Why EOG Resources Is a Buy Amidst Oil Carnage

By Sean O'ReillyFool.com

The 50% drop in oil prices has been all the financial pundits have been able to talk about over the better part of the last year. I have no desire to discuss what financial pundits, or OPEC oil ministers for that matter, believe oil prices might do tomorrow. That is a fool's errand (and not the good kind). Successful long-term investing requires focusing on what you can control and, in this case, it seems like following the age old advice of the world's greatest investor is the best way to take advantage of the current turmoil in the energy markets.

For investors willing to step up to the plate and sift through the devastation within the oil sector, Mr. Buffett tells us just what to look for. While there's no such thing as a brand name in a commodity like oil, what we can do is find the low cost producer. As we shall soon see, that company is EOG Resources (NYSE: EOG).

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Location, location, locationThe first major cost advantage EOG Resources has is thanks to the location of its reserves. Over 60% of EOG's FY 2014 production came from the Eagle Ford Shale of Southern Texas. This area is ideally situated to deliver crude oil to some of the largest oil refineries in the U.S.,thus saving the company a bundle on transportation costs. Many of the company's shale oil competitors, such as Continental Resources (NYSE: CLR) and Whiting Petroleum (NYSE: WLL), operate in the Bakken Shale region of North Dakota, the Marcellus Shale located in the Appalachian Mountains, in addition to having a modest presence in the Eagle Ford. While many have some presence there, none can matchEOG's status as the largest operator in the Eagle Ford where it possesses some 632,000 net acres of oil leases.

Source: geology.com

The company received a large chunk of this acreage when it was spun off from the infamous Enron in 1999 (hence the name EOG, which stands for Enron Oil & Gas). No one knew it then, but this unloved component of the Enron empire would one day own some of the most ideally located shale-oil acreage on the planet. Southern Texas also happens to be considerably easier to operate an oil well in, especially when compared to, say, those tropical North Dakota winters.

The low-cost shale producerNot only is the company blessed with a large amount of perfectly situated oil reserves, but EOG is making the most of those assets. While it could be said that EOG competes on a global basis with every E&P company, large or small, comparing the operations of EOG to competitors that don't operate in the Eagle Ford (such as Continental Resources) wouldn't paint an accurate picture of just how effective EOG's management is. Fortunately for us, there are two competitors that operate on a similar scale and have comparable geographic profiles to EOG:Devon Energy Corp. (NYSE: DVN)andChesapeake Energy Corp. (NYSE: CHK). While there are a number of important operating metrics to consider, let's first take a look at these three companies' ability to both generate free cash flow for investors while at the same time grow total production:

Estimated Free Cash Flow* (in billions):

*Cash flow estimates calculated by subtracting "capital expenditures" from "cash from operations". Source: S&P Capital IQ Data

Total Production (MMBoe):

Source: Corporate SEC Filings.

Let that sink in for a second. Not only has EOG drastically outperformed the competition in production growth, but it has done so while maintaining the healthiest cash flow profile of the three. The ability to grow a business, while at the same time generate excess cash flows that can be distributed to owners or reinvested in the business is the sign of a truly great operation.

Granted, an exact comparison between the three is tricky. The vast majority of EOG's total production comes from actual crude oil, whereas Chesapeake and Devon derive about half their revenues from the production of natural gas. However, this is mediated somewhat by converting all types of production (Crude oil, Natural Gas, LNG) into barrels of oil equivalent.

Natural gas wells have slighty different cost structures and typically longer lives than your average shale well, but since the advent of the shale revolution both Devon and Chesapeake have not only focused more and more on oil production but they have done so in EOG's backyard. Chesapeake produced 31.3 million barrels of oil in FY 2012 while last year it produced 42.3 million barrels, all while its natural gas production stayed flat. Devon derived 48% of its revenues from actual oil production last year, up from 40% in 2012.

Despite the increasing focus on shale oil production by Chesapeake and Devon, EOG's competitive position becomes all the more apparent when we take a look at a few more key operating metrics:

Fiscal Year 2014:

Source: S&P Capital IQ Data*Reserve Replacement Costs according to Ernst & Young U.S. Oil & Gas Reserves Study 2014**Boe: Barrels of Oil Equivalent

By vertically integrating its operations through ownership of rail cars, internally producing its own fracking sand, and engaging in its own water recycling, all while focusing on extraction technology advancements, EOG has created an extremely lean and efficient operation. One that not only extracts oil more cheaply than the competition but one that is able to replace oil reserves for a lower cost per barrel as well.

EOG's status as the low cost shale-oil operator is further cemented in the company's third-quarter conference call late last year where its CEO, Bill Thomas, noted that the company expects a direct after-tax rate of return of 10% in Texas' Eagle Ford Shale formation should prices crash to a yet-unreached $40 per barrel. Its returns at $80 a barrel, should oil prices recover modestly? Over 100%!

Lastly, it is worth noting that recently, in aninvestor presentation dated March 17, 2015, the company stated that thanks to its industry-beating efficiency and advanced methods of extraction the company is currently experiencing higher internal rates of return at crude prices of $65 per barrel oil than it did in FY 2012 at $95 per barrel. This is particularly important if oil prices stay low for an extended period. Should such a scenario play out the ability to extract as much oil as possible from each and every single well becomes increasingly important.

ValuationEOG's shares are not absurdly "cheap" as one might expect given the recent carnage in the oil markets. That being said, the modest pullback that its share price has experienced represents a prime opportunity to buy and hold a high quality company with a superior growth profile (even when compared to a wide array of oil-industry players) for years to come:

Source: S&P Capital IQ Estimates

I don't put a ton of faith in Wall Street earnings estimates, and neither should you. However, given EOG's track record as the best-of-breed operator, it's probably safe to give EOG's growth potential the benefit of the doubt.

Final thoughtsNo one really knows what oil prices are going to do tomorrow or even next year. This fact is just what makes EOG Resources such an attractive investment prospect: as the most efficient operator in the shale industry it will almost certainly survive the current downturn only to emerge on the other side stronger than ever. We don't know what the future holds, but there is one thing we can do as Foolish investors: follow the Oracle of Omaha's advice and buy a high-quality business with a strong competitive advantage such as EOG Resources.

The article Why EOG Resources Is a Buy Amidst Oil Carnage originally appeared on Fool.com.

Sean O'Reilly has no position in any stocks mentioned. The Motley Fool recommends American Express, Apple, Coca-Cola, and Costco Wholesale. The Motley Fool owns shares of Apple, Costco Wholesale, and EOG Resources, Inc. and has the following options: long January 2016 $37 calls on Coca-Cola and short January 2016 $37 puts on Coca-Cola. 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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