Published: September 29, 2010

Any casual observer of the energy markets is probably aware that during the past two years, a bit of dichotomy has developed between natural gas and crude oil.

On the one hand you have a global commodity -- a transportation fuel whose price has been well-supported by robust demand from emerging markets such as China. On the other hand you have a domestic fuel, consumed primarily to satisfy heating and cooling needs.

If you haven't already guessed, the global fuel is crude oil, while the domestic fuel is natural gas.

The stark differences between oil and gas don't stop there. Indeed, crude oil has always been a global commodity, while natural gas has always been a domestic commodity. What has changed is the outlook for energy supply. Oil is becoming ever-scarcer and more expensive to extract. Highlighted by the latest BP Gulf of Mexico disaster, companies have to go to more and more challenging environments to find and produce oil. In the case of natural gas, breakthroughs in technology, specifically with regard to horizontal drilling and hydraulic fracturing, have enabled producers to find and exploit vast new resources which were not considered economically viable in the past.

As one might expect, the combination of strong emerging market demand and scarce supply has served to keep crude oil prices relatively high, while the abundant supply picture for natural gas has considerably weakened prices for the fuel. The oil to gas ratio, which measures how expensive oil prices are relative to natural gas prices, has recently been fluctuating between 15 and 20, compared the 10-year average of 9.3. The ratio, which serves little practical purpose due to the inability for oil consumers (drivers such as you and me, for instance) to switch to natural gas, is nevertheless a good illustration of the new landscape of the energy sector.

What if investors could take advantage of this paradigm shift? Recall that natural gas supply has grown enormously in large part due to advances in drilling technology. What if companies could harness this new technology to find and produce more oil?

That brings us to EOG Resources (NYSE: EOG), a leader in the new, early-stage North American oil boom. The company has accumulated vast holdings of oil shale in places such as the Bakken, Barnett Combo, and Eagle Ford shale fields, among others. For those familiar with the various natural gas shale formations, some of those names may sound familiar. That's because, in addition to oil, these plays contain enormous amounts of natural gas. In fact, the Barnett Shale is currently the largest natural gas producing field in the United States. But while other companies were busy searching for more natural gas within these and other plays, EOG was searching for oil, in large part because management anticipated the weakening of gas fundamentals.

EOG estimates that it has accumulated resource potential of nearly 1.7 billion barrels of oil equivalent in addition to 29 trillion cubic feet of natural gas. While the company is still predominantly a natural gas producer, it is rapidly transforming into an oil producer, and is set to benefit from the resulting higher margins from this transition. Overall production growth during the next two years will average +20%, while oil production growth will average +52.5%. Notably, liquids production (oil plus NGLs) will represent nearly 46% of total production in 2012, up from 22% in 2009.

Action to Take --> EOG's impressive growth in oil production should translate into equally impressive returns for shareholders. Total production growth of +44% in the next two years combined with higher margins from a greater proportion of oil output, means that operating cash flow may increase as much as +77% in this time period. Importantly, these figures are based on a flat $75/bbl oil and $5/mcf gas price deck. Furthermore, the company maintains a pristine balance sheet, with only $14 a share in debt, for a debt-to-capitalization ratio of 15.7%.

The market has yet to adequately price these robust fundamentals into EOG's shares. The firm is valued at a mere four times 2012 debt-adjusted cash flow versus the peer group average of 5.9. That's a +66% return if the stock were to just catch up to the sector average. If anything, EOG should be trading at a premium valuation due to its above-average growth and vast holdings of oil resources. Investors should consider adding EOG Resources to their portfolios before the market wises up.

 --Sumit Roy
Contributor
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