EOG May Be Consolidation Candidate

EOG's optimistic valuation and high spending versus generated cash flow had previously been a concern to us. However, recent underperformance makes the valuation look more reasonable and higher commodity prices have turned the EOG model free cash positive (about $1.0 billion) in 2008.

With the shares 31% off its 52-week high, we see a more balanced risk-reward profile for EOG.

EOG is now trading at a 26% premium to its proved (1P) net asset value of $80 compared to a 16% discount for the large-cap peers and the group overall. When including upside we assign to 8.2 trillion cubic feet equivalent of unproved reserves, EOG is trading at a 31% discount to our risk-weighted (2/3P) net asset value of $145, which is now more in line with the 33% discount for the large-cap peers.

EOG is trading at 4.0 times 2009 Ebitda, which is in line with the large-caps and below the overall group at 4.9 times. On proved reserves, EOG is trading at $3.36 per thousand cubic feet equivalent on pro forma year-end reserves versus $3.48 per thousand cubic feet equivalent for the group average.

The improved spending balance and low financial leverage (13% debt-to-cap) now gives us better confidence in the sustainability of 13% to 15% per annum production growth.

We are raising our 2008/2009 earnings-per-share estimates to $10.47/$10.67 from $10.44/$10.03 to reflect second-quarter results and updated guidance (lower costs).

EOG reported an adjusted second-quarter 2008 EPS of $2.52 compared to our $2.37 estimate and the $2.37 [Thomson] First Call consensus. Relative to our estimates, the earnings beat was due to lower income taxes (by seven cents), lower exploration (by six cents), lower production costs (by five cents) and lower production taxes (by four cents) partially offset by weaker pricing (by five cents) and lower production (by two cents).

Our net asset value rises to $145 (from $138) on lower costs and additional value for the Bakken shale (125 million barrels of equivalent); however, we are reducing our target price to $116 (from $124) as it is now based on a 20% discount to net asset value (versus 10% prior), reflecting less market appreciation for unbooked reserves generally for the group.

We think EOG's dominant footprint in several key basins (i.e., Barnett and Bakken shale, Uinta basin) could make it an attractive consolidation candidate for a major oil [company] looking to expand its U.S. gas holdings.

We would highlight recent investments by Big Oil in the Haynesville and Woodford shale plays, and in the Piceance and Green River basins of the Rockies. Lastly, we see good value in natural-gas producers today. While worries on demand and production growth plague sentiment currently, the overall group reflects about $6.50-$7.00 per million British thermal units long-term gas prices; below the economic threshold of production we estimate ($8.50-$9.00 per million British thermal units).