Here we model the evolution of EOG Resources (NYSE: EOG) share price. Imagine that you have to predict (describe) the evolution of a share price for a company from Energy sector. A natural first guess is that this share price is driven by the change in some energy-related prices. Apparently, financial health of this company depends on the price and amount goods and services it sells. When these goods and services have a higher pricing power the company is likely healthy and generates some extra profit reflected in its share price.
Figure 1. The observed and predicted monthly closing prices for EOG between July 2003 and March 2012.
EOG engages in the exploration, development, production, and marketing of crude oil and natural gas. We extend our original model and describe the evolution of the EOG share price as a weighted sum of two individual producer price indices selected from a set of five producer price indices borrowed from the Bureau of Labor Statistics: the overall PPI, the PPI of electric power, EL, of natural gas, GAS, of coal, COAL, and the PPI of oil, OIL. (We do not use consumer price indices in for EOG.) Thus, the model seeks for the best pair of PPIs which minimizes the error since 2003. We also allow both defining PPIs lead or lag behind the modeled share price. Additionally, we introduced a linear time trend and an intercept term. Not surprisingly, the best fit model is obtained with the pair GAS and OIL:
EOG(t)= 0.129GAS(t-0) + 0.115OIL(t-0) + 7.85(t-2000) – 45.12; sterr=$7.77
where EOG(t) is the (monthly closing) share price in U.S. dollars. We allowed both time leads to vary between 0 and 12 months. In the best model, both time leads are zero, i.e. the share price evolves in sync with the PPI of oil and gas. Instructively, both slopes in the model are positive and the share prices rises with that of oil and gas. The time trend coefficient is also positive and provides an annual increase of $7.85. The model standard error for the period from July 2003 to March 2012 is $7.77. It is important that the above model is valid and reliable since the middle of 2011, i.e. the defining PPIs, lags, and coefficients are the same for all contemporary models since July 2011.
Figure 1 shows that the model based on the producer price index of natural gas and crude petroleum (domestic production) accurately predicts the current EOG price. There were two major fluctuations in the first half of 2010 and in the fourth quarter of 2011. Both ended on the fundamental price curve. This behavior is very indicative – all deviations should return to the predicted curve. In November 2011, we would estimate the EOG price as a highly undervalued one. In that sense, the predicted price might be considered as the fundamental price level, which is fully defined by the producer prices of natural gas and oil.