How Unloved Are Frackers? Even the Best Got Called Out
In a way, EOG brought this on itself by saying the right thing. The first of its three goals listed in Wednesday’s results deck is:
Be one of the best companies across all sectors in the S&P 500.
Sounds intuitive, perhaps, but that is actually a bold statement for a company in a sector that has underperformed the market by more than 100 percentage points over the past five years.
EOG’s formidable reputation within the E&P sector is well-earned. It has cut cash costs per barrel of oil equivalent by 17 percent since 2014, notably embracing oil-field digitalization before it became fashionable. More than half the weighting in EOG’s executive compensation goals is linked to returns and other financial metrics, as opposed to the growth-skewed model that predominates among its peers (much to their detriment). Return on capital employed last year was, by EOG’s calculation, 15 percent.
The problem is, while that might make EOG a city on a hill in shale-landia, the broader market is unmoved. Since 2015, when EOG adopted its strategy of targeting only “premium”, or high-value, wells, the stock has generated a total return of just over 5 percent. The SPDR S&P 500 ETF has returned just over 47 percent in that time. Even the iShares Treasury ETF has returned 8.3 percent.
Yes, EOG is exposed to the commodity cycle. But that just comes with the territory. And, as Mizuho Securities analyst Paul Sankey put it in his parting comment at the end of the earnings call:
… The problem does remain that the stock is not competing with the S&P in the way that you want it to.
The analyst preceding him on Q&A, Doug Leggate at Bank of America-Merrill Lynch, pointed out a critical issue:
You guys are a very large company, and at the high end of your prior target range, 25% at $60 oil, your growth in oil is 10% of global demand growth. And we know that growth isn’t rare but growth with cash returns is, So I’m just again trying to reconcile, why not go at a slower rate and step up the cash distribution?
EOG’s dividend yield is less than 1 percent. Given that the case for the prosecution against E&P stocks is that they put too much money into the ground and not enough into shareholders’ pockets, that yield would seem to be a good place to start to address the apparent mismatch between EOG’s operational excellence and its ho-hum stock performance. Just matching the S&P 500’s current yield of just under 2 percent would cost EOG roughly an extra $600 million a year in cash flow. That’s a chunk of change, but cash flow in 2018, even after existing dividends, was $1.25 billion.
Doing so would serve several purposes. First, it would tangibly support EOG’s goal of competing with the broader market. Second, it would reassure investors that free cash flow is sustainable. There is some cause for concern here. Free cash flow before dividends swung positively by $1.55 billion last year. Yet with cash cost per barrel having ticked up slightly in 2018, the increase in realized price of $9.92 per barrel of oil equivalent generated an extra $2.21 billion even before volume growth. And what oil prices giveth, they can also taketh away.
Given the oil rally so far in 2019, that fear may not be pronounced right now. But it raises another concern: overspending if prices strengthen further. A higher dividend would help here, too, signalling EOG would share more of any windfall from the oil-market gods with investors. It would also rein in production growth, which, as Leggate’s question got at, presents a headwind to oil prices in general.
Possibly, EOG is concerned about locking in a dividend that it then has to cut if oil prices fall, and that’s legitimate. But the company could combine a smaller increase with a big share buyback. After all, if the stock has gone nowhere even as EOG has been making progress for several years on its strategy, why not call the market’s bluff and buy it itself? If investors aren’t listening to what EOG is saying, then it needs to change the message.
A coda. In case any other E&P executives feel tempted to indulge in a little schadenfreude, they might consider pausing and asking themselves a question: If even EOG is taking tough questions despite turning in record results, what does that say about the current level of affection for everyone else?
Return on capital and other metrics, like after-tax rate of return, are slippery customers in the oil sector. If you have five minutes, it's worth your time checking out this Twitter thread posted in January by the anonymous @EnergyCredit1, where they go through some of the underlying numbers and issues: https://twitter.com/EnergyCredit1/status/1081593384484130816
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.
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