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Martin Tillier

Martin Tillier

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A Value Stock In A Depressed Industry

The increasing popularity of ETFs over the last decade or so has changed investing in many ways. Massive index funds have resulted in greater correlation in stocks overall, and that is also true, albeit on a smaller scale, when it comes to sectors and industries. As a result, when an industry is out of favor, even companies that are outperforming get dragged down, and that can create opportunities. There is one such opportunity right now in oil and gas exploration and production (E&P).

Investors in E&P companies have had a rough year. That is clear when you consider that the SPDR Sector ETF for E&P stocks (XOP) is down just over forty percent from its 52-week high in July of last year. That is due in part to the obvious, that both crude oil and gas prices are lower than a year ago, but that doesn’t explain all the drop.

There is also a feeling amongst investors that the industry has not handled falling prices particularly well, continuing with high capital expenditure and failing to rein in other costs. Logically then, if you look for a company that is bucking that trend you have a good chance of a decent return, even if oil and gas prices remain somewhat depressed. EOG Resources (EOG) fits that description.

(Click to enlarge)

As you can see, EOG is also down significantly on the year, although it has outperformed the industry average, losing “only” around thirty percent from its July levels. In the context of an industry whose immediate future is questionable that makes sense, but if you look at the actual performance of EOG, it looks way overdone. Even as crude prices were falling out of bed during the second half of last year, EOG reported significant increases in revenue, a trend that continued with their Q1 2019 results. Related: $4.5-Trillion: The Price Tag of A Fossil Fuel-Free U.S.

(Click to enlarge)

Figure 1: EOG Revenue and EPS. Source: Nasdaq.com

That growth has entailed growing capital expenditure, which is one of the knocks on the industry mentioned above, but there are two things to note about that in EOG’s case. First, their capex increases in 2018 were in the first two quarters, when crude prices were riding high. They then cut back from those levels in the second half of the year as oil dropped (see table below), indicating they have the flexibility needed in tough markets.

(Click to enlarge)

Figure 2: Source: CSIMarket.com

Second, according to a Stifel research report released this morning, EOG’s cash return on that expenditure is running at around thirty percent, nearly twice the average for the energy sector as a whole. That same report indicates that EOG’s wells are outperforming those of their rivals in most areas on a like to like basis, which goes some way toward explaining that great return.

The analyst at Stifel, Michael Scialla, concludes from all this that EOG is undervalued, and comes up with a “buy” rating and a price target of $138, over forty-eight percent higher than the current price around $93. Nor is Scialla alone in seeing value in EOG. According to Nasdaq.com, eighteen of the twenty-three Wall Street analysts that cover the stock give it a “strong buy” rating, with two “buys”, three “holds” and no “sell” recommendations at all.

That almost unanimous verdict of those that study the actual numbers makes the big drop in EOG over the last year seem puzzling in some ways, but it does make it more likely that it is general industry weakness that has dragged the stock down more than anything else. That in turn means that, barring a complete collapse in oil prices or some other unforeseeable event, the downside to the stock will be limited. If prices continue higher, however, and especially if natural gas also bounces, it is likely that just as EOG has outperformed its competitors on the way down, it will outperform on the way up.

That combination of a limited downside and strong potential upside is what makes for a good trade, so buying EOG on the understanding that it has been dragged down by negativity around the industry rather than their own results and in anticipation of a bounce looks like a smart move.

By Martin Tillier for Oilprice.com

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