-quality assets make it a potential takeover target.

Shares of Oasis Petroleum have appreciated by almost 20 percent since we highlighted the stock in the July 6 article, Oil’s Value Menu. We remain bullish on Oasis Petroleum’s long-term growth story and rate the stock a buy up to 38.