1

Executive Summary
Company Highlights
EOGs portfolio of assets consists of large holdings in North Americas top unconventional resource plays: the Eagle Ford Shale, the Bakken/Three Forks Formation, the liquids-rich area of the Barnett Shale, and the Permian Basin. This has been the reason why EOG has been able to organically grow their total production at a 5-year CAGR of 9.71% compared to an industry average of 9.71%. Switching their focus from gas to liquids in 2007 has led their total liquids production (Oil + NGL) to grow at a 5-year CAGR of 37.63% while their gas production has decreased at a 3-year CAGR of -3.43%. Their high quality asset base and focus on highervalued liquids have allowed them to grow their revenues at a 5-year CAGR of 22.01%, which is considerably faster than the industry average of 15.46%. EOG has significant technical and logistical capabilities. EOGs technical team has added value through the optimization of their well completion techniques. This has resulted in a higher EUR per well and also lowering well spacing requirements (higher density of wells in a given area). Their logistics teams ability to think outside of the box has allowed them to reduce costs through innovative methods. Two examples of this are shipping crude by rail from North Dakota and mining their own fracking sand. Adding rail capacity allowed EOG save the $25/bbl cost of shipping by truck and also allowed them to sell their crude at a premium to WTI. Mining their own fracking sand has allowed them to save approximately $500,000 per well by not having to buy sand at inflated market prices. Concerns over EOGs fundamentals arise due to the impairments of natural gas assets and also their high capex requirements. The main impact of these charges is a reduction in EOGs net margin and ROE. I dont feel that investors should be worried about these because EOG has been divesting natural gas assets since 2008 in an effort to focus on the production of liquids. Their capex has outsized cash flow from operations for the last few years which has led to increased levels of debt in order to fund this spending. This should also pose little concern to investors due to EOGs strong CFO that can be used to cover the interest expense.

Valuation
To estimate EOGs intrinsic value I used their WACC to discount their projected FCFF. This resulted in EOG having an estimated value of $179.95 per share. This suggests that EOG might be slightly undervalued at their current share price of $169.12. EOGs was compared to its peers using a several multiples to see if they were relatively cheap or relatively expensive. The results of this analysis are mixed. EOG is more expensive than its peers based on comparisons of their P/E and EV/EBITDA ratios. EOG is cheaper than its peers when compared on both price per flowing barrel and price per flowing barrel of liquids. The results of an analysis of EOGs technicals are also mixed. Analyzing EOGs 50, 100, and 200day moving averages suggests slowing momentum. EOGs 50-day MA is fixing to cross their

2 100-day MA which is a bearish indicator. In contrast, EOGs RSI indicator is showing that EOGs momentum is increasing which is a bullish indicator.

Recommendation-HOLD
Even though I feel EOG is a really great company, I dont feel like its that good of a stock right now. I dont think the 6% discount of market price to intrinsic value is enough to warrant a buy recommendation. There is just too much variability surrounding EOGs estimate of intrinsic value. The contradicting technical indicators and the mixed results of my relative valuation also support the hold recommendation. In order for me to change recommendation to a buy or sell I would need to see stronger evidence that EOG is actually mispriced. The difference between EOGs market price and intrinsic value would have to be upwards of 25-30%. The results of my relative valuation would also have to support my intrinsic valuation.

Possible Future Catalysts for Divergences from Intrinsic Value

When the industry starts to consolidate in the future, EOG is a strong candidate for acquisition by one of the supermajors. The desirability of EOGs assets should mean that investors would receive a significant premium over the market value of EOGs shares. News of an acquisition could cause EOGs share price to diverge from its intrinsic value enough to make a buy or sell recommendation. Increased regulation on hydraulic fracturing could have a significant impact on EOGs operations. The market may over (under)estimate the impact of these regulations on EOGs value.

Table of Contents
INDUSTRY ANALYSIS .............................................................................................................................................. 4 INDUSTRY DEFINITION .....................................................................................................................................................4 KEY MACRO FACTORS .....................................................................................................................................................4 INDUSTRY TRENDS ..........................................................................................................................................................7 WHAT DO WE DO NOW?................................................................................................................................................31 COMPANY ANALYSIS ........................................................................................................................................... 35 COMPANY OVERVIEW ...................................................................................................................................................35 FINANCIAL ANALYSIS .....................................................................................................................................................39 FINAL THOUGHTS ON EOG .............................................................................................................................................44 INTRINSIC VALUATION ......................................................................................................................................... 45 DISCOUNT RATE...........................................................................................................................................................45 WACC AND COST OF EQUITY .........................................................................................................................................51 VALUING EOG USING FCFF ...........................................................................................................................................51 CONCLUSIONS REGARDING EOGS INTRINSIC VALUE ...........................................................................................................54 RELATIVE VALUATION .......................................................................................................................................... 55 PRICE TO EARNINGS RATIO.............................................................................................................................................55 EV/EBITDA ...............................................................................................................................................................56 EV/BOEPD ................................................................................................................................................................57 TARGET P/E ................................................................................................................................................................57 FINAL THOUGHTS ON RELATIVE VALUATION ......................................................................................................................58 TECHNICAL ANALYSIS ........................................................................................................................................... 58 MOVING AVERAGES .....................................................................................................................................................59 RSI............................................................................................................................................................................59 FINAL THOUGHTS ON EOGS TECHNICALS .........................................................................................................................59 REFERENCES......................................................................................................................................................... 60 RESEARCH REPORTS ......................................................................................................................................................60 BOOKS .......................................................................................................................................................................60 WEBSITES ...................................................................................................................................................................60 DATA .........................................................................................................................................................................60

Industry Analysis
Industry Definition
The industry being analyzed is the North American Exploration and Production industry. The operations of firms within this industry are focused primarily on the development of oil and gas from onshore locations in North America. Firms whose production comes primarily from international or offshore operations are excluded this analysis because their risk characteristics are significantly different than firms who are focused on the development of onshore, North American assets. Firms with significant downstream operations are also excluded for the same reasons.

Key Macro Factors

The overall health of the exploration and production industry is highly dependent on the market price of oil and natural gas. Firms in this industry are price takers; they are forced to sell their products for whatever the prevailing market price is at the time. Because of this, revenues are almost perfectly correlated with the market price of oil and gas.

Oil Prices
The price of oil is a representation of all of the forces that influence its supply and demand around the world. The highly volatile nature of oil prices stems from the face that prices are highly sensitive to changes in supply and demand. Oil Demand The demand for oil is highly dependent on the overall state of the economy. In addition to being used as a fuel for transportation, oil is also used in the manufacture of a plethora of other products. The demand for oil increases during times of economic expansion due to the rise and industrial production. During times of economic contraction, there is a decline in the demand for oil due to decreasing industrial production rates. Chart 1 shows the high degree of positive correlation between the growth of the nominal global GDP and the growth in the global demand for oil. With an R^2 value of 0.953, approximately 95% of the variability in the demand for oil is explained by changes in the nominal global GDP. Oil Supply OPEC OPEC is an organization that attempts to actively manage the production of its member countries. According to the

5 Energy Information Administration, approximately 40% of the global production of oil comes from the twelve OPEC member countries. Due to their large market share, changes in the amount of oil they supply to the market can have a significant impact on oil prices. Morgan Downey, author of the book Oil 101, says that OPEC spare production capacity acts as a buffer against global oil supply shortages. Periods of low spare capacity place upward pressure on oil prices because a risk premium is built into prices due to the increased probability of supply disruptions. Low spare capacity also results in more volatile oil prices as shortages cant be compensated for by increased OPEC production rates. Chart 2 shows that between 2003 and 2008, low OPEC Spare capacity coincided with extremely high oil prices. Currently, spare capacity levels are the lowest theyve been since 2008. Downey believes that increased global demand, maturing fields and few new discoveries will cause OPEC spare capacity to continue its downward trend. This will likely lead to higher oil prices and increased volatility in the future. According to the organizations website, OPEC member countries usually meet semi-annually to decide on their aggregate production target and to allocate this target among their individual member countries. The current price and volatility of oil is one of the main factors in deciding on their aggregate production target. Although one of OPECs goals is to reduce unnecessary volatility in international oil markets, their chief concern is with the wellbeing of their member countries. OPEC will not attempt to reduce volatility or high prices if it's detrimental to its member countries. Chart 2 shows that OPEC tends to increase production targets during times of high prices and decrease them when prices are low. In the past, OPEC has had to make several adjustments to their targets before prices started moving in the right direction. The EIA says that OPEC has no power to enforce the individual country quotas that they set. This means that the effect of changing their aggregate production target depends on individual member countries adhering to their quotas. Historically, there has been a significant amount of cheating among OPEC members.

6 National Inventories Inventories serve are similar to OPEC spare production capacity in the sense that they act as a buffer during supply shortages or during times of high demand. An EIA article on national oil storage says that commercial inventories are usually increased whenever there's excess supply and drawn down whenever current demand exceeds current supply. Building inventories usually means that the market expects higher prices in the future. Geopolitical Events and Natural Disasters Any event that has the potential to disrupt the supply of oil to consumers can affect prices. When there's adequate spare capacity, from producers or inventories, to offset the possible loss, the effect of the event on prices is reduced considerably, says Downey. For example, the release of oil from the US SPR greatly minimized the effects of Hurricane Katrina on oil prices were minimized due to the release of oil from the U.S. Strategic Petroleum Reserve (See Chart 2). Low spare capacity or inventories can magnify the events impact on prices. Usually, the impact of geopolitical events on the price of oil is only temporary. Prices return to normal after the event dissipates and supply flows return to normal. However, events that cause long lasting shifts in the balance between supply and demand can affect prices for indefinite periods of time. For example, during the Asian Financial Crisis of the late 90s, decreased demand from Asian countries suppressed oil prices for several years (see Chart 2).Industry Performance Revenues and Production An improving global economy has helped drive oil prices higher since the recent depression. The average realized price of oil that E&P companies received increased from their low of $57.26 in 2009 to $92.84 in 2011 with a CAGR of 27.33% over the three year period. As a result of the rebound in oil prices, industry revenues for 2011 were approximately $897 Billion and grew with a three year CAGR of 26.86%. Chart 3 shows how revenue growth fluctuates with the growth in global GDP. In Chart 3, it's visible that between 2001 and 2011, the percentage of total revenue coming from natural gas has decreased over the eleven year period. Natural gas production accounted for 18.9% of total revenues in 2011 which is much lower than the eleven year historical average of 27.4%. In contrast, Chart 4 shows that both the volume of natural gas produced (BOE) and its share of total production volume have increased over the same eleven year period. A

7 recent IBIS World Industry Report credits this growth in production volume to new development techniques that have allowed E&P companies to produce deposits of gas in previously inaccessible shale formations in the U.S. and Canada. Excess supply from shale deposits has suppressed natural gas prices and has resulted in the decline in revenues from gas production. In 2011, E&P companies produced approximately 19.74 million barrels of oil per day which accounts for 22.33% of total global production. In Chart 4, it is clear that oil production growth has remained relatively flat between 2001 and 2011. The CAGR for oil production during this period was only 0.92%. This stagnant production growth means that increases in revenues from oil production have come entirely from changes in the price of oil.

Industry Trends Increasing Consumption from China and other developing economies
The long-term, sustained economic growth of China, India, Brazil and Saudi Arabia has resulted in large increases in oil consumption. This large increase in demand has placed upward pressure on oil prices. There is a twofold explanation for the link between increasing economic development of emerging economies and increasing oil consumption. As economies develop, they gradually become more industrialized. As a result, demand for oil as an input for industrial processes increases. Secondly, as countries become wealthier, vehicular transportation begins to become a more feasible option for people; resulting in the increased Chart 5: Increasing demand from China and other developing consumption of oil for transportation countries, as a result of sustained economic growth, has been a conintuing trend that has placed upword pressure on oil prices purposes.
Percentage of global oil consumption(China, Brazil, India, Saudi Arabi 9000 8000 Nominal Per Capita GDP-USD 20% % of Annual Global Oil Consumption

China SA
15%

India Brazil

3.24% 7000 3.01%

6000

2.06%
10%

3.94%
5000 4000

2.67% 2.95% 11.08%

3000 2000

Chart 5 shows that China, India, Saudi Arabia and Brazil were responsible for 11.08%, 3.94%, 3.28% and 3.01% of annual global consumption during the most recent fiscal year, respectively. Combined, these countries accounted for approximately 21.3% of global oil consumption with a combined

5%

6.22%

Source:BP Statsitcal
1000 0

0%

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

8 consumption of 6.84 billion barrels during 2011. This is a 53.12% increase over their combined percentage of global oil consumption in 2000 of 13.90%.

The aggregate nominal per capita GDP of Brazil, India and Saudi Arabia and the nominal per capita GDP of China grew with a 5-Year CAGR of 6.30% and 10.87%, respectively. The aggregate combined oil consumption of India, Saudi Arabia and Brazil along with the oil consumption in China grew with a 5Year CAGR of 5.56% and 5.70%, respectively(see Chart 5). Demand growth in these four countries greatly outpaced the 5-Year CAGR of -0.01% for global growth in oil demand during the same five year period (2007-2011). In terms of the year over year change in the actual number of barrels of oil consumed daily (KBbls/Day), global growth in oil consumption consists mainly of growth in these four countries. As seen in Chart 6, a huge percentage of the growth in global oil demand is due to the consumption growth in China.

Between 2000 and 2011, China accounted for 43.67% (1.822 billion barrels) of the 4.172 billion barrel increase in global oil consumption. Chinas contribution to global consumption growth during the period was typically around 30%, but has varied between a minimum of 14.4% to a maximum of 85.2%.
3800

Chart 7: Chinese oil demand continuing to grow after slowdown around the middle of the year
Rolling 6mo Average Oil Consumption vs Rolling 6mo CAGR Chinese Demand Growth

0.02

Chinese Oil Demand (MMbbl/Yr)

To help sustain continued economic growth and shield consumers during times of high oil prices, many developing countries have initiated oil consumption subsidies. Oil consumption subsidies in China, India, and Saudi Arabia have helped to continue the strong growth in consumption from these countries during times of high prices.

3500

0.005

3400

3300

-0.005

3200

Source: EIA Data 2011 2012

-0.01

2010

Rolling 6mo CAGR

Around May of this year, there was some concern about slowing oil consumption in China (see Chart 7). Consumption growth began to pick up in August and has been around 3.75 billion barrels per year.

3700

0.015

3600

0.01

9 A recent S&P Industry Survey says that the continuance of high oil prices in the future is heavily dependent on the continued growth in oil consumption of China as well as other developing countries. The strong relationship between Chinese demand and oil prices can be seen in Chart 8. The high R^2 value means that Chinese demand has a high degree of explanatory power in regards to predicting oil prices.

Chart 8: There is a strong relationship between monthly Chinese oil demand and oil prices Chinese oil demand vs Brent Crude Price
4500 Chinese Oil Demand (MMbbl/Year) 4000 3500 3000 2500 2000 1500 1000 500 0 0 20 40 60 80

To help sustain continued economic growth and shield consumers during times of high oil prices, Brent Crude Price many developing countries have initiated oil consumption subsidies. Oil consumption subsidies in China, India, and Saudi Arabia have helped to continue the strong growth in consumption from these countries during times of high prices. I feel this adds to the power of Chinese demands explanatory power in predicting oil prices.
100 120 140

y = 18.104x + 1545.8 R = 0.7835

Growth in global oil demand would be stagnant without the growth in consumption from these countries, which would eliminate the current upward pressure on oil prices. This means that the future growth of the exploration and production industry is highly sensitive to changes in the economic growth of China and other developing countries.

Bottleneck at Cushing is Causing the Price Differential between Brent and WTI
Since 20010, WTI has been trading at a discount to Brent. The spread is currently around $22.00 a barrel but in the past has widened to as much as $27.31 a barrel in November of last year. In Chart 09, you can see that Brent-WTI spread oscillated around parity prior to 2010 Cushing inventory levels surged during 2010 because of large production growth from North Dakotas Bakken field and the Canadian oil sands. According to a recent S&P Industry Report, Cushing was designed to get oil from the Gulf of Mexico and Canada to refineries in the Midwest. This means that most of the pipelines connected to Cushing are set up to flow in the wrong direction to send oil anywhere except refineries in the Midwest. Refiners in the Midwest dont have enough capacity to handle the amount of oil thats flowing into Cushing each month and there is
Cushing Inventory(Kbbls)

Chart 9: Bottleneck at Cushing is causing WTI to trade at a discount to Brent 60000 WTI differential and Cusing Inventory(Kbbls)
50000 40000 30000 20000 10000 Source: EIA Data 0
Jan-08 Mar-07 May-06 May-09 Mar-10 Sep-04 Feb-05 Jan-11 Dec-05 Nov-08 Nov-11 Aug-07 Aug-10 Sep-12 Jul-05 Oct-06 Oct-09 Jun-08 Apr-04 Jun-11 Apr-12

30 25 20 15 10 5 0 Brent-WTI Spread

Midwest Field Production-Left Axis Cushing Inventory-Left Axis WTI-Brent Differential-Right Axis

Brent-WTI Parity

-5 -10

10 not enough pipeline capacity to get the oil to refineries in the gulf. This bottleneck has caused the Midwest to become greatly over supplied with oil. The substantial discounts of WTI to Brent have resulted from this oversupply. In November of 2011, Enbridge announced that they would reverse the flow of their Seaway pipeline that connects Freeport, TX to the Cushing hub. According to a recent Alliance Bernstein report on oil prices, the reversal of the pipeline is the first stage in a multi-phase project that will add 150 Kbbls of pipeline capacity from Cushing to the Gulf Coast. Upon news of the announcement, the spread shrunk from approximately $23/bbl to around $10/bbl, but rebounded back to $20/bbl a few months later. The announcement is marked in Chart xx by the yellow shaded circle. Enbridge completed the first phase of the project in May of 2012 (green circle). This caused the spread to shrink from $16.50/bbl to a low of $12.86 in July. Since July, the spread began to grow and is currently around $22.00 a spread. After the completion of the reversal, inventories at Cushing began to drop until reaching a bottom of 30.4 million billion barrels in October (black arrow). After bottoming out, inventories have shot back up to almost 40 million barrels of oil. It is clear that the WTI differential has closely tracked inventory levels since completion of the reversal. This leads me to believe that the reversal of the Seaway did not add enough capacity to end the bottle neck at Cushing. According to Alliance Bernsteins research, the WTI differential should narrow as new pipeline capacity comes online. This new capacity will come from two possible sources: Additional phases of the Seaway project and TransCanadas Keystone XL pipeline. Phases two and three of the Seaway project are scheduled to be completed by the middle of 2014 and are expected to provide an additional 700,000 BPD of pipeline capacity. TransCanada is planning on reapplying for a presidential permit to construct their Keystone XL pipeline. If the project is approved, management expects the project to be completed by 2015 and to add an additional 510,000 BPD of pipeline capacity.
Chart 10: Oil input at refineries is getting heavier and more sour. This implies that cheap, easy sources of light/sweet crude are likely long gone.

33 32.5 32 API Density 31.5 31 30.5 30 29.5 1985 1987 1988

API Density and Sulfur Content(% Weight)

1.6 1.5 1.4 Sulfur Content (% by Weight)

API Density Sulfur Content Density Increasing

Light, sweet crude getting more difficult and expensive to find

Chart 10 is a plot of API density and the sulfur content of crude being used in factories in the U.S. You can see that as time has passed the density of the average barrel used in refineries has increased.

1.3 1.2 1.1 1

Source: EIA Data 1990 1991 1993 1994 1996 1998 1999 2001 2002 2004 2006 2007 2009 2010

0.9 0.8

11 According to Oil 101, heavier oils have higher densities because they're hydrocarbon molecules contain more molecules than lighter oils. Heavier crudes are more difficult to turn into higher valued items like gasoline and diesel. This means that heavier crudes trade at a discount to lighter crudes. This translates into fewer revenues for those companies who have assets producing heavy oil. Rising sulfur content is also a sign of decreasing oil quality. Oil 101 explains that sulfur molecules take up space that could be occupied by hydrocarbon molecules and that this decreases the energy content of the oil. In addition, Environmental regulations force refiners to remove sulfur from many of their finished products. Both of these things mean that crudes with higher sulfur will trade at a discount to sweeter crudes. All of the cheap and easily recoverable sources of light sweet crude have already been recovered. This means that as time passes, the cost of finding the additional marginal barrel of oil will increase while its quality will go down. The mature nature and high degree of competitiveness between participants in this sector means that it's extremely unlikely that there are any major discoveries just lying out in the open. Companies are going to have to spend a lot to find new sources of oil and gas in the future. Chart 11 shows how companies have had to dig deeper and pay more to find new sources of hydrocarbons. With the exception of the late 70s it appears that well costs were fairly flat until 1994. It's at this point that the cost of drilling wells really started to increase. Between 1994 and 2007, the average real costs of drilling wells increased with a CAGR of 15.93%
Chart 11:Companies are having to look deeper and pay more as the shallower, cheaper and easier plays are all gone
Avg Feet Per Well (Exp. and Dev.) and Avg. Real Cost for Drilling a Well 7000 6500 6000 5500 5000 4500 4000 3500 Exploratory wells much deeper 4,000.00

Avg. Real Dollar Cost per Well Avg. Ft.-Exp. Well Avg. Ft-Dev. Well
Out of cheap, eassy sources here?

3,500.00 3,000.00 2,500.00 2,000.00 1,500.00 1,000.00 500.00 Cost of Wells Drileld in Real USD-1000's

Also notice on Chart 11 how much Source: EIA Data deeper exploratory wells were 3000 compared to development wells. This large difference means that although companies were undoubtedly finding oil this deep, it just wasnt economical to develop these sources at that period in time. This gap started to decrease after 1994 as companies started to develop sources that were growing deeper. The combination of increasing well costs and deeper developmental wells leads me to believe that the early to mid-90s was the end of easy to find oil.
1963
1960 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002

Feet per Well

Unconventional Oil and Gas in the US

Unconventional resources are one of the biggest things occurring in the industry right now. In a 2011 industry report, Alliance Bernstein analysts compared the importance of unconventional resources to

2005

12 the oil and gas industry to that of the power loom and assembly line for the textile and manufacturing industries. Unconventional resources are the area that holds the most future growth potential for the industry. The Basics A point I would like to make to start off with is that when people talk about shale oil, they're talking about tight oil. Shale oil is just source rock (kerogen) that hasnt been turned into oil yet. The book Oil 101 describes tight oil as oil that is trapped inside of a source rock due to the low porosity and permeability of the source rock. In order for there to be oil or gas present in the source rock, it has to be at the right temperature and pressure for the right amount of time to be converted into oil or gas. This optimal set of conditions is known as the oil window for oil and gas window for natural gasses. Kerogen is source rock that isnt exposed to these optimal conditions. The low porosity and permeability of the source rock means that if it is drilled into, no resources will be able to flow. In order to be able to recover oil or gas from the well, it has to be completed with hydraulic fractures. Fracturing involves pumping water, chemicals and sand down a well bore at extremely high pressures. This creates fractures throughout the source rock that act as passageways for oil and gas to flow through. Pay zones are usually quite thin and require a great deal of precision to be able to hit them. Horizontal and directional drilling technologies are typically used because they allow you to steer the bit as your drilling. This gives you the ability to access a tremendous amount of resources by allowing you to drill a narrow pay zone for very long distance.

Unconventional Trends
Sustained $2-$3 natural gas prices have caused exploration and production companies to focus on more liquids rich plays. Alliance Bernstein researchers say that the Bakken, Niobrara, and Eagle Ford shale plays are becoming increasingly popular because they produce a lot more crude oil and natural gas liquids than dry gas. Chart 12 shows the increasing number of rigs drilling for oil over gas as companies make the switch.
1800 Number of Rotary Rigs in Operation 1600 1400 1200 1000 800 600 400 200 0 Shale Oil Boom Oil Rigs in Operation Gas Rigs in Operation

Chart 12 :Shifting focus from gas to oil due to low natural gas prices
Number of Oil Rigs and Gas Rigs Operating in the US

Source: EIA Data

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2010

2011

Common themes among shale plays

North American unconventional resource plays share several common features. This section contains a detailed analysis of these commonalities using the Bakken/Three Forks formation located in North Dakota as a case study.

2012

13

Sweet Spots
While the actual areal size of a play can be large, analysts at Alliance Bernstein claim that the actual play is a lot smaller because of core areas (or sweet spots) within the play that produce wells that yield superior economic returns. To explore the existence of sweet spots within plays, I examined the production data from wells located in the Bakken/Three Forks formation in North Dakota. My sample consisted of 1642 wells drilled between 2006 and 2010. In my analysis of the sweet spots, I first ranked all of the individual wells in the dataset according to their average daily rate over their first 30 days of production. Ranking was based on initial production rate because it is commonly used as a metric to gauge the economic potential of new wells. High IP rates are a strong indicator of high production rates throughout the early stages of development. High early production rates help wells combat steep decline rates, which results in them producing a higher total volume of oil than those with lower rates of production. High early production rates also translate into a faster payback period which reduces risk. I used ESRIs ArcGIS and data from the states geological website to map the position of all the wells from my sample. Map 1 shows that the initial production rates are definitely not homogenous throughout the play. The dark orange and red points represent wells that have IP rates in the top 20th percentile of the sample. The circled area on the Eastern edge of the play has the densest population of wells with high IP rates. The area enclosed by the larger polygon is my approximation of the plays sweet spot. The distribution of wells with higher than average IP rates is extremely scattered outside of this enclosure.

I used the Average Nearest Neighbor utility in ArcGIS in order to test the significance of this clustering. The ANN utility calculates average distance from each feature to its nearest neighbor and the expected and compares it to the average distance in a randomly distributed population. For an alpha equal to 0.05 (95th Percentile), the critical Z-Scores were 2.58 and 1.96 while the resulting Z-Score was -67.98. This value was way less than the lower critical value which means that the odds of this clustering being random are extremely low.

14 This sample of data captures the period before the Bakken/Three Forks became extremely popular. Since 2010, the total number of unconventional wells in North Dakota has increased by approximately 3600 wells. Although well production data in an easily manipulated format wasnt available after 2010, I used ArcGIS to map individual wells drilled after 2010 in order to see if drilling was still focused in the sweet spot after 2010. Map 2 is a representation of the density of wells drilled per field during 2011 and 2012. The dark green fields have the lowest well densities while the dark red fields have the highest. This image shows that drilling is still heavily focused in the previously defined sweet spot (solid polygon). The dashed line shows how drilling has been extended outside of the original sweet spot as open acreage becomes scarce. First Mover Advantage Analysts at Alliance Bernstein claim that the first movers within a play have an advantage over late comers in terms of lease location and terms. The first companies to explore a play have the ability to secure the best acreage for themselves and limit competitors access to the sweet spot. Chart 13 uses a companys percentage of the total number of wells drilled within the Bakken/Three Forks sweet spot as a proxy for the amount of acreage they control within the sweet spot. The more wells a company has drilled the more acreage it must control. This chart shows that the 7 companies with the highest percentage of wells during the early period of the Bakken development (first movers) continue to dominate the play.

Chart 13: Companies that move first on a play can secure prime acerage and dominate a plays sweet spot. Companies w/largest percentage of wells in the Bakken/TF sweet spot during early years (2006-2008) and total life (2006-2012) 100.0% 90.0% 80.0% 70.0% 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% First Movers: 2006-2008 Total Wells: 2006-2012

25.8% 4.2% 5.2% 6.8% 9.5% 14.3% 15.7% 18.5%

Others XTO Whiting Burlington Continenta l Marathon EOG Hess

35.8%

4.9% 9.2% 5.7% 10.8% 9.1% 10.5% 14.1%

Source: ND Geological

Very Steep Decline Rates Wells from the Bakken/Three Forks formation typically have high initial production rates that decline very quickly. To construct an average Bakken/TF well, I first normalized all the wells by moving the start

15 of each wells production to a unified point in time and then took the simple average of each months production rate. One of the techniques the E&P industry uses to make production forecasts is decline curve analysis (DCA). According to the Petroleum Engineers Handbook, DCA is an empirical technique that matches a curve to historical production and then extrapolates that curve in order to forecast future production. Most of my research indicates that Arps Hyperbolic Decline Equation is one of the most widely used methods of performing DCA within the industry for two main reasons: its relatively simple and doesnt take that long to do. The method I chose to use is a slightly modified version of this model. A technical paper written by Fekete Associates, an oil/gas consulting and software company, states that the most general form of the Arps equation is given by the equation for hyperbolic decline: (1) where: qi is the initial production rate and qt is the rate at time t, Di is the decline rate at flow qi, and b represents the curvature of the decline trend Hyperbolic decline occurs when 0<b<1. During hyperbolic decline, the decline rate changes as the rate of production changes. Exponential decline occurs when b=0. Under exponential decline, the decline rate is constant and the rate of production declines at constant percentage. Harmonic decline occurs when b=1. In this situation, the decline rate is proportional to the production rate. The use of the hyperbolic decline model to forecast production from tight oil or gas formations has been heavily criticized by some over the last few years. In his widely cited article, U.S. Shale Gas: Less Abundance, Higher Cost, Arthur Berman claimed that industry gas reserves are overstated by at least 100 percent due to the inappropriate use of the hyperbolic decline model to estimate reserves. The hyperbolic equation is only meant to be used with b values between 0 and 1, but fitting a curve to the historical production of tight oil or gas resources typically results in having to use a b value greater than 1. Using the hyperbolic model with a b value greater than one makes the production rates decline at an extremely slow rate during the later life of wells. This results in the overestimation of reserves. One workaround to using the Arps hyperbolic decline equation for tight oil and gas resources is to use a two-segment model. The model starts off using the standard hyperbolic decline rate equation but switches to and exponential decline model with a minimum terminal decline rate during the later life of the well. In their September/November 2011 Quarterly Newsletter, analysts at Ryder Scott stated that this terminal decline rate compensates for the tendency of hyperbolic models with b>1 to over predict the estimated ultimate recoveries (EUR) of tight gas/oil wells if left unconstrained. I chose to use this model for my analysis of Bakken/TF wells. The reason I chose this model is because it was the easiest method I could find to develop reasonably accurate production forecasts from tight oil/gas plays.

16 To generate the initial hyperbolic decline curve I used Palisades Evolver (similar to Excels solver but more powerful and faster) to solve for qi, Di, and b from Equation 1. The goal of this optimization was to maximize the square of the regression coefficient (r^2): ( ) (2)

Where: SSE=Sum of Squares Error, SST=Sum of Squares Total q(t)=historical production rate, q(t)=forecasted production rate, and qavg=average historical production rate To maximize r^2, must be as close to as possible. To do this, I set up Evolver to maximize r^2 by changing the variables qi, Di, and b. After 5000 trials Evolver returned a value of 0.9981for r^2. This value is very close to one which means that the hyperbolic decline curve closely matches the historical production data. The forecasting of future production is accomplished by inputting the months you want to predict, along with the optimized values of qi, Di, and b into Equation 1. . To make the switch from hyperbolic decline to exponential decline, a minimum terminal decline rate must be selected. I decided to use a range of terminal decline rates instead of just choosing one because I was unable to find any detailed discussion or method for choosing the minimum decline rate. In my opinion, using a range of terminal declines and forecasting production as a distribution makes more sense because there is already a lot of uncertainty built into the forecast. The vast majority of the terminal decline rates I saw being used ranged between annual effective declines of 6% and 10%, so I decided to use terminal rates of 7.5% and 10% in my forecast. From the previously mentioned paper by Fekete Associates, the formula to convert from hyperbolic to exponential decline is as follows: (3) Where: and , are the production rate and time at the terminal decline rate

To find each terminal rates associated or , I first had to convert the terminal rates from an annual effective rate into a monthly nominal rate. After that, I just had to match up each terminal rate to the hyperbolic decline rate closest to it. The values of , , and Monthly nominal rate) for the 7.5% and 10% terminal decline rates are listed in Table 1.

Table 1: Di, tlim, and qlim for the chosen terminal decline rates 10% Terminal Decline 7.5% Terminal Decline 0.0088 0.0065 214 311 12.0350503 8.892836538

Di tlim qlim

17

Looking at the values for tlim in the table above, its clear that using a terminal decline of 10% will forecast less cumulative production than the 7.5% terminal decline rate. The effects of the 10% terminal decline are stronger and take effect sooner than those of the 7.5% decline. Therefore, the 10% case will be my low (worst) case, the 7.5% my middle (average) and the straight hyperbolic model will be my high (best) case. To examine the overall effects of the model and parameter choice, I forecasted the production of all three cases to 40 years, 480 months, past the start of production. Chart 14 shows the estimates of cumulative production from each of the three cases over a 40 year period. The difference between the high and low estimates was relatively small at only 11.2%. These results are contrary to my research as most of it claimed that estimates from the hyperbolic model were vastly overinflated. Although skeptical about my results, I feel that they are sufficient enough to get across my points later in the paper.

Chart 14: Cumulative oil production over 40 years

315000 310000 305000 300000 295000 290000 285000 280000 275000 270000 265000 260000

307,962.66 297,597.23

Bbls

276,960.10

10% Terminal Decline 7.5% Terminal Decline

Hyperbolic

According to the Standard Handbook of Petroleum and Natural Gas Engineering, the high initial production rate and steep decline from Bakken/Three Forks wells is because they are drilled horizontally and are completed by using multi-stage fracing techniques. Multi-stage fracing involves isolating segments of the horizontal well bore and hydraulically fracturing each segment (stage) before a well is put on production (typically). This process creates fractures along the length of the lateral that immediately frees a large amount of oil or gas from the source rock and allows it to flow into the well bore. The high initial production rates are caused by the fact that there is already a large volume of oil or gas ready to flow to the surface as soon as soon as production is started. The low permeability of the source rock prevents the migration of hydrocarbons from areas far outside of the stimulated (fractured) area into the well bore. This means that oil and gas are flowing out of the well much faster than they are getting to the bore hole. This causes production rates to drop rapidly. Chart 15 provides a visual of the extremely fast decline in the rate of production for an average Bakken/TF well. The average production rate was calculated by taking the simple average of the three curves at each point in time. Wells are producing at just 25% of their initial production rate by the end of their first year and by the end of their fourth, theyve already produced half of the oil theyre going to produce over their lifetime.

18

Chart 15:Average Bakken/TF Decline Rate and Cumulative Production 500

450 400 350 (BOPD and Bbl)

3.E+05 3.E+05 2.E+05 2.E+05 1.E+05 Bbls

The Economics of a Single Bakken/TF Well

BOPD

BOPD

300 250 200 150

In this section, we analyze the economics of Bakken/TF using the decline curve derived in the previous section.

Assumptions The assumptions for the model can be 100 5.E+04 found in Table 2. Although less than the 50 18.75% the state of North Dakota is 0 0.E+00 currently charging to drill, I chose to 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 implement a royalty of 17% because I feel it Years better represents the average royalty paid by oil and gas producers in the state. The Bakken is not new and much of Table 2: Assumptions for Well the land has already been signed with leases offering lower rates. No other Economics Price of Oil $65 - $125 costs associated with acquiring land are included in this analysis.
Production Tax Extraction Tax Conservation Tax LOE/Month Royalty Discount Rate 5.0000% 6.5000% 0.1875% $7.00/bbl 17% 10%

Capital Expenses $10,000,000

Producers in North Dakota are levied a tax of 11.688% on every barrel of oil that comes out of the ground (not net of royalty payments). After the daily production rate of a well drops below 30 BOPD it becomes exempt from the 6.5% extraction tax and all future production from that well is taxed at 5.18%. In the end, producers end up losing between 25% and 30% of their total production to royalties and taxes.

The upfront capital expenses for drilling and completing (fracing) horizontal wells are massive. Many plays also require producers to make significant investments to be able to get their production to market. Bernstein analysts estimate that upfront capital expenses are approximately $10MM with 75% of that going to drilling and completion while the other 25% goes towards midstream development. Capital expenses were treated as one-time expense at t=0. The value of $7/bbl for lease operating expenses was estimated by averaging the LOEs from companies highly leveraged to the Bakken formation: Kodiak, Oasis, and Northern. I was unable to come up with a way to separate the fixed and variable cost components from the LOE. This implies that a well wouldnt be taken off production until it was producing less than $7 in oil, which is a very unrealistic assumption. To get around this, production is I assume all wells are taken off production in 30 years.

The Economics A copy of the model I used can be downloaded here. Chart 16 displays the NPV10 values for an average Bakken well under the four oil price scenarios. Its clear that $85/bbl is slightly above the break-even point for an average Bakken well. The exact break-even price can be calculated by deriving a line of best

19 fit in Excel and then solving for the price of oil to make NPV=0. The price of for an average Bakken well to break even is $82.57. Anything below $82.57 and it becomes uneconomic for producers to develop average quality Bakken/TF acreage. Prices need to be $100+ for producers to earn any kind of significant return.
Chart 16: Sensitivity of NPV10 to Oil Prices for Average Bakken Well
$6.00E+06 $5.00E+06 $4.00E+06 $3.00E+06 $2.00E+06 $1.00E+06 $0.00E+00 -$1.00E+06 -$2.00E+06 -$3.00E+06 -$2.16E+06 $2.98E+05 $2.14E+06 $5.21E+06

$65.00

$85.00

$100.00

$125.00

Its important to point out that not all of the Bakken formation will require at least $85/bbl to break-even. From our previous discussion on sweet spots, we know that resource plays are composed of zones that produce wells with similar economic returns. If these economic returns vary from zone to zone, the breakeven oil prices for zones must vary as well. This means that in areas with above average economic returns, the break-even price of oil will be lower than average.

To analyze the economics of wells in above average areas, I divided the wells with IP rates in the top 40% of wells into 3 different groups: 60%-75%, 75%90% and the top 10%. I then averaged each of the individual wells within the groups to derive an average set of production data for each group. After that, I used the optimized effective decline rates (Di) from the average Bakken decline curve to forecast 30 years of production for each group.

Chart 17: NPV is highly dependent on the quality of your holdings.

$3.00E+07 $2.50E+07 $2.00E+07 $1.50E+07 $1.00E+07 $5.00E+06 $0.00E+00 -$5.00E+06

The same model and assumptions were used to analyze each group at the four different oil price NPV10 for each group under the four oil price scenarios scenarios. Chart 17 displays the NPV10 at each oil Average price scenarios for each group. The data from the 60%-75% 75%-90% average Bakken well is displayed again for visual Top 10% comparison. This chart makes it obvious how important it is to be located in (or very near) the core areas of resource plays. At $100/bbl, being positioned on above average acreage can mean having an NPV 3x to 7x higher than the average. Another way to examine the differences in quality amongst the $65 $85 $100 $125 Bakken is by calculating the oil price required to breakeven on the well. The top 10% of Bakken wells only need oil to be $41.40 to break-even, while the 75%-90% and 60-75% group have break-even prices of $54.00/bbl and $62.66/ bbl. respectively. Table 3 gives us some indication as to whats driving the huge differences in NPV. The biggest two drivers of value are the estimated ultimate recoveries (total lifetime production) and how fast they can be produced. The top 10% of wells will produce around 140% more oil over their lives than the average. Using the IP rate as a general indicator of the production rate over a wells life time, we can see that wells in the top 10% are generally going to have production rates much higher than average. Faster

20 production rates tend to reduce risk because they decrease the payback period for production companies. Faster payback periods offer companies more flexibility by not tying their cash up for unnecessarily long periods of time. This also means that a smaller percentage of a companys total cash flows from a well be effected by the large discount rates in the later lives of a well.
Table 3: IP Rates and EURs for above Bakken Core

Group Top 10% 75%-90% 60%-75% Average

EUR 671434.2 482866.9 404675.4 278793.133

IP Rate 895.8688 799.6977 636.3036 435.67

Its clear that the volatility of a wells NPV is largely due to changing oil prices and the variable EUR (quality) of wells throughout the play. I used linear regression to create a line of best fit based on the relationship between EUR and oil prices to NPV. After coming up with a line of best fit for both variables, I estimated best/worst case scenarios for each along with a base case scenario. All scenarios are based on the average production curve discussed earlier (280,000 bbl of EUR). Changes in EURs represent variability in estimation capabilities, and other things that could cause the production of a well to stop before its economic limit is reached (natural disaster, accidents, etc.). The best, worst and base cases for oil prices are: $125/bbl, $65.00/bbl and $100.00/bbl. The scenarios

Chart 18: Sensitivity of NPV to EUR and Oil prices

-3000 -2000 -1000 0 1000 2000 3000 4000

NAV(000's) 5000 6000

7000

EUR(Lifetime Production)
Worst Case Scenarios: EUR=200,000 and $65.00/BBl

-$959.36

Base Case: EUR=280,000 bbls and $100.00/bbl

Oil Prices

-$2,158.17

Best Case: EUR=400,000 bbls and $125.00/BBL

for EUR are 380,000 bbl for the best case and 200,000 bbl for the worst. Chart 18 shows how far each extreme deviates from the base case. A $1.00/bbl move in oil prices produces $122,827 change in NAV which is almost equivalent to a change of 1000 bbl of EUR. This makes sense because these are the only two things that create cash flow. `

Possible Sources of Error There are several possible sources of error in my analysis of the economics of the Bakken formation. The largest of these have to do with my well production estimates.

21 Im not a petroleum engineer and have no formal training in decline curve analysis. There is a plethora of material explaining the math and theory behind it, but not very many detailed examples that didnt involve data I had no way of accessing. I feel I firm grasp of the theory and background behind the models I employed but without any real examples to follow I had to go with what seemed right to me. As an example: Even though it seemed right to average the three decline curves I created, this may be totally wrong. Another source of error could be the production data I was using. The state of ND publishes monthly production data from all individuals wells monthly. I had to use a set of data that only went up to 2010. This meant I had relatively little production data to base my curves on, which is a definite source of error in my model. As operators have gained more technical skill in producing shale oil, the production rates have tended to increase, my model doesnt account for that. Another source of error could be the 10% discount rate I used. Even though this is standard in the industry, it may not be correct. The discount rate should represent the market related risks of the cash flows its discounting. Production from the Bakken formation could be more or less risky than the 10% discount rate thats used. NPV will be overestimated (underestimated) depending on how much more risky (less risky) the cash flows are. With all that being said, I feel the results of this analysis are definitely reasonable. Although my EURs are somewhat lower than most estimates, (Alliance Bernstein estimates EUR to be 323 bbl for Bakken wells), they are definitely in the ball park. My annual decline rates and other derived numbers are fairly close as well. Well Spacing Why is well spacing important? If you have good acreage, the more wells you can drill on your property the better. Well spacing places a limit on the number of times you can do this and still remain profitable. If wells are spaced too close together, wells would start cannibalizing the production of other nearby wells. The optimal well spacing in a play occurs whenever the distance between wells is the smallest it can possibly be without affecting the performance of nearby wells. In other words, the goal is to pack as many wells into an area as possible without negatively affecting the production of any other wells. Brief Discussion on Fracing According to the Standard Handbook of Petroleum and Natural Gas Engineering, the high initial production rate and steep decline from Bakken/Three Forks wells is because they are drilled horizontally and are completed by using multi-stage fracing techniques. Multi-stage fracing involves isolating segments of the horizontal well bore and hydraulically fracturing each segment (stage) before a well is put on production (typically). This process creates fractures along the length of the lateral that immediately frees a large amount of oil or gas from the source rock and allows it to flow into the well bore. The high initial production rates are caused by the fact that there is already a large volume of oil or gas ready to flow to the surface as soon as soon as production is started. The low permeability of the source rock prevents the migration of hydrocarbons from areas far outside of the stimulated (fractured) area

22 into the well bore. This means that oil and gas are flowing out of a well much faster than they are getting to the bore hole. This causes production rates to drop rapidly. The Geometry The distance that the resulting fractures extend into the rock in one direction is known as the half-width (xf). Multiplying the half-width by two yields the width of the fracture. Multiplying the fracture width by the length of the wells lateral yields the surface area of rock thats hydrocarbons can flow through to reach the well bore. Bernstein research states that the frac half-widths for most unconventional plays range from 500ft-1500ft (or 1000-3000 feet). The tight oil and gas resources that E&Ps are targeting exist in intervals that are usually only several hundred feet thick so the fractures extend far enough along the vertical axis that they entire thickness of the target interval is stimulated. Land measurements in the oil and gas industry are predominately done in sections. A single section is equivalent to a square mile or 640 acres. Many contracts stipulate that leases must be held by production, which means that producers forfeit the lease if they dont start producing from it within a certain period of time. One well per section is usually the requirement to the retain rights of that section. A simple way to think about well spacing is to estimate how many wells could fit into a single section and then just divide the area of a section by that number. We can keep this analysis 2-dimensional by assuming the fracture stimulates the entire thickness of the interval. Determining well spacing only requires calculating the total surface area that the well bore and fractures are in contact with, which is equal to the length of the wells lateral multiplied by twice the frac half-width: Eq. 4: Assuming that well laterals are usually between 5000ft and 10000ft long, along with the frac half-widths mentioned earlier; we can calculate the typical unconventional resource well has a surface are between 5.00E6ft^2 and 3E7ft^2. A section has a surface are of 2.79E07ft^2. This gives well spacings of 128 acres and around 640 acres. Similarly, the surface area of a Bakken well is equal to its twice its half-width multiplied by the length of its lateral (2(750)*9000). By this calculation, the surface area of a horizontal Bakken well is approximately 13,500,000ft^2. Converting ft^2 to acres, we can see that a slightly over two wells can fit in a single section (2.06), which means the well spacing for the Bakken formation is 310 acres. Horizontal vs. Vertical Well Spacing Fractured vertical wells interact with a much smaller volume of the reservoir than fractured horizontal wells. Imagine that the square and rectangular figures below represent the top and side view of a tight oil/gas reservoir. If someone challenged you to pick one of the shapes and put as many of those blue dots on there as possible, which side would you choose?

23 Its obvious that the square could hold a lot more circles than the rectangle. This is analogous to the difference in infill spacing between horizontal and vertical wells. You can fit a lot more vertical wells horizontal wells in the same amount of area. Now imagine the smaller rectangle is a cross section of the reservoir and the blue circle is a side view of the path that the drill bit took through it. This illustrates how little of the reservoir is actually contacted by with vertical drilling. Bernstein analysts claim that vertical wells may only interact with between 0.06 billion cubic feet and 0.6 billion cubic feet reservoir while a horizontal well contacts between 1 and 3 billion cubic feet of the reservoir. In terms of spacing, a single section may have enough room for between 10 and 100 vertical wells while the same section may only room for a single horizontal well. Analysts say that estimates on infill spacing contain a huge amount of uncertainty and are one of the most common to be overinflated because they dont occur for many years until after the initial production of a well. Stacked Pay Zones A cross sectional view of tight oil and gas resources would reveal multiple layers of source that vary in thickness. Multiple layers of source rock can contain the volume of hydrocarbons necessary to make them economical to drill opportunities. In some cases, these layers maybe stacked in a way that they can be drilled in the same location. These stacked pay zones can increase the total amount of EUR from and area by a significant amount. In addition to the Bakken formation, the Williston Basin also contains the Three Forks (TF) formation. The US Geological Survey recently released a report that claims that the TF formation has an EUR of 3.73 E9 barrels of oil. This more than doubles the estimate of 3.65 E9 barrels of oil in an earlier release that only studied the Bakken formation. Bringing it all Together: Forecasting the production of the entire Bakken formation Provided in a Bernstein Research report, the total resources can be calculated as follows: Eq.5 Now that we know the well spacing of the play, the final step in calculating the total resources in the Bakken is coming up with an estimate of its size. The US Geological survey estimates the Bakken formation we now only need to estimate the throughout the play, the goal is to try and determine the areal extent of the plays surface. Due to the difficulty of deriving a reasonable estimate myself, I chose to use an estimate published in the 2011 Alliance Bernstein Report North American E&Ps: Aligning the Stars of the North American Resource Play Constellations. Their research was focused on determining the extent of the Bakken formation most likely to be developed. Given that companies will almost certainly try to position themselves in the best land possible, prospective acreage was judged on a variety of factors that indicate better than average economics. These indicators (metrics) included 30 day IP rates (IP30), finding & development costs, and average EURs among others. Based on their analysis, there is approximately 7 million prospective acres within the Bakken formation.

24 Dividing the total acreage of the formation by its well spacing yields the maximum number of wells that the formation will contain. A total size 7 million acres and well spacing of 310 acres means that the Bakken will contain a maximum of 22,580.. The amount of time it takes to reach this point is dependent on the level of drilling activity (rig count) within the play, which is provided on the ND Dept. of Mineral Resources website. To estimate how long it will take to complete 22,580 wells we need to forecast the number of rigs Chart 19: The Bakken Formation will run out of acreage to drill by 2022 operating in the Annual number of wells completed each year and cumulative number 2000 25000 Bakken in future of wells Source: Rig Activity info from ND Dept. of Mineral years. 1800 Total Wells The average number of rigs operating in 1400 the formation has 1200 15000 grown at a CAGR of 33.69% from 34.67 1000 during 2006, to 800 10000 197.92 in 2012. 600 Bernstein analysts expect rig rates to 400 5000 stabilize and remain 200 at 200 until the 0 0 Bakken well count 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 reaches its max. I did the same in my forecast as well. I also held assumed that the number of wells drilled per rig would remain at 0.79/month (or 9.45/year). Chart 19 shows a plot of the annual number of wells completed each year as well as cumulative production. The cumulative number of wells in the play will increase until there is no more acreage left to drill. My forecast estimates that total remaining undrilled acreage will be less than 310 acres during the beginning of 2022.
1600

Number of Wells Drilled Each Year

20000

I employed the average Bakken curve derived at the beginning of this section to model production from the entire field. I felt that this was a reasonable choice because its composed of every well drilled in the formation weighted by its frequency of occurrence. The production from a formation or field is not only dependent on its geological properties (represented by the average production profile), but also on the rate at which its developed (number of well completions each year). To develop the production curve for the Bakken formation, I set up a matrix with each column representing one year of production from the formation. Every column was populated with the annual production volume from the average Bakken well. The first cell in each column to contain data was one row lower than the previous column. The cells in each column were then multiplied by the number of wells that were drilled during that particular year. Each cell was then divided by 365 in order to turn them into daily production rates. The data points of each row were then summed together determine the formations daily rate of production for a particular year. Table 4 is an example of how I set up the matrix to make things more clear.

Cumulative Wells

Wells/Year

25

Table 4: Matrix Example

Years of Production 1 2 3

1 X X X

2 Y Y Y

Z Z Z

Rates X XY XYZ YZ Z

Chart 19 plots the daily rate of production from the Bakken formation as a function of time. Each of the individual pieces represents the production curve of wells that were completed during a specific year. Notice how each pieces contribution to the total rate of production is dependent on the number of wells completed that year. The rate of production increases as long as the quantity of new wells is sufficient enough to overcome the decline rates of all previously drilled wells. The chart shows that the formation will reach its peak rate of production of 1.07 million BOPD as soon as the wells completed in 2022 begin producing. No new wells are drilled after this point because the formation has reached its maximum carrying capacity of 22,580 wells. After this point, the fast decline rates that are characteristic of tight oil/gas formations set in and production rates begin to decline rapidly.
Chart 19: Production Profile from the Bakken Formation Height of curve represents peak bakken production in BOPD and the dotted 2000 line represents the number of wells completed each year
1000000 Bakken production rate will rach a maximum of 1.07 MM BOPD 800000 1800 1600 1400 1200 BOPD 600000 1000 800 400000 600 400 200 0 0 2006 2008 2010 2012 2014E 2016E 2018E 2020E 2022E 2024E 2026E 2028E 2030E 2032E 2034E 2036E

200000

Wells per Year

26 Final Thoughts on the Bakken/Three Forks Formation The production characteristics from the Bakken/TF formation are not homogenous throughout the surface are of the play. The highest production rates are confined to sweet spots. This means that the first movers into a play have a significant advantage over late comers in being able to identify and lock up the best areas. The main drivers of a plays economics are its EUR and well spacing requirements. Wells with a higher EUR will produce a higher volume of liquids over its lifetime, which increases its NPV. Lower well spacing requirements mean you can fit more wells in a given area. More wells equates to higher revenues for producers.

Sizing Up the Other North American Unconventional Plays In this section we analyze the characteristics from North Americas other unconventional plays. From this analysis we are able to rank these plays based on a variety of factors.

Chart 20: IP Rate vs. First Year Production as a Percent of Total EUR for North American Shale Plays
1600 1400 1200 IP Rate (BOEPD) 1000 800 600 400 200 0 Horn River Higher IP rates and faster Decline rates means a faster Deep Anadarko payback period Basin Eagle Ford Marcellus Permian Bakken Woodford Barnett Niobarra Mississippi Lime Utica Haynesville

10%

20%

30%

40%

50%

First Year Production as a Percent of EUR Source: Alliance Bernstein Report

Production Characteristics Shale plays are well known for their high initial rates of production as well as their fast decline rates. Chart 20 plots IP rates against first year production as a percent of total production for 12 North American shale plays. The higher the percentage of total EUR produced in the first year, the faster the rate of decline. Although this may be counterintuitive, faster decline rates are preferred over slower rates of decline because they return a larger portion of their cash flows during the earlier parts of a wells life. Higher IP rates also increase early cash flows. Its important to note that that the previous chart only represents the rate at which cash flows are returned relative to total cash flows. It doesnt take into account whether a play is more weighted towards liquids production (NGL and oil) or gas production. Plays weighted towards liquids are preferred over gassier plays due to extremely low natural gas prices. One BOE of natural gas is worth only $23.00, assuming oil prices are $100/bbl and natural gas prices are $4.00/mcf. Chart 21 shows how much

Chart 21: The $ Value of a BOE Produced from Each of the 12 Plays along with the percentage of liquids per BOE

$100.00 $80.00 $60.00 $40.00 $20.00 $0.00

-Assumes oil is $100/bbl, NGL prices are 40% of oil prices and natural 95% gas is $4.00/mcf

50%

75% 50%

70% 50% 43% 1% 15% 0% 0% 31%

Source: Alliance Bernstein Report

27 a BOE is worth from each of the 12 plays. The value of a BOE ranges from $23.00/bbl for the Haynesville and Horn River formations to approximately $90.16 for the Bakken formation.
Chart 22: Cumulative Undiscounted Revenue per Well for each Shale Play
Cumulative Revenue=EUR*$/BOE
$45.00 $40.00 $35.00 $30.00
$MM

660,000 1,600,000 656,000 1,042,000 400,000 618,000 467,000 277,000 288,000 320,000 224,000 380,000

$25.00 $20.00 $15.00 $10.00 $5.00 $0.00

Chart 22 shows the total cumulative revenues for a single well from each play. The chart is arranged from left to right in order of descending EUR value. Its clear that the value of single well is dependent on its total cumulative production (EUR) as well as the value of each BOE it produces. Even though wells in the Horn River formation out produce Eagle Ford wells by nearly 1 million BOE over their lifetime, Eagle Ford wells still have higher cumulative revenues ($40.66E6 vs. $37.12E6).

Sweet Spots The existence of conventional oil and gas fields is contingent on a host of factors lining up just right. In Oil 101, Downey describes seven steps that must occur in the creation of conventional oil and gas formations. First, there must be a quality source rock present. Second, this source rock must be located at the correct depth for the source rock to undergo maturation. This is the process by which the source rock is broken down by heat and pressure into lighter oil and gas molecules. Third, the source rock must be in contact with a reservoir rock that is permeable enough to allow the oil and gas to migrate through it and porous enough to be able to hold oil. Fourth, an impermeable cap rock must be positioned in a way that traps the oil and gas in the reservoir rock and prevents it from migrating to the surface. Finding an area with a high probability of meeting all of the required prerequisites is very difficult and doesnt happen very often. This is why wildcat wells are about four times more likely to result in a dry hole than a successful one (101). With tight oil and gas formations only two of the conventional prerequisites are required: source rock and maturation. Analysts at Alliance Bernstein say that these two factors are usually correlated across basins. This implies that if something is working in one area, its likely to be successful in other areas of the play as well. The depth and areal extent of tight oil and gas formations are relatively well known which means E&Ps dont have much difficulty in hitting it. This means that traditional exploration risk (probability of a dry hole) is greatly diminished with tight oil and gas plays. Does this mean that tight oil and gas plays are free from risk free? Not even close.

Source: Alliance Bernstein Research

28 One of the early misconceptions regarding shale formations was that they should have fairly uniform production characteristics across the play. As previously discussed, we know that well performance is far from uniform across a play. Localized areas with above average well performance (sweet spots) exist in all shale formations. Chart 23 shows the variability of the ratio of IP in the top 10% of the population to those in the 50th percentile from 11 North American shale plays. Assuming that IP rates are correlated with long term performance; the larger the ratio, the more value there is to being in the sweet spot (or core area). This chart also shows how production is more homogenous in some plays than others. This means that being in the sweet spot might not matter as much in plays like the Haynesville or Horn River formations. Stacked Pay Another factor that can be seen 3.5 in multiple plays is the presence 3 of stacked pay zones. Multiple pay zones provide additional 2.5 1.96 drilling opportunities from the 2 1.69 same area. This translates into a 1.5 higher overall well density (lower 1 minimum well spacing) and a 0.5 higher EUR per well. Compiled 0 with data from an Alliance Bernstein report, Table 5 shows the impact of stacked pay zones on well density for 7 US shale Source: Alliance Bernstein Reportc plays. The play most impacted by potential zones is the Deep Anadarko Basin. This formation has a well spacing of 115 acres, which equates to a well density of 5.6 wells per section. The presence of 12 possible zones increases the number of wells per section to approximately 66.9.
Chart 23: Ratio of Wells with IP Rates in the Top 10% vs Average IP Rates 3.32 3.03 2.75 2.8 2.84 2.37 2.38 2.42 2.42
Table 5: The Impact of Stacked Pay Zones on North American Shale Formations

Formation Eagle Ford Deep Anadarko Marcellus Haynesville Barnett Core Horn River Bakken

Well Spacing (Acres) 110 115 138 110 207 220 310

Wells Per Section Per Zone 5.8 5.6 4.6 5.8 3.1 2.9 2.1

Potential Zones 2 12 3 2 2 2 2

Total Wells per Section 11.6 66.9 13.9 11.6 6.2 5.8 4.1

29 Ranking North Americas Shale Plays To briefly summarize, we know that the better quality shale plays have: High IP rates, fast decline rates, production weighted towards liquids, and high EURs. High IP rates and fast decline rates mean that a larger percentage of cash flows are returned earlier in the life of a well. This means that companies with a huge inventory of drilling opportunities can reinvest their cash into the next set of wells more quickly. The production from liquids rich plays is much more valuable than gassier plays due to the low price of natural gas. Wells with higher EURs produce more barrels (cash flow) over their lifetime than wells with lower EURs. One factor we havent examined yet is the areal extent of each individual play. Its important to remember that not all areas within a play can be produced economically. This means that its not the total size of the play that matters. Whats important is the total acreage within a play that can be produced economically. The total prospective acreage within a play, along with its particular well spacing requirements, act as constraints on the on the maximum number of wells that can be drilled within it. Table 6 lists the total amount of prospective acreage, well spacing, and the maximum number of wells that the can be drilled in the prospective acreage for the 12 most important shale plays in North America. Bernstein analysts estimated the total prospective acreage using mapping techniques similar to those used in the previous section on sweet spots in the Bakken formation. These estimates represent the total prospective acreage available at the beginning of the plays development. Well spacing requirements and corresponding well counts were calculated using the same method as before. Examining the differences in the well counts between the Eagle Ford, Permian, and Bakken formations highlights the huge effect well spacing has on the development of a play. The Bakken and Eagle Ford are roughly the same size, but the Eagle Fords tighter well spacing allows it to fit almost twice the number of wells as the Bakken formation.

Table 6: Total Prospective Acreage in Each Play

Play Eagle Ford Bakken Permian Niobrara Mississippi Lime Deep Anadarko Basin Utica Marcellus Barnett Haynesville Horn River Woodford

Prospective Acreage 6,547,200 6,831,642 5,800,000 2,240,762 3,994,624 3,000,000 2,350,367 2,952,141 2,271,552 1,600,000 1,515,238 9,600,000

Well Spacing 120 284 200 200 240 150 200 150 150 100 200 200

Maximum Number of Wells 54560 24055 29000 11204 16644 20000 11752 19681 15144 16000 7576 48000

30 Knowing the maximum number of wells that can fit within a plays prospective acreage allows us to estimate the total BOEs a play will produce over its lifetime. Lifetime production estimates are illustrated in Chart 25. The Eagle Ford formation is 1st in total lifetime production. It out produces its closest competitor (Deep Anadarko) by an estimated 35% over its lifetime.

40 35 30 25 20 15 10 5 0

Chart 25: Total BOEs Produced Over Lifetime of Play

-BOE*10^9 Broken Down into Oil, NGL and Gas

BOE 10^9

Gas NGL Oil

Well costs are a major expense for E&Ps choosing to operate in North Americas Source: Alliance Bernstein Research unconventional resources. According to research from Alliance Bernstein, well costs range from $12.5E6 (Horn River) to $3.15E6 (Barnett) and average around $7.5E6. Chart 26 shows the price of a BOE from each individual play based on the following price assumptions: $100/bbl Oil, $40/bbl NGL, and $4.00/mcf Gas. All production related costs, including those associated with drilling and completing wells, were converted into $/bbl amounts in order to examine the margin per barrel for each play. The 3 plays with the highest profit margins are the Eagle Ford, Bakken and Permian Basin, respectively. The Eagle Ford formation has is on top due to its relatively small production related costs and its liquids rich production. Even though Bakken formation has the highest production related costs in the group, its production is the most valuable ($90/BOE) due to its extremely high liquids content. On the other end of the spectrum, the Haynesville and Woodford plays are not even breaking even under the current gas price scenario. To break even, the Haynesville and Woodford plays need gas prices to be $4.40/mcf and $7.14/mcf, respectively. Chart 26: Estimated Costs per Barrel ($/bbl)
100 90 80 Costs per Bbl($/Bbl) 70 60 50 40 30 20 10 0 -Assumes $100/bbl Oil, $40/bbl NGL, and $4.00/mcf Gas -Wooodford and Haynsesville Revenues are less than Cost to Produce (Red Cirlce Price of BOE) Margin Ad Valorem/Production Taxes Royalty Capex Opex

In my opinion, the best way to rank these plays would be to use some NPV based metric. Using NPV would account for the liquids content of production, time value of money, EURs, and the production profile of a well. Doing this would require creating a schedule of cash flows based on each plays average type curve. Unfortunately, I dont have access to the data required to construct the 12 individual type curves that are necessary. I ended up having

Source: Alliance Bernstein and

31 to use the NPV10s given in an Alliance Bernstein report. They calculated NPV10s (10% discount rate) for each of the twelve plays by matching cash flows to each plays average type-curve and using the data located in Table XX in Appendix 1. Chart 27: Total NPV10 and NPV/10 Acre for Each Play Chart 27 shows both the total NPV10 and NPV10/Acre for each of the 12 plays. 50000 Total NPV10 is calculated by multiplying 40000 the NPV of an average well by the total 30000 maximum number of wells that will be NPV10/Acre Total NPV drilled in a play (based on well spacing). 20000 The 3 plays with the highest total NPV10s 10000 are the Eagle Ford, Bakken, and Permian, 0 respectively. Total NPV10s look only at the maximum number of wells that can -10000 be drilled within a play. This means that -20000 total NPV10s dont account for the differences in well spacing between plays and produce results that are slightly Source: Alliance Bernstein Research biased towards those with the larger areas (larger area=more wells). Evaluating the plays based on NPV10/acre allows for size independent comparison and also brings well spacing requirements into the picture. After ranking the plays according to their NPV10/acre, we see that the Deep Anadarko Basin jumps from 4th to 2nd and pushes the Bakken and Permian to 3rd and 4th, respectively. This jump can be attributed to the Deep Anadarkos higher IP rate and lower well spacing requirement.
Total NPV (10^7)

50000 40000 30000 NPV10/Acre 20000 10000 0 -10000 -20000

Final Thoughts on North Americas Other Plays The majority of North Americas jump in oil production can be attributed to the Eagle Ford, Bakken and to a lesser extent, Permian formations. The fact is, all of the other plays dont really add that much in the larger scheme of things.

What do we do now?
With all of North Americas best resource plays nearly leased out, where are E&Ps supposed to go from here? The likelihood of discovering another Eagle Ford or Bakken in North America is fairly remote, but there still is some opportunity for organic growth. In a recent report, analysts at Alliance Bernstein screened the entire North American continent for future possible plays. The total surface area and number of separate intervals within each play were the two most important characteristics since both of increase the number of drilling opportunities that are available. This analysis revealed that the most likely places to find new resource plays are right where theyre at. Analysts believe that the best bet for E&Ps to find new, economic drilling opportunities is to dig up (down) in order to find older (younger) source rock or move laterally across the basin in search of

32 new ground. The other option thats available is to head off in search of frontier plays, which involves a lot more risk. They believe that the first option is superior and that the majority of future development will be the Gulf Coast, Permian, Rockies and Anadarko Basin.
Image 2: The 1st (Left) and 2nd Quartiles of Potential Plays

Source: AB Research

The notion that the best unexplored areas are located within or near well-known plays that are already crowded poses somewhat of a problem for those companies that havent secured any acreage in these areas. These companies will either be forced to explore in new, remote areas, pay premium prices for acreage in the popular areas or merge/acquire another E&P that has acreage in these areas.

Will the Industry Consolidate in the near future?

The E&P industry has historically consolidated during times when little organic growth opportunities were present. The size and magnitude of M&A deals started to pick up during 2012, but really slumped after the New Year (see Chart 28 below). This is surprising due to the decreasing amount of open acreage in North America. I feel that consolidation must happen sometime in the future but am unsure of how long that will be. The supermajors and even some of the larger E&Ps (APC, APA, and EOG) have exceedingly large cash balances that they have been stockpiling for a while now (See Chart 29). The conditions are right and the money is there. There is no way to escape major consolidation.
Chart 28: The cash balances of Supermajors and Large Independents have growing for quite some time Supermajors 16000 18000 14000 12000
$MM

1600 1400 1200 1000

$MM

Chart 29: Value and Frequency of Deals Appears to be Declining Dollars spent($MM) and Frequency of deals per Quarter180 60000
50000 40000

Top 5 Independents

$MM

10000 8000 6000 4000 2000 0 FQ12000 FQ12001 FQ12002 FQ12003 FQ12004 FQ12005 FQ12006 FQ12007 FQ12008 FQ12009 FQ12010 FQ12011 FQ12012 FQ12013

800 600 400 200 0

100 80

30000 20000 10000 20 0 0 60 40

Source: Capital IQ

1999FQ1 2000FQ1 2001FQ1 2002FQ1 2003FQ1 2004FQ1 2005FQ1 2006FQ1 2007FQ1 2008FQ1 2009FQ1 2010FQ1 2011FQ1 2012FQ1 2013FQ1

Source: Capital IQ

Frequency

$M&A per Quarter Deals per Quarter

160 140 120

33

Porters 5 Forces
North American E&Ps compete in one of the most competitive and difficult industries in the world. Threat of New Entrants- Low E&Ps face little threat from new market entrants because of extremely high barriers to entry. The main barrier to entry is the extremely high capital costs associated with drilling for and producing oil. To drill a single well in the Eagle Ford Shale would require an outlay of $7.00E6 just to get it drilled and its not enough to just drill one well: you have to drill a bunch! Knowing how to successfully produce oil also requires a high level of skill that can only be gained with years of experience. Its not like selling Avon, you cant just up and decide to do it. Supplier Power-Medium The various oil service companies do possess some supplier power over E&Ps because many of these companies offer differentiated products or services. The way a well is fracked has a large impact on its profitability. If one particular company is having a lot of success with their method of fracing, they could impose their supplier power of E&Ps. E&Ps face high switching costs from their data management or software providers. Some of the software that E&Ps use is extremely expensive and complicated to learn. Switching to another brand would cost a lot of money and slow everything down until all employees were comfortable using the new software. Since nothing is cheap or easy about drilling for oil, I feel safe making the assumption that a lot of things in the industry have large switching costs. Buyer Power-Low Commodities can only be differentiated on price, but oil and gas contracts are traded at various exchanges and prices are determined by the laws of supply and demand. This means single buyers cant have a large enough impact on price in order to exert any kind of power of E&Ps. Threat of Substitutes-Low Currently there are zero substitutes to for oil and wont be for the foreseeable future. In Oil 101, Downey claims that if all the corn grown in the US for food production was turned into ethanol, only 6% of our demand for fuel would be offset. Wind and wave energy also face severe scale issues. The only remotely possible substitute for oil would be natural gas. If this occurred I think the price drop in oil would at the very least be offset by the increasing price of natural gas. Degree of Rivalry among Competitors- High There is a high degree of rivalry among existing competitors. There is a finite amount out of oil located beneath the surface of the earth. Every gallon of oil extracted makes the pie a little smaller for everybody else (exactly the same as industry with slowing growth). Companies also have an extremely high level of fixed costs. In order to exit the industry, a company would have to divest a significant amount of assets. The fact that every company in the industry is competing over the same decreasing volume of oil intensifies and all face high exit costs intensifies the rivalry within the industry.

34 Overall Industry Assessment The low threat of substitutes and new entrants are positive indicators for the industry. The intense level of rivalry due to industry participants competing over a diminishing volume of resources and high exit costs detract from the attractiveness of the industry. The limited buyer power is offset by the volatility of the prices of natural resources. Overall I feel the attractiveness of this industry is attractive in the short term, but its long term viability is questionable.

Industry Growth
Short Term Most analysts believe that the rush to secure land in North Americas best unconventional resources is over and the prospects of finding any more plays like the Bakken or Eagle Ford are bleak. This implies that the rate of oil production will increase until it can no longer keep pace with the steep rates of decline from unconventional wells. Most of my research indicates that this peak will occur within the next 7-15 years. Production rates will decline quickly after the peak. Oil production is what will drive the growth of this industry in the near future. The depressed prices of natural gas products have caused most companies to focus on oil production. While natural gas will have a role at some time in the future, I am unsure of when that will occur. I predict that revenues will increase over next five years due to E&Ps ramping up production from their holdings. I also believe that the number of competitors within the industry will decline due to consolidation. Long Term The long term outlook for North American E&Ps will depend on the innovativeness of its members. This industry is composed mostly of smaller companies whose operating space is constrained to North America. They dont have the capital necessary to run all over the world looking for easy to produce oil. The necessity to make the best with what you have has been why some of the biggest innovations to impact the entire oil and gas universe have come from smaller North American E&Ps and not one of the supermajors. It was well known that shale rock contained large quantities of natural gas and oil during the 1990s. The need to replace depleting reserves forced Mitchell to develop a way to develop natural gas from shale rock at economic rates during the late 90s. The resurgence of North Americas oil production wouldnt have been possible without Mitchells important contribution. Why wasnt this developed by one of the supermajors? Devoting the time and capital necessary to develop a way to extract natural gas from shale rock wouldnt make any economic sense to companies like Exxon or Shell. Doing so would be inefficient from a portfolio management perspective given their large inventory of possible projects. Smaller independents like Mitchell Energy didnt have this large inventory of projects.

35 I believe that the long term future of North American oil contains some degree of optionality. Ten or 15 years ago, no analysts could have predicted the boom we are currently experiencing. Although its unlikely, whos to say something like this cant happen in the future? For example, conventional and unconventional resources have recovery rates of approximately 30% and 8% respectively. That means roughly 80% of North Americas oil will remain after the last well is drilled. Is it possible that some innovative E&P will develop a way to economically extract this huge quantity of oil?

Company Analysis
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 30 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.
Table 7: Size of EOG holdings

Chart 30: 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

Play Bakken Eagle Ford Permian Barnett Haynesville Marcellus Anadarko Horn River

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

Size (Acres) 600,000 600,000 400,000 350,000 450,000 170,000 125,000 638,000

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.

36 both the Bakken/Three Forks and Eagle Ford formations are positioned well within the sweet spots of each play. In addition, they also hold smaller positions in the Barnett, Marcellus, Anadarko, Haynesville and Horn River plays. The approximate size of each position is listed in Table 7. EOG was able to secure a large position within the Eagle Fords sweet spot by being one of the first movers into the play. Their annual 10-K states that approximately 569,000 of their total 639,000 net acres is located within the oil window of the play. They are currently the largest 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 31 shows the breakdown of oil production from all of EOGs North American holdings.
Chart 31: 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

37 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.

38 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.

39

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 32 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 32: 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 33 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. EOGs expected capital expenditures during 2013 are approximately $7.2B, according to

$MM

1000

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

Chart 33: Volatile Net Working Capital Requirements

500 400 300 200 NWCR Peer Avg. NWCR

MM

100 0 -100 -200 -300 Peer companies consist of NBL, APA,APC, PXD,MRO,DVN,SWN, RRC and CHK Source: Capital IQ 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

40 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. EOG is currently 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 capex 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 34 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 34: 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 35. 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.

41 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. Chart 35: EOG's Debt/Proved Reserves has been increasing rapidly since 2007
EOG Peer Average

14 12 10 8 6 4 2 0

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

Long Term Growth

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

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 a reserve life of approximately 10.4 years, which is lower than the peer average of 11.48 years. Even though EOGs reserve life is shorter than that of their peers, their proved reserves are more valuable than the industry average because they are strongly weighted towards liquids.

42 Even though EOGs RRR and reserve life are less than their peer averages, I still feel that their revenue growth will outperform the industry average into the future for two main reasons. EOG has a significant quantity of unproven reserves that these metrics dont account for. Also, EOGs reserves are also more weighted towards higher valued liquids. Margins We can see that EOGs gross profit margin 100.00% Gross Margin Peer has declined at a CAGR of -20.1% over the 95.00% Average 90.00% last five years, see Chart 36. Growth in the NYSE:EOG 85.00% 80.00% peer group has been stagnant. EOGs 75.00% declining gross margin has been due to 70.00% 65.00% two main factors. The first is the crash in 60.00% Source: Capital IQ 55.00% oil and natural gas prices during 2008. 50.00% 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.
Chart 36: EOG's gross margins have fallen sharply while the peer average has remained stagnate Chart 37: EOG's net margin moves closely with peer average, but doesnt move with as much intensity

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

EOG Net Margin Source: Capital IQ

EOGs net margin has moved along with their peer average in the past, see chart 37. The slight decline during 2012 was due to an 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 the development of 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 thing I 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.

43 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 38 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 38 how low the spread is between EOGs all-in and organic F&D costs are. This is due to the fact Chart 38: EOG's all-in and organic F&D costs have they are growing reserves almost always remained below their peer average. exclusively through organic -organic and all-in F&D costs (3 year rolling average) methods.
Source: Capital IQ

25

20

$/BOE
5 0

15

10

The next metric I would like to discuss is the leveraged full-cycle ratio (LFCR). According to Moodys, the LFCR reflects the productivity of reinvested capital on a BOE basis. EOG All In F&D Peer Average All In F&D This measure indicates whether a EOG Organic F&D company is generating a positive Peer Average Organic F&d return on their overall production. This metric helps to highlight which FY2002 FY2003 FY2004 FY2005 FY2006 FY2007 FY2008 FY2009 FY2010 FY2011 FY2012 companies are better at generating cash-on-cash returns. LFCR is calculated by dividing the 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 39 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 39: 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

44 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.

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

Chart 40: EOG's ROE has tracked peer average, but there have been some divergences
EOG Average

ROE Decomposition

Chart 40 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 Source: Capital IQ section). EOG earned a lot larger margin 2000200120022003200420052006200720082009201020112012 during 2008 than the rest of the industry because of differences in their asset mixes. EOG started divesting gassier plays several years prior to the 2008 crash in natural gas prices. This meant that EOG wasnt as affected by the large write-downs 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. 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

45 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.

Intrinsic Valuation
In this paper I will first discuss the components that make up the discount rate and calculate EOGs cost of equity and WACC. Following that, I will use a FCFF model to value EOG and then use a simulation model to help develop Best/Worst case share prices.

Discount Rate
The value of an asset is the sum of its discounted future cash flows. These cash flows must be discounted in order to account for variability (risk) in their final value. The discount rate used should represent the risk inherent in these cash flows. The following equation describes the components of the discount rate:

Where: E(R) = expected return of security Rf = Risk-free Rate Beta ERP = equity risk premium

46 In the following sections, we will discuss the Risk-free rate, Beta, and the Equity Risk Premium. Each of these components will also be estimated in order to calculate EOGs discount rate.

Risk-free Rate
The risk-free (RF) rate of return is the foundation that all expected return models is built around. Its a generally accepted principle that bonds issued by governments in developed countries are indeed riskfree. The maturity of the bond chose to represent the RF rate of return should match the time horizon of the cash flows we are valuing. This implies that the proper RF rate is that of a long-term government bond. The recent financial crisis has caused the rates of all government bonds to fall substantially. US 10-year rates fell to a low of 1.43% during the summer of 2012. This has caused many to turn to using a normalized RF rate in their valuations, but is this the right thing to do? I dont believe so. What is the correct normalized interest rate to use? What is normal is a completely personal thing. While a 4% interest rate may seem like the logical RF rate, others may believe it should be 5%, 7%, or even 12%. Normalized rates reflect the time period they were calculated from. The matter of selecting the correct time period to average is completely subjective with no clear right or wrong answer. Using a RF rate based on historical data assumes that future economic conditions will be similar to those of the period used to calculate normalized rates. There is no guarantee that the future will look anything like the past. Another argument against using normalized rates is that RF rates are supposed to represent the opportunity cost of choosing not to invest in a risky asset. In other words, this is the rate you would receive if you didnt invest in the risky asset. Choosing to use a normalized rate violates this principle because you cant invest in a normalized RF rate. The main reason for not using a normalized RF rate is that it introduces our personal opinions and beliefs about the direction of the economy into the valuation. Choosing to use a normalized RF rate changes the estimate of the companys cost of capital used in the valuation, which impacts its final value. The final valuation will be a combination of your views on the company and the direction of interest rates. Although its impossible for a valuation to be completely free of personal opinions, they should definitely be minimized. This means that using a normalized RF is inconsistent with the principles of valuation. This means that the RF rate used in a valuation should be the actual market rate of interest for a longterm government bond. The RF rate chosen in this valuation was the discount rate for a 10-year US government bond. This was 2.94% at the time of this writing.

Beta
Betas measure the systematic risk present in a particular stock by measuring of much it moves in relation to the market. I chose to use the Bottom-Up method of calculating beta thats described by Damodaran in his book Investment Valuation. The justification for using this method and a description of the process are discussed below.

47 Regression Betas A popular method of estimating beta is to regress the returns of a particular stock against the returns of an index used as a proxy for the market portfolio over some specified time period. Damodaran believes that this method has several issues that make it unsuitable for use in valuations. These include choosing an index to proxy the market portfolio, the time period over which returns are regressed, and the time period that the returns are computed over. Table 8 illustrates the different estimates of EOGs beta after changing various parameters. The most notable change occurred when changing from weekly to monthly returns for two year betas on both indexes. This leaves us with the question, is there a better way to estimate beta?
Table 8: Which one is the right beta?

S&P500 Years

Russell 3000

Weekly Monthly weekly Monthly 2 1.45791365 0.61360676 1.43602097 0.69480792 3 1.39785849 1.45357865 1.3554658 1.444926592 5 1.310784199 1.33518625 1.27033302 1.314227199

Bottom-Up Betas In his book, Investment Valuation, Damodaran says that while regression may be used to estimate beta, its the firms fundamental decisions that determine it. A firms beta is dependent on the type of business or businesses its in, their degree of operating leverage, and their financial leverage. The more sensitive a sector is to market conditions or discretionary its products are, the higher its beta. A firms operating leverage is defined by the relationship between its fixed and variable costs. Firms with a higher operating leverage will have large deviations in EBIT. This increases a firms beta, holding everything else constant. Similarly, higher levels of financial leverage increase variation in net income due to interest payments, which increases beta. Bottom-up betas are calculated by first breaking betas down into their business, operating leverage and financial leverage components. To do this we must unlever a firms beta using the following equation: Where: = Levered beta for equity = Unlevered Beta t = Corporate tax rate D/E = Debt/Equity Ratio

48 This equation was first developed by Hamada in 1972. According to Damodaran, if we assume that all of a firms financial risk is taken on by its stockholders, then the beta of debt is zero. This means that the levered beta of a firm reflects the type of business the firm operates in and the amount of financial leverage its taken on. The unlevered beta of a firm reflects the firms level of business risk and also the firms operating leverage. The first step in calculating a bottom-up beta is to separate the firm into its separate businesses. After that, find other companies operating in each of the firms separate business and compute an average (or median) beta for each business. Unlever this average beta by the using the average (or median) D/E ratio of each business. Then, compute the firms unlevered beta by computing the weighted average of each of the individual businesses the firm operates in. The weights are derived using the proportion of firm value derived from each business. Finally, compute the levered beta by estimating current market values for debt and equity and use that D/E ratio to estimate the levered beta. Damodaran states that one of the main benefits of bottom-up betas is the reduction in standard error. Even though the individual betas used in the calculation may be noisy, averaging across each individual business provides a significant reduction. The bottom-up beta also reflects the firm as it exists today because its based on the current weightings of its different businesses. This means that the beta estimate can be easily updated to reflect changes in business mix. Lastly, the estimate is based on current levels of debt, not the average level of debt over the time period of the regression. In my opinion these are significant improvements over regression betas. The following section outlines the general process I used to calculate EOGs bottom-up beta. Calculating EOGs Beta The main criteria I had for selecting comparable firms was that their primary line of business had to be exploration and production because this is EOGs only line of business. I chose to filter out firms with significant refinery operations or those that operated primarily outside of the US because those firms have different risk characteristics than EOG. I also chose to filter out firms who primarily operated in the Canadian oil sands for the same reasons. The final group of comparable firms consisted of 20 companies with market caps between $5,000MM and $40,000. To calculate the average leveraged beta for the group of comparables I averaged their three-year regression betas using weekly prices. In Damodarans work, he says to use market D/E ratios to de-lever the averaged betas, but I am unsure of whether he means the Debt/Market cap ratio or the market value of debt divided by the market cap. I could not think of a time efficient way to calculate the market value of debt for 20 companies so I chose to use the firms debt/market cap ratio. I averaged these D/E ratios and then used this to delever the average beta previously calculated. The average beta was delevered by dividing it by (1+(1-t)(D/E)). The tax rate used was the US marginal corporate tax rate of 40%. The results of these calculations can be seen in Table 9.

49
Table 9: Inputs used to calculate bottom-up beta (Source: Capital IQ)

Average Levered Beta 1.51

Average D/E Ratio 0.29

Average Unlevered Beta ( ) 1.26

Average Unlevered Beta adjusted for Cash Balance (Sector Beta0 1.30

The cash adjustment seen in Table 9 is made to account for the fact that companies usually invest cash in risk-free instruments ( =0). Cash has the effect of lowering the unlevered beta (business beta) because its calculated as the weighted average of all its components. Assuming that cash has beta of zero allows us to simply divide the average unlevered beta by (1-CashW) to remove the impact of cash balances (CashW is equal to the firms total cash divided by its enterprise value). This beta is known as the pure business or sector beta. In this case, choosing to remove the effect of cash from the unlevered beta does not have that big of an impact because the average cash balance of E&Ps is only around 2.5% of their enterprise value. The next step is to calculate EOGs unlevered beta by adding back in the effect of EOGs cash balance on sector beta. This is done by multiplying the sector beta by (1-CashW-EOG). After that, you have to relever the beta by multiplying it by (1+(1-t)(D/E)). EOGs market D/E ratio was used in the calculation. I estimated the market value of debt for EOG by turning all the debt on their books into a single coupon bond. The value of this bond is the market value of debt. This method is illustrated by Damodaran in his book Investment Valuation. EOGs final levered-beta was estimated to be approximately 1.37. The results and inputs to these calculations can be seen in Table 10.
Table 10: Final inputs and values for bottom-up beta (Source: Capital IQ)
Mkt Debt EOG 6276.77 Mkt Cap 46176.50 Mkt D/E 0.14 Cash/Firm Value 0.03 Adjusted for cash 1.26 Re-levered Beta 1.37

The benefits of using a bottom-up beta over a regression beta can be comparing the standard errors of the two methods. The beta estimated by regressing EOGs weekly returns against those of the S&P 500 over a 3 year period was 1.30 and had a standard error of .098. This means that there is a 67% chance that EOGs true beta is between 1.398 and 1.202 (1 std. deviation). The beta estimated using the bottom up method was estimated to be 1.37 and had a standard error of .035. This means that even at the 95% confidence the bottom up beta will be within .07 of EOGs true beta. This is a huge improvement over the beta estimated via regression.

Equity Risk Premium

The Equity Risk Premium (ERP) is the expected return above the RF rate of return that investors demand for investing in equities. According to Damodaran, the ERP reflects fundamental judgments that we make about how much risk we see in an economy/market and what price we attach to that risk. This

50 means that the ERP represents the hopes and fears of all investors. When fears (hopes) about the market rise, the ERP also rises (falls) to reflect these fears, and stock prices fall (rise). There are three ways to measure the ERP. These include using a historical (normalized) rate, surveying investors about their expectations of future returns, and calculating an implied ERP. The estimation of both historical and implied ERPs will be discussed in the following sections. Historical ERP This method measures the actual returns on stocks over those earned on a default-free security over a long time period. Using historical ERPs suffer from many of the same issues as using normalized RF rates. The main issue deals with selecting the time period over which to estimate the ERP. How far back in time should you go to estimate the premium? Some analysts choose to go as far back as possible, while others choose shorter time periods that may only go back 10, 20 or 30 years. Proponents of using extremely long time periods claim their estimates are the best because they contain less noise. Those who use shorter periods believe theirs are better because the risk aversion investors is likely to change over time and a shorter time period includes more recent estimates of the ERP. Damodaran notes that estimating the ERP using historical data yields estimates with a significant amount of standard error regardless of the length of estimation period used. He says that using time periods of less than 25 years have standard errors larger than the actual ERP. Even using 80 years of data will still yield and ERP with a standard error of 2.2%. Implied ERP An implied ERP is calculated by using the formula for the value of a stock to back out the expected return. This is accomplished by computing the IRR of the S&P 500 (or any index) and then subtracting out the RF rate. Implied ERPs dont require historical data to be estimated. They assume that while individual stocks may be mispriced, the market is correctly priced in the aggregate. One of the main advantages to using an Implied ERP over a historical ERP is that they allow you to remain market neutral. In contrast to historical ERPs, implied ERPs dont force you to make assumptions about the direction they are heading. Another advantage of implied ERPs over historical ERPs is that they are forward looking. This is because implied ERPs are estimated using a valuation model which uses expectations of future cash flows. ERPs vary over time due to changes in investor risk aversion and changing macroeconomic conditions. Implied ERPs do a much better job of reflecting these changes than historical models. This is because they are based on current expectations and not on historical data. The implied ERP I will be using in this valuation is 5.19%. This is the premium calculated by Damodaran every month; its available on his website. Final Thoughts on estimating the ERP When weighing the merits of using a historical versus using an implied ERP, the scale is clearly tipped in the direction of implied ERPs. They are a forward looking number instead of backward looking like historical ERPs. They allow you to remain market neutral and not bring your assumptions about the

51 future direction of the ERP into the valuation. Finally, they are dynamic enough to reflect current changes in macroeconomic conditions and changes in the risk aversion of investors.

WACC and Cost of Equity

To calculate EOGs cost of equity, we simply multiply an implied ERP of 5.19% by EOGs beta of 1.37 and add the current RF rate of 2.9%. This gives us a value of 10.34% for EOGs cost of equity. To get from the cost of equity to a WACC, we must weight EOGs cost of equity and cost of debt by their market value weights of both debt and equity to total capital. Doing this gives us a value of 9.25 for EOGs WACC. EOG is an industry with an extremely variability of returns due to volatile commodity prices. This means EOGs WACC should be higher to reflect that risk. I feel that the calculated WACC of 9.25 is high enough to do so.

Valuing EOG using FCFF

I didnt realize it at the time, but I made my life a lot more difficult when I decided to choose EOG this project. They are lacking single major component required by many valuation models-Free Cash Flow. Due to their extraordinary capital expenses, they havent had any free cash flows since 2005. Since EOG has been paying a dividend for a long period of time, I thought I could get around this by using one of the dividend discount models. Every model I tried severely undervalued the stock with anything remotely resembling a realistic growth rate. All of them required extremely unrealistic long term growth rates to approach for the price to be greater than $50/share. I believe this is because their dividend yield is so low. They are only paying out 75 cents annually which means their dividend yield is only 0.44%. This meant I was forced to use one of the FCF models. To get around their negative FCF, I had to project their earnings into the future until they had positive FCF. The following section discusses the assumptions and methods I used to accomplish this.

Getting to Positive FCF

Management has said they would be cash flow positive between 2014 and 2017 at several recent presentations. The results of my projections lead me to believe that EOG will have positive a FCFF of $2,086MM in 2015. This is dependent on their continued high growth in oil production and holding their capex close to the same levels.

EOGs Growth Rate

While EOGs revenues have grown at a CAGR of 42.6% between 2009 and 2012, this is not likely to continue forever. The main driver of EOGs revenues is their oil production. Their oil production growth has been extremely high due to their large holdings in the Eagle Ford and Bakken/Three Forks formations. As discussed in my analysis of the industry, the production characteristics from unconventional plays is not uniform across its entire surface area. I feel that EOGs high growth in oil production is due to them developing the best areas of the play first. This means their production growth will start to decelerate as they run out of prime areas to drill. This deceleration will occur until

52 growth starts to become stagnant and eventually turns negative. Once this occurs, the high decline rates of unconventional wells will start to catch up with them and production growth will start to turn negative. My projections of EOGs future production can be seen in Table 11. Oil production starts out growing at 39% and then starts to decelerate. Their total oil production peaks around 2019 and then starts to fall as fast well decline rates overtake the production from new wells. I believe that the decline in gas growth will start to decrease and eventually turn positive as EOG has no other choice but to develop gassier areas. I assumed the production of NGLs would follow along the same lines as oil production.
Table 11: EOG's Forecasted Revenues from Production Source: Capital IQ
2011 Total Oil Production(MMbbl) % Change Total Gas Production (MMboe) % Change Total NGL Production (MMbbl) % Change Revenues % Change 41.39 0.52 104.23 -0.05 15.48 0.39 6881 0.40 2012 57.79 0.40 98.90 -0.05 20.46 0.32 7962 0.16 2013E 80.33 0.39 89.01 -0.10 23.73 0.16 10445 0.31 2014E 104.43 0.30 78.33 -0.12 26.11 0.10 12463 0.19 2015E 133.67 0.28 66.58 -0.15 28.19 0.08 14905 0.20 2016E 167.09 0.25 59.92 -0.10 29.60 0.05 17815 0.20 2017E 200.50 0.20 58.73 -0.02 30.20 0.02 20821 0.17 2018E 224.56 0.12 60.49 0.03 31.10 0.03 23069 0.11 2019E 235.79 0.05 63.51 0.05 30.17 -0.03 24111 0.05 2020E 233.43 -0.01 66.69 0.05 30.47 0.01 23989 -0.01 2021E 224.10 -0.04 70.02 0.05 29.86 -0.02 23201 -0.03 2022E 203.93 -0.09 73.52 0.05 28.37 -0.05 21403 -0.08 2023E 183.54 -0.10 77.20 0.05 26.95 -0.05 19593 -0.08

While EOGs production revenues start off with an extremely high growth rate, it starts to slow due to deceleration of oil production growth. These forecasts are made assuming prices of $90/bbl, $24/BOE and $45/bbl for oil, gas, and NGLs respectively. Growth in revenues, along with oil production, start to turn negative around 2020. Revenues from production will grow at a CAGR of 8.6% over the period. Their total revenues also include revenues from gathering and marketing activities. These are the revenues from their rail lines. I assumed those would also grow along with production revenues. To calculate the growth in FCFF, I forecasted the required statement items along with revenues. Future capex was based on the equation obtained by regressing historical production and historical capex. This regression had an RSQ of .94, which means capex is a good predictor of total production. DD&A was also estimated via regression. The regression between DD&A and capex had an RSQ of .97. NWC was projected as a percent of revenues as Damodaran does in his teachings. COGS are composed mainly of costs due to exploration and production so I also projected it as a percent of revenue. The results of these can be seen in Table 12. FCFF grow at a CAGR of 10.41% between 2015 and 2023. The entire model can be downloaded from my Dropbox account from the following link: Download Model
Table 12: EOG's Cash Flow Forecast
2012 EBIT EBIT(1-t) DD&A CAPEX NWC FCFF 1287 792 3170 7355 -66 -3328 2013E 2187 1345 3472 6906 179 -2268 2014E 5584 3434 3886 8669 235 -1583 2015E 12871 7915 4459 9730 280 2364 2016E 15393 9467 5282 11257 335 3157 2017E 18399 11315 6240 13035 400 4120 2018E 21502 13224 7021 14484 468 5294 2019E 23825 14652 7410 15205 518 6339 2020E 24900 15314 7443 15266 541 6949 2021E 24774 15236 7250 14908 539 7040 2022E 23961 14736 6719 13924 521 7011 2023E 22104 13594 6189 12941 481 6362

53

Getting a Value for EOG

To get their total enterprise value, I discounted each FCFF by EOGs WACC. This process can be seen in Table 13. I assumed EOGs terminal growth would be 2%, which is lower than that of the economy. This is because North Americas oil is a finite resource. Popular consensus is that after unconventional start to slow down, its over for North America. Summing these discounted cash flows gives us a value of $58,929MM for EOGs debt and equity. Getting to equity value requires adding back in cash and marketable securities and subtracting out debt. This gives a value of $52,652 for EOGs equity.
Table 13: Discounting Cash Flows
2014 FCFF Total Discount Factor 1583.11 1.09 1449.13 2015 2364.08 1.19 2016 3156.74 1.30 2017 4120.31 1.42 2018 5293.95 1.56 2019 6338.97 1.70 2020 6949.11 1.86 2021 7039.50 2.03 2022 7010.73 2.22 2023 6362.17 2.42 101865.77 42071.40

Undiscounted Terminal Value PV of Cash Flow 1980.86 2421.18 2892.77 3402.19 3729.01 3741.97 3469.84 3163.20

To get to share price we must take into account the dilution caused by management options. One way of doing this is by valuing them using the Black Scholes model. EOGs management options have a weighted average exercise price of $85.81. Using the three year standard deviation of 0.26, a risk free rate of 2.90% and an average maturity of 5 years gives us a value of $78.11 per option. Multiplying this by the total amount issued gives us a value of $4,842 for management options. Netting this out of the total equity value and dividing by the number of shares issued gives us a share price of $179.95.

Accounting for Volatile Commodity Prices

Since EOGs revenues are dependent on commodity prices I feel some other price scenarios should be examined. Since oil prices are the main driver of EOGs revenue, we will look at the impact have on their value. I believe that the possibility of extremely low oil prices is low. I feel there is a much stronger possibility of extremely high prices in the future. Therefore I will look at the impact of oil prices at $75.00/bbl and $130.00/bbl. All other variables are held constant. If we assume and environment with oil prices that are $75bbl, EOGs share price will be $113.00/share. This is approximately 37% less than our previous value. If oil prices increased to $130/bbl EOGs stock price would jump to $400.63/share. Although this isnt a very realistic exercise, it helps highlight the impact of commodity prices on an E&Ps value.

Valuing the firm with Simulated Commodity Prices

To set up the simulation I first fit distributions to historical oil, gas, and NGL prices that were adjusted for inflation. Palisades @Risk software chooses the distribution that has the highest Chi-Square value. This measures the goodness of fit between the data and the distribution. The best fit distributions for oil, gas and NGLs were logistic, lognormal, and normal, respectively. These distributions were then linked to the price input on my revenue model and ran 10,000 simulations

54 The simulation yielded a mean firm value of $65,424 with a standard deviation of 17,325. This means that theres a 67% chance that true firm value will be between 82,749 and 48,099. Calculating share price from the given mean yields a price of $203.74/share.
Chart 41: Results from Simulation

Chart 41 shows the distribution of firm values calculated from the simulation. I feel unsure of the precision of this model. I did not include account for the correlation between oil, natural gas and NGL prices. This simulation does help to show the impact of price changes on share price better than our previous analysis. Instead of holding prices constant through the valuation, different prices are used to calculate revenues for every period of the valuation. It also changes the values of all through products instead of just oil. To calculate Best/Worst case values for EOG, I used the standard deviation of firm value estimated from the simulation along with the firm value calculated from my original valuation. Table 14 shows the differences in firm value and share prices between my best, worse and base scenarios. The best case scenario is based on high commodity prices while the worst case is based on low prices.
Table 14: Best, Base, and Worst Case Scenarios

Best
Firm Value Share Price $76,164.00 $267.21

Base
$58,929.32 $179.96

Worst
$41,694 $116.82

Conclusions Regarding EOGs Intrinsic Value

I think it should be clear that oil, gas, and NGL prices have a huge impact on an E&Ps value. While we dont know the actual prices used to calculate firm value during my best/worst case scenarios, I still feel its better than the sensitivity analysis I did using oil prices. This is because the simulation doesnt hold prices constant throughout the entire valuation and it also changes more than one price at a time. In my opinion using plus or minus one standard deviation from my average base price just makes more sense. Even though this analysis says that EOG is 6% undervalued, I still believe that it is a hold. I feel that 6% is just too small of a difference in value to make it a buy for an E&P.

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Relative Valuation
Relative valuation methods try and determine how a firm is priced relative to its peers. The critical aspects of relative valuation involve choosing comparable companies and controlling for differences between firms. In this section, we analyze EOG based on its P/E, EV/EBITDA, and EV/BOEPD ratios. EOG is also valued using a hybrid intrinsic/relative valuation model that involves choosing a target P/E ratio.

Price to Earnings Ratio

EOG is currently trading at 41x earnings which its above its median P/E of 20.21x. This means its relatively expensive when compared to their past. In Chart 42, theres a visible spike in their P/E during February of this year due to their in EPS dropping from $4.10 in 2011 to $2.51 in 2012. Their reduced income during the fourth quarter of 2012 was due to the large write-down of a Canadian natural gas play. Since then their P/E has been trending downwards, but investors are still paying more than double what they have historically paid for earnings. Chart 42: EOG's P/E trending lower
200.00x 180.00x 160.00x 140.00x 120.00x 100.00x 80.00x 60.00x 40.00x 20.00x 0.00x
P/E-Earnings fom trailing LTM
EOG P/ELTM Median

14 12 10 8

Chart 43: EOG is expensive relative to EPX index

-EOG Relative P/E to Median P/E of EPX EOG Relative P/E EOG's Median Relative P/E

Source:Capital IQ

6 4 2 0
Source: Capital IQ

Chart 44: EOG expensive when compared to the market

12 10 8 6 4 2 0
-EOG Relative P/E to Median S&P500 P/E
EOG P/E Relative to S&P 500 Median Relative P/E

Source: Capital

Chart 43 shows that when compared to the EPX index, EOG is more expensive relative to its industry/peers. The EPX index is relatively small and contains EOGs entire peer group, so I feel it is a fair to substitute it in lieu of peer comparisons. EOGs mean relative P/E ratio of 1.25 means that at its current relative P/E ratio of 1.08 its trading at a 16.8% discount to the industry. Chart 44 shows that EOG is currently expensive when compared to the S&P 500. Its current relative P/E ratio of 2.29% is trading at a premium of 115.2% when compared to its median relative ratio of 1.139.

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Thoughts on the P/E Ratio

I feel the P/E ratio is a poor valuation metric for this industry. E&Ps have a huge capex requirement which means that EPS are extremely volatile. EOG is one of the only companies in the industry not to have significant gaps in its P/E ratio history due to negative earnings.

EV/EBITDA
One of the main advantages of the EV/EBITDA model is that its further up the income statement than EPS. This means that the E&Ps large capex requirements wont play havoc with the multiple. In his book Investment Valuation, Damodaran says that the EV/EBITDA multiple is determined by five components: Tax rates, DD&A, reinvestment requirements, cost of capital, and expected growth. Knowing the components of a multiple allow us to run a regression based on these predictors in order to predict a firms multiple. The predicted multiple allows us to compare firms after accounting for differences between firms. To calculate a predicted EV/EBITDA multiple for EOG, we first have to compile a group of comparable firms. I used the constituents of the EPX index for this analysis. After that, I ran a multiple regression using the following as my predictors: DD&A/EBITDA, Capex/EBITDA, effective tax rate, ROC, and expected revenue growth for the next two years. The results of the regression analysis can be seen in Table 15.
Table 15: Results of Multiple Regression Expected Growth in Revenues-2yr 27.47

R Square 0.45

Intercept 18.14

Tax Rate 0.03

ROC -73.04

Net Capex/EBITDA -0.30

DD&A/EBITDA -17.77

The most important thing to note in the table is the R-square (RSQ). The RSQ of a regression measures how good its predictors are at actually predicting the variable. An RSQ of 0.45 may be considered horrible for textbook problems, but in the real world this is actually pretty high. Solving for EOGs predicted multiple using the coefficients and actual values gives us a predicted EV/EBITDA of 6.37. EOGs actual EV/EBITDA is 7.44, which means EOG is relatively expensive.
19 17 15

Chart 45: Points above the line are relatively expensive after accounting for differences between firms
RRC PXD COG

Predicted

13 11 9 7 5 3 3 5 7
APA WTI NBL SWN EOG TSO APC WLL XEC DNR :SM

CHK

The real power of regressing a multiples components is the ability to quickly visualize which companies are overvalued (or undervalued) based on the multiple. Chart 45 is a plot of predicted versus actual multiples for every company in the sample. The trend line allows us to quickly see which companies are undervalued by simply noting which are under the trend line!

Actual

11

13

15

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EV/BOEPD
The EV/BOEPD ratio is also known as the price per flowing barrel. This is one of the most commonly used valuation multiples in the E&P industry. Price per flowing barrel compares a firms enterprise value to its daily oil-equivalent production rate. Natural gas production rates are usually reported in thousands of cubic feet per day (Mcf/d). Standard Chart 46: EOG's price per flowing barrel is practice is to multiply this by 6 in order to convert it to cheaper than that of its peers. bbl/day. Companies with a multiple thats higher -EV/Kboe/day Source: Capital IQ (lower) than their peer average are considered CHK expensive (cheap) relative to their peers. PXD
CLR CXO EV/Kboe-d 150 EOG APC APA 50 MRO TLM NBL MUR RRC INE XEC

250

200

100

Chart 46 shows that EOGs price per flowing barrel is less than the peer average. EOGs price per flowing barrel of production is $100.66M compared to the peer average of $115.95M. This means that EOG is relatively cheap when compared to its peers. One of the main problems with this metric is that it doesnt account for differences between the weighting of a BOEs components. This means that a company that appears cheap could have production heavily weighted towards natural gas. To account for this, companies can be compared based on their price per flowing barrel of liquids. This is calculated by dividing a companys enterprise value by their average daily liquids production (Liquids=Oil + NGL). Chart 47 shows that EOG even cheaper than its peers after adjusting for gas production. EOGs price per flowing barrel of liquids is $180.85M compared to a peer average of $257.96M. EOGs liquids production is discounted by approximately 30% compared to the peer average.

900 800 EV/Kbbl Liquids per Day 700 600 500 400 300 200 100 0

Chart 47: EOG's is cheaper than peers based on price per barrel of fowing liquids CHK
-EV/Kbbl of liquids per day Source: Capital IQ

RRC PXD APC APA NBL TLM EOG MRO MUR INE

CLRCXO XEC

10

15

Other problems still exist with this metric even after accounting for differences in the weighting of the components that make up a companys production profile. One of the primary issues is that price per flowing barrel doesnt account for differences between undeveloped reserves (either proven or unproven). This means that a high multiple could just be the result of a company having higher EV due to a large number of undeveloped reserves.

Target P/E
Valuing a firm using a target P/E ratio is a hybrid relative/DCF valuation method. This technique requires you to first forecast a firms dividends five years into the future and then sum their present values. You then multiply a target P/E by the firms forecasted EPS in the fifth year, calculate its present value and

58 add it to the present value of the dividends. All forecasts were made using the FCFF model used in the intrinsic value section of this paper. The 10.17% cost of equity calculated in the section on discount rates was also used. I chose to use EOGs average P/E of 31 as the target P/E. I could have also used the firms median P/E of 20.6, but I feel that this was too representative of the past characteristics of the firm. Going back to Chart 1, you can see that EOGs P/E was steady prior to around 2007. It has been much more volatile since then. I feel this is due to the switch from conventional resources to unconventional resources. Tight oil/gas plays have large decline rates and require firms to develop plays at faster rates to keep their overall production rate from declining which requires a lot more capex. As previously discussed, large capex requirements can cause EPS to be quite volatile. I calculated EOGs share price to be 97.34 using the target P/E of 31. Table 16 lists a range of P/E around my target as well as the target P/E required to equal the share price today. The target P/E calculated is approximately 42.5% less than the value of todays P/E. To get to a price of $169 requires using a P/E of 54, which is higher than todays. I feel that this is due to the same reasons why none of the DDM models would give anywhere close to a reasonable value. The value of EOGs dividend is tiny when compared to its price. Dividend yields are currently around .04%, which is extremely low.
Table 16: Value using Target P/E of 31
Target P/E Value 30 94.2

25 78.5

26 81.64

27 84.78

28 87.92

29 91.06

31 97.34

32 100.48

33 103.62

34 106.76

35 109.9

54 169.56

Final Thoughts on Relative Valuation

EOG is more expensive on a relative basis when comparing their P/E ratio against their historical ratio, their peer/industrys ratio and the S&P500s ratio. Regressing the components that determine the EV/EBITDA allowed me to come up with an equation to calculate a predicted multiple using EOGs components. Their actual multiple was higher than what was predicted by the equation, which meant they were expensive relative to their peers. EOG is cheaper relative to peers when compared on both price per flowing barrel and price per flowing barrel of liquids. The results of EOGs relative valuation are mixed. While EOG is more expensive relative to its peers when compared using the P/E and EV/EBITDA ratios, its relatively cheaper than its peers when compared on a basis of price per flowing barrel of production and price per flowing barrel of liquids. This leads to recommend EOG as a hold based on its relative valuation.

Technical Analysis
Technical Analysis is the process of analyzing historical data for patterns that could be used to predict the future direction of prices. There are many different types of patterns and indicators that investors use to forecast future price movements. In this section I will be analyzing EOG using two of the most common indicators: Moving Averages (MA) and the Relative Strength Index (RSI).

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Moving Averages
A stocks moving average is just a time series of its simple average calculated over a certain period. In this section I will use EOGs 50-day, 100-day and 200-day MA in order to make observations regarding EOGs past and future price history. This summer marked the start of a steep uptrend that ended on 11/05 when EOG broke through the support level at the trend line (circled area on Chart 48). Momentum has begun to slow considerably. While their 200-day MA is still sloping up, their 100-day MA is starting to level off and their 50-day MA has been sloping downward since 11/25. The 50-day MA appears to be about to cross the 100-day MA which is a bearish indicator.
Chart 48: EOG's Technicals Source: Yahoo Finance

RSI
The RSI indicator is a momentum oscillator that estimates a stocks momentum by comparing recent gains to recent losses. The RSI ranges between 0 and 100. Looking at EOGs RSI we can see that it started diverging prior to the peak of its trend on 11/05. The line across the top of the RSI indicator marks a series of lower highs which indicate that the RSI is diverging from price. Their RSI started swinging sharply upwards starting on 12/12 as EOGs price increased from $156.26 on 12/11 to $168.52 on 12/20. This large increase in momentum is a bullish indicator and could mean EOGs price will climb higher.

Final Thoughts on EOGs Technicals

These two indicators are contradicting, which means theres a lot of uncertainty in EOGs price right now. As it stands currently, EOGs technicals reinforce my opinion that they are a definite hold. I would need to see their price moving in a clear direction on strong volume for me to change my recommendation to a buy or sell.

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References
Research Reports
Alliance Bernstein Industry Research: o North American E&Ps: Manifest Destiny and the Unconventional Resource o North American E&Ps: Aligning the Stars of the Resource Play Constellations o North American E&Ps: Swords into Ploughshares These can be found in the EBSCO database.

Books
Oil 101 by Morgan Downey The Global Oil & Gas Industry: Management, Strategy and Finance by Andrew Inkpen and Michael Moffett Introduction to Oil Company Financial Analysis by David Johnston Economic Risk in Hydrocarbon Exploration by Ian Lerche and James Mackay Project Economics and Decision Analysis Volumes 1 and 2 by M.A. Mian Investment Valuation: Tools and Techniques for Determining the Value of any Asset by Aswath Damodaran

Websites
EOGs Corporate Website: http://www.eogresources.com Damodarans Website: http://pages.stern.nyu.edu/~adamodar/

Data
Financial data came from Capital IQ and Bloomberg EIA Production data came from North Dakotas Oil and Gas Division, the Railroad Commission of Texas o http://www.rrc.state.tx.us/ o https://www.dmr.nd.gov/oilgas/