Company Overview

EOG is an independent E&P whose operations are focused In North America. They were created in 1999 after being spun-off from its parent company, Enron. After the breakup, Enron Oil and Gas Company changed its name to EOG Resources and elected Mark Papa as Chairman and CEO of the company. With a current market cap of approximately $46E9, EOG is the largest company operating within this industry.

Market Share
EOG produced approximately during 2012 170.7 MMBoe during 2012. This accounted for approximately 8.1% of total industry production. Their revenues from production totaled $7,952MM, which was approximately 9.4% of the total market. Chart 1 shows that EOG had the fourth highest market share within the North American E&P industry. The reason their percentage of total industry revenues is higher than their percentage of total production is because their production is strongly weighted towards liquids. This increases the price of their average BOE.

Chart 1: EOG currently has the fourth largest market share in the industy
25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Apache Anadarko Talisman EOG
-market share measured as percent of total production revenue Source: Capital IQ

Areas of Operation
EOGs assets are highly focused in North America. At the end of 2012, EOGs North American produced was approximately 147MMboe, which accounted for nearly 86% of their total production. Their remaining production came from smaller holdings in Trinidad and Tobago, the UK, China and Argentina. The term, the nuts, is used in poker to describe the best possible combination of cards that could be dealt in a hand. EOGs portfolio of North American assets is effectively the nuts. They hold large positions in the three best North American plays: Williston Basin, Eagle Ford Shale and Permian Basin. Their positions in both the Bakken/Three Forks and Eagle Ford formations Table 1: Size of EOG holdings are positioned well within the sweet spots of each play. In addition, they Play Size (Acres) also hold smaller positions in the Barnett, Marcellus, Anadarko, Bakken 600,000 Haynesville and Horn River plays. The approximate size of each position Eagle Ford 600,000 is listed in Table 1. Permian 400,000 Barnett 350,000 EOG was able to secure a large position within the Eagle Fords sweet Haynesville 450,000 spot by being one of the first movers into the play. Their annual 10-K Marcellus 170,000 states that approximately 569,000 of their total 639,000 net acres is Anadarko 125,000 located within the oil window of the play. They are currently the largest Horn River 638,000 producer in the play with a net volume of 106Mboed (75% oil and NGL) at

the end of 2012. EOGs also holds large positions in the Bakken, Three Forks and Elm Coulee plays within the Williston Basin. These two plays make up approximately 80% of EOGs total oil production. Chart 2 shows the breakdown of oil production from all of EOGs North American holdings.
Chart 2: Bakken and Eagle Ford account for most of EOG oil production Source: EOG presentation

Culture
EOGs culture is focused on finding innovative ways to increase shareholder value. They have been able to do this in several unique ways. The lack of pipeline capacity out of North Dakota in 2008 pushed EOG to start researching other viable ways to get their product to market. Instead of choosing to transport their owl by truck at a cost of $25/bbl, they decided theyd do it by rail. According to Forbes article on EOG, they had to spend approximately $100MM building a rail spur and loading terminal in order to accomplish this. They sell their oil in Louisiana which means its priced off the Louisiana Light Sweet index rather than the WTI. The significance of this is that LLS has been trading at a premium to WTI due to the bottleneck at Cushing. EOG has earned an average premium of $9.18/bbl over WTI since the railway came online at the end of 2009. Due to added pipeline capacity, this spread has shrunk to $3.52 as of the end of September 2013 (source: EIA data). Investing in railways allowed EOG to start economically mining their own fracking sand. EOG uses around 3.0MM tons sand per year in its fracking operations, according to a Forbes article. The tight oil/gas renaissance has increased the price of sand to around $350 per ton. EOG invested approximately $200MM in three sand mines and two processing plants in Wisconsin. This sand is shipped to North Dakota and Texas. This has saved EOG, on average, approximately $500,000 per well. EOG has managed to secure large amounts acreage in the best spots in North Americas best plays. This was possible for one main reason. EOG decided to switch their focus from natural gas to oil in 2007 because they feared the tremendous volumes of natural gas being produced would cause prices to

crash. This meant they had a two year head start on the competition to locate and secure acreage in the plays sweet spots. EOG has also focused heavily on optimizing completions. This is made possible by employing the use of micro-seismic technology. This has allowed EOG to develop accurate 3-d models of wells during the fracturing process and see how effective their fracs have been. In a recent earnings call, EOGs CEO, Bill Thomas, said that they had been able to increase the performance of wells by drilling shorter lateral lengths and using shorter, wider fracs. He also commented that they were adding a lot more sand to their fracing mixture. Doing this makes sure rock is evenly fractured along the length of the well (especially near the bore of the well) and the extra sand ensures the fractures dont close back up. This process has led to an increase in the IP rates as well a slower decline in all of their wells. With shorter lateral lengths they can fit more wells in a given area, increasing the total EUR for each play.

Management
In this section I will give a brief overview of EOGs management team. Mark G. Papa: Former CEO and Chairman of the Board According to EOGs website, Papa has worked at EOG and its predecessor companies for over 32 years. He served as EOGs CEO and Chairman of the Board from 1999 until his retirement earlier this year. Papas creativity and out of the box thinking have been instrumental in EOGs success. Papas belief in the viability of shale gas led to EOG being one of the first producers to capitalize on the opportunity. According to a Forbes article in July of this year, Papa switched the companys focus from natural gas to oil in 2007 because he believed the huge volumes of gas being produced would eventually cause prices to collapse. This foresight gave them a large head start over the rest of the competition in the race to acquire land in North Americas most liquid-rich plays. They were able to able to remain nearly debt free during this time because they were able fund these land acquisitions by selling off gassier holdings for top-dollar to their competitors. The Forbes article also credits Papas foresight as the reason behind EOGs move to ship crude by rail and to start mining sand for their fracturing operations. EOGs decision to build their own rail spur has allowed them to avoid the $25/bbl cost of shipping crude by truck and also allowed them to earn a premium by selling their crude in Louisiana versus Cushing. Mining their own sand saves them approximately $500,000 per well according the article. William Thomas: Current CEO and Chairman of the Board Thomas has been with EOG for over 30 years, according to the companys website. Prior to his appointment as CEO and Chairman of the Board, Thomas was senior executive vice president for exploration. Although he hasnt been CEO for very long, former CEO Mark Papa believes he is up to the job. An article in the Houston Business Journal quotes Papa as saying that Thomas exhibits EOG DNA. He believes that Thomas reflects EOGs corporate culture because of his innovativeness and dedication to making EOG an even better company that it already is.

SWOT Analysis
Strengths Large positions in North Americas best unconventional plays Strong technical skills as evidenced by their improving EUR per well and well-spacing requirement. EOGs innovativeness has allowed them to cut costs by setting up their own rail lines to ship crude out of North Dakota and mining their own fracing sand Production strongly weighted towards high valued liquids Weaknesses Large capex requirements have substantially increased their use of financial leverage. Opportunities Increasing natural gas prices would have positive effect on revenues. This would also cause previously uneconomic areas of their holdings to become positive NPV drilling opportunities. The possibility of economic drilling opportunities in intervals located below, above or adjacent to those they are currently drilling. Threats Falling oil prices would have a severe impact on EOGs operations Tighter government regulations over hydraulic fracturing could have serious impacts on EOGs future production. Conclusions Based on SWOT Analysis EOGs main competitive advantage has been their innovativeness. Their out of the box thinking has led to them being able to produce higher volumes of hydrocarbons while simultaneously lowering their production and shipping costs

Financial Analysis
Short Term Viability
Liquidity In measuring the short term viability of EOG, we first compare their cash flow from operations (CFO) to their earnings before interest and taxes (EBIT). In Chart 3 you can see a huge drop in 2009 for both their CFO and EBIT. This drop is due to the crash in oil prices during 2008. This is an illustration of the volatility in oil prices and the large impacts they can have on profitability. It appears that EBIT and CFO both moved at the same rate of change before 2009. The price crash appears to have had a much larger impact on EBIT than on CFO. This is due to the impairments of natural gas properties caused by the crash in natural gas prices. CFO and EBIT diverge again in 2012. This is also due to a large write-off of Canadian natural gas assets during the 4th quarter of 2012. EOG is highly leveraged towards oil producing plays and wouldnt expect any more large natural gas write-offs.

6000

Chart 3: CFO and EBIT Diverge During 2012

EBIT and CFO between 2000 and 2012

5000

4000

EBIT Cash From Operations

3000

2000

Due to Impairment
Source: Capital IQ

Even though their EBIT and net income show a decline in profitability, they were still able to grow their cash flow by a significant amount. In their 2012 10K, EOG reports their discretionary cash flow as $5,745MM for 2012. This is an increase of approximately 26% over their 2011 discretionary CF of $4,568MM. EOGs net working capital requirements have been extremely volatile over the companys history. Although no clear long term trend is visible, their NWCR has increased sharply over the last two years. Chart 4 shows that EOGs peer group also has very volatile NWCR and the same sharp rise over the last two years. EOGs NWCR was approximately $290MM compared to a peer average of $237.98MM at the end of 2012. The positive NWCR means that EOGs working capital is a use of cash rather than a source, which is normal. My only concern has to do with the sharp over the last two years, but Im unsure whether this just normal volatility or the start of a recurring trend.

$MM

1000

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Chart 4: Volatile Net Working Capital Requirements

500 400 300 200 NWCR Peer Avg. NWCR

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100 0 -100 -200 -300 Peer companies consist of NBL, APA,APC, PXD,MRO,DVN,SWN, RRC and CHK Source: Capital IQ

EOGs expected capital expenditures during 2013 are approximately $7.2B, according to their recent 10K. They believe their cap-ex in the following year is likely to exceed their cash flow. To overcome this deficit they plan to divest non-core assets for approximately $550MM. In addition they have a $2.0B revolving credit agreement that had no outstanding borrowings or letters of credit at the end of 2012.
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

EOG is currently their growing their production. This means that their cap-ex consists of two components: maintenance cap-ex and growth cap-ex. According to the S&P criteria for rating E&Ps, maintenance cap-ex is the amount of investment required to replace current production and keep the size of a companys reserve base constant. Growth cap-ex is the amount of investment required to grow a companys reserves. This means that EOG would be able to scale back their cap-ex if the need arises (like a large decline in oil prices). Although EOGs large cap-ex goals do add some liquidity risk I dont have any major concerns regarding liquidity in the near future. Their proven history of growing cash flows, large cash balance on the books

and large line of revolving credit are enough to negate the risk added by their cap-ex goals. They also have the option of scaling back on their cap-ex if need be. Solvency Moodys uses EBITDA/Interest expense because it is a pre-capex measure of cash flow. This means that it doesnt reflect the capital intensive, asset-depleting nature of E&P companies. Chart 5 shows that EOGs EBITDA/Interest Expense ratio has been exceptionally volatile in the past. This can be attributed to two main factors. EOG needed financing in order to continue developing and expanding their positions in the Eagle Ford and Bakken Formations. To do this, they issued approximately $1,650MM of debt. Oil and natural gas prices crashed during the same time this was happening. The increased levels of debt coupled with suppressed earnings from low prices and large write-downs due to impaired natural gas assets caused a tremendous drop in EOGs EBITDA/Interest ratio. Chart 5: EOG leads peers in EBITDA/Interest Expense EOGs interest ratio was approximately 26.88, which is higher than the peer EOG average of 20.91. This is the second good score (Aa) according to Moodys grading Peer Group methodology. This means EOG should be Source: Capital IQ able to cover interest expense and other fixed charges without any difficulties.
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

120 100 80 60 40 20 0

The next solvency metric I will discuss is debt to developed reserves (PDR). PDRs are an E&Ps cash generating assets. This is how lenders calculate the debt capacity that a given quantity of reserves will support and then make loans based on that amount. EOGs debt/PDR ratio is quite high as can be seen in Chart 6. At the end of 2012, EOGs D/PDR ratio was 11.78 while the peer average was only 5.91. Their D/PDR ratio has grown at a CAGR of 54.67% while the peer average has had relatively stagnant growth of only 4.24% over the same time period. This means that the level of EOGs debt is growing at a much faster rate than its developing reserves. Their need to take on debt is caused by their capex intensive development program. While I dont believe theyre in over-levered at the present, EOG needs to figure out a way to curb their appetite for debt to avoid problems in the future.

14 12 10 8 6 4 2 0

Chart 6: EOG's Debt/Proved Reserves has been increasing rapidly since 2007
EOG Peer Average

Source: Capital IQ

Closing Thoughts on Short Term Viability I dont feel that EOG has any serious liquidity or solvency issues. Although their increased use of debt is concerning, I do not yet feel that it is at the level to cause any real

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

problems. This is something management needs to watch in the future.

Long Term Growth

In this section we will look at EOGs long term growth prospects by analyzing their production growth and margins. Top Line Growth EOGs revenues have increased at a 5-year CAGR of 22% compared to an industry average of 15.46%. This outperformance can be attributed to their positioning within North Americas best plays; most notably the Bakken/Three Forks and Eagle Ford formations. This has allowed them to increase their production of higher valued liquids (Oil + NGL) at a CAGR of 37.63% while decreasing their production of natural gas at a 3-year CAGR of -3.43%. While strong production growth is definitely a good indicator of performance, it doesnt tell the whole story. The fact that E&Ps produce a nonrenewable resource means that firms are highly focused on replacing their continuously depleting reserves. This is analyzed with the reserve-replacement ratio (RRR) within the industry. The RRR is calculated by dividing all new additions in a given year by that years total production. EOG had an RRR of 2.43 at the end of 2012. The fact that this is slightly lower than the peer average 3.05 shouldnt be of any concern about EOGs growth potential. This ratio only includes proved reserves. EOG has a large portfolio of excellent plays that havent been developed yet. The R-P ratio is another commonly used metric to judge reserve life. This is calculated by dividing a companys total proved reserves by its annual production. The result is an estimate on the number of years it will take to deplete the current quantity of proved reserves. EOG has an inventory life of approximately 10.4 years, which is lower than the peer average of 11.48 years. Even though EOGs inventory life is shorter than that of their peers, their proved reserves are more valuable because they are more weighted towards liquids than the industry average. . of much higher quality than the industry averageit is of much higher quality I still feel that their revenue growth will continue to outperform the industry average into the distant future. A large portion of their portfolio remains undeveloped. is because they have a large quantity of undeveloped reserves (both proven and unproven). They have a their large to their signto grow at will continue to grow faster indicates that their revenue growth will continue to grow faster than the industry average. Factoring in EOGs significant undeveloped reserves (Proven and unproven) streyou look at EOGs undeve EOGs revenues have increased at a CAGR of 22% over the last five years. This tremendous growth has been the result of their positioning within nearly all of North Americas best plays, most notably the Bakken/Three Forks and Eagle Ford formations.
100.00% 95.00% 90.00% 85.00% 80.00% 75.00% 70.00% 65.00% 60.00% 55.00% 50.00%

Chart 7: EOG's gross margins have fallen sharply while the peer average has remained stagnate
Gross Margin Peer Average NYSE:EOG

Margins We can see that EOGs gross profit margin has declined at a CAGR of -20.1% over the last five years, see Chart 7. Growth in the peer group has stagnated. EOGs

Source: Capital IQ

declining gross margin has been due to two main factors. The first is the crash in oil and natural gas prices during 2008. This hurt revenues as well as gross margin. The other factor is an increase in the cost of sales, namely the cost of marketing. In their annual 10-K, EOG says that the marketing cost has come as a result from purchasing crude and natural gas from third-party producers at their rail facility in North Dakota.
0.3 0.25 0.2 0.15 0.1 0.05 0 -0.05 -0.1 -0.15
Chart 8: EOG's net margin moves closely with peer average, but doesnt move with as much intensity

EOG Net Margin Source: Capital IQ

EOGs net margin has moved along with their peer average in the past, see chart 8. The slight decline during 2012 was due to the impaired Canadian gas asset, as previously mentioned. The suppressed nature of both EOGs net margin as well its peers could be the result of ramping up production on their holdings. This requires a lot of capex and could be the reason why not much cash is making it all the way down the income statement.

Other metrics more geared towards E&Ps The first think would like to discuss is finding and development costs (F&D). F&D costs are equivalent to the sum of all the costs involved in locating and developing reserves to the point of production. Most analysts use the three year average of F&D in order to account for the delay between the initial outlay of capital spending and the booking of reserves. Computing F&D costs into a per-unit amount allows you to compare costs across companies and measure how efficiently they are at adding reserves. We first look at EOGs all-in F&D costs. All-in F&D costs measure the capital costs incurred from all methods of reserve growth: Acquisitions, Exploration and Development, and Improved Recoveries. Chart 9 shows that EOG has been able to keep their all-in F&D below that of their peers during the length of the period studied. This chart also shows that EOG was able to keep their organic F&D costs below their peer average as well. Organic F&D costs only measure the cost of adding reserves through exploration and improving oil recoveries. Low F&D costs increase the returns on each unit of oil or gas thats produced. This helps lowers EOGs risk by allowing them to remain profitable in a wider range of price environments. Also Notice in Chart 9 how low the spread is between EOGs all-in and organic F&D costs are. This is due to the fact they are growing reserves almost exclusively through organic methods.

The next metric I would like to discuss is the leveraged full-cycle 25 ratio (LFCR). According to -organic and all-in F&D costs (3 year rolling average) Moodys, the LFCR reflects the 20 Source: Capital IQ productivity of reinvested capital on a BOE basis. This measure 15 indicates whether a company is generating a positive return on 10 their overall production. This EOG All In F&D metric helps to highlight which Peer Average All In F&D 5 EOG Organic F&D companies are better at Peer Average Organic F&d generating cash-on-cash returns. 0 LFCR is calculated by dividing the FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 FY2012 cash margin of generated per BOE by all-in F&D costs (3 year avg.) Cash margins per BOE are calculated by subtracting operating costs, total G&A expense, and interest expense (all on a per-unit basis) from the average realized price per BOE of production. Chart 9: EOG's all-in and organic F&D costs have always remained below their peer average. Chart 10 shows that EOGs LFCR exceeded the peer average during the time period examined. The large spike in 2010 came from increasing cash margins due to the realized price per BOE growing at a much faster rate than cash costs. The sharp drop in LCFJ between 2010 Chart 10: EOG's LCFJ has been remained consistently 7 higher than its peer average. and 2011 is from increasing F&D costs increasing at a much faster 6 EOG than cash margins. EOGs 5 Average historically strong LCFJ 4 performance is evidence of their 3 ability to deploy capital that earns higher cash on cash returns than 2 their competition. 1
0
FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 FY2012

Final thoughts on Growth EOGs rate of production has continually been improving which means that their revenues have also been growing. Their ability to replace their reserves faster than the rate than they are being depleted while also maintaining low F&D costs is also a positive indicator for growth. EOGs portfolio of assets consists of large holdings in North Americas best plays. According to a recent investor presentation by EOG, they have a drilling inventory with a life of more than 15 years. This means that their overall growth rate is dependent on the rate at which they can develop these assets. This is constrained by capex requirements. As long as they have the funds necessary to reinvest back into their portfolio they should continue growing at a rate faster than that of the industry.

$/BOE

ROE Decomposition
Chart 11 shows the ROEs of both EOG and that of the industry. Its clear that while EOGs ROE has followed the industry average, there have been some large divergences. While they both measures experienced a severe drop, industry ROE started declining sooner and dropped a lot farther than EOGs. This is can be explained by differences in their net margins (Chart 8 in the previous section). EOG earned a lot larger margin during 2008 than the rest of the industry because of differences in Chart 11: EOG's ROE has tracked peer average, but there have been some divergences their asset mixes. EOG started divesting EOG gassier plays several years prior to the 2008 Average crash in natural gas prices. This meant that EOG wasnt as affected by the large writedowns of natural gas reserves. A much smaller divergence occurred at the end of 2012. Industry ROE slightly increased while EOGs decreased. This is due to the previously mentioned write-down of a Canadian natural gas asset that occurred during the last quarter of 2012. This reduced EOGs net margin, which decreased their ROE.

0.35 0.3 0.25 0.2 0.15 0.1 0.05 0 -0.05 -0.1

Source: Capital IQ

2000200120022003200420052006200720082009201020112012

Chart 11 also shows that the ROEs of both EOG and the industry have been depressed since 2008. I think a lot of this has to do with the capital intensity of the industry. Net margin is further down the income statement then capex. Since most E&Ps are ramping up their production, capex has increased by a significant amount. This could be lowering net margin more than usual.

Final thoughts on EOG

I dont have any major concerns regarding EOGs short term viability because they have no real liquidity or solvency issues. They should be able to increase their production at a rate faster than that of their peers due to the quality of their portfolio. The size of their holdings should also allow them more drilling opportunities than their peers. For these two reasons, I believe that EOGs revenues should continue to grow faster than that of their peers.

Is EOG a Possible Takeover Candidate?

I feel that decreasing organic growth opportunities will force consolidation within the industry as it has in the past. As discussed in my analysis of the E&P industry, I feel this consolidation should occur within the next few years. Because of this, I feel that any discussion on EOGs future must also cover their potential as a possible takeover candidate.

Analysts at Alliance Bernstein believe EOG is a strong candidate for acquisition by one of the supermajors for many reasons. The acquirers of EOG would be gaining one the best technical and logistics teams in the industry. EOGs technical and logistic capabilities have been previously discussed in the section covering their company culture. The primary reason EOG is a likely candidate for acquisition is their huge portfolio of high quality unconventional resources. Their asset base consists of large positions in North Americas four best plays: the Eagle Ford Shale, the Bakken/Three Forks formation, the liquids rich area of the Barnett shale and the Permian Basin. The faster these plays can be developed, the more value they have (assuming the returns on these wells is greater than the companys cost of capital (not destroying value)). This means that an acquirer with greater capex capabilities than EOG could add significant value by developing these positions at a faster rate than EOG.