By Matthew DiLallo | The Motley Fool |
For years, the focus of the oil industry was on growing production no matter the cost. Drillers would spend everything that came in — and then some — to drill new wells. This approach had disastrous consequences because it ultimately drove oil supplies well past demand, causing prices to crash, which made it hard for oil companies to keep up with the debt they incurred to juice growth.
However, thanks to a small handful of oil companies led by EOG Resources (NYSE: EOG) and ConocoPhillips (NYSE: COP), those days of growing just to grow are long gone. That’s because they’ve disrupted the industry’s long-held way of thinking and have shifted the focus from increasing production to growing shareholder value. It’s an approach that’s now spreading like wildfire, making the oil sector a much more appealing option for investors.
Drilling for returns, not oil
Through the years, most oil companies drilled new wells to produce more oil and gas. While they wanted to earn a return on their investments, many drilled countless money-losing wells. In fact, Chesapeake Energy’s CEO admitted a few years ago that at one point, 54% of its wells lost money.
EOG Resources, however, has started disrupting this mindset by making it clear that it sees the production of oil as a byproduct of its aim of earning a lucrative return on the capital it invests in new wells. While the company always has focused on drilling for returns, it cemented that view in early 2016 when it unveiled its premium drilling inventory, which are locations that can earn a minimum 30% after-tax return at $40 oil. By setting the bar that high, the company would ensure that its wells still would make money, even if crude plunged below $30 a barrel. One of the many benefits of drilling high-return wells is that EOG can produce more oil for less money, enabling it to grow faster than most rivals.
EOG’s focus on drilling to earn premium returns has already started changing the way competitors operate. Encana (NYSE: ECA) was one of the first to latch on to the idea when it unveiled its premium-return inventory in late 2016 along with a new five-year growth plan. The only difference was that Encana set a lower-return hurdle of 35% after tax at $50 oil. Meanwhile, many other drillers have started focusing their attention on identifying their highest-return locations, even if they don’t use the premium label.
In some ways, Encana has taken EOG’s focus on returns even further since the company no longer draws attention to how much it can grow production. Instead, it highlights its ability to increase cash flow. That change happened last year when it unveiled an update to its five-year plan.
Instead of targeting a production growth rate, Encana pointed out that it could increase cash flow at a 25% compound annual rate through 2022. Further, it could deliver that robust growth rate while generating $1.5 billion in free cash at $50 oil. Several other drillers have followed its lead by highlighting how much they can increase cash flow instead of trumpeting production growth.