EOG Resources (EOG -1.48%) recently reported decent second-quarter results. While it didn't earn as much money as analysts expected due in part to weaker oil prices, its production and costs were better than anticipated, which demonstrated the strength of its underlying operations. Still, oil prices remain below what the industry expected this year, which is forcing rivals to rethink their plans.
Given those market conditions, CEO Bill Thomas stated on the accompanying conference call that: "Over this last quarter, the question we received most often from the investment community was, how does EOG plan to respond to lower oil prices. Obviously, that question isn't unique to ask as the entire industry is being asked to demonstrate capital discipline in the face of extended lower commodity prices."
He then laid out four things the company focuses on, which dictate how it responds to the direction of oil prices.
Image source: Getty Images.
We focus on returns above all else
Thomas started off by hammering home that the key to understanding EOG's response to prices is to remember that "EOG is a return incentivized company...and has been since its founding." Furthermore, Thomas noted that "capital discipline is our core value and the fundamental driver of EOG's history of peer-leading returns." Because of this, the company's focus isn't on oil prices, but the returns it can earn on the capital it employs drilling new wells.
That focus led the company to set a hurdle rate for new wells of 30% after tax at $40 oil, which for perspective is a higher hurdle rate than Encana (OVV -2.18%) given that it defines its premium wells as those that can deliver 35% after-tax returns at $50 oil. EOG then separated its drilling inventory into wells that could achieve that premium-return hurdle rate and those that could not. Its focus going forward will be to invest its capital dollars on drilling premium wells while striving to convert other locations to premium through innovation or monetizing those sites and using that cash to otherwise bolster its premium inventory.
We'll remain disciplined
While EOG's focus is on drilling for returns, it plans to stay disciplined on spending. Thomas pointed out that, "from the beginning of the downturn in 2014, we have consistently executed a disciplined plan to return to industry-leading ROCE and industry-leading U.S. oil growth." That discipline led it to cut spending 40% in 2015, which would cause production to flatten out, stating at the time that it's "not interested in accelerating crude oil production in a low-price environment."
That choice stood in direct contrast to what many rivals decided to do. Devon Energy (DVN -1.39%), for example, only cut spending 20% in 2015, which still put it on pace to deliver 20% to 25% growth. However, that decision came back to bite the company since crude continued crashing. As a result, in early 2016 Devon slashed both spending and its dividend 75% and sold $1.5 billion in stock to shore up its financial situation.
That's not a situation EOG ever wants to face. As such, Thomas stated that:
Looking forward, regardless of where oil prices go from here, EOG will respond accordingly. We are committed to returns, delivering within our means and a strong balance sheet. We believe production growth should be the result of investing in high-return drilling, and have never been fans of outspending cash flow to pursue growth for growth's sake.
Image source: Getty Images.
We'd rather find our own oil than pay someone for theirs
One way EOG intends on maintaining a strong balance sheet is by avoiding acquisitions to drive growth since most companies use debt to make purchases. That was one of Devon's downfalls as it spent $1.9 billion, including $1.15 billion of cash and borrowings, to pick up additional acreage in the STACK play of Oklahoma and Powder River Basin of the Rockies in late 2015. That's on top of spending $6 billion to buy into the Eagle Ford Shale in 2013. Encana, likewise, spent heavily on acquisitions, including handing over $7.1 billion in cash for acreage in the Permian Basin in 2014 and another $3.1 billion for land in the Eagle Ford that same year.
EOG, on the other hand, plans to "continue to execute our robust exploration program to capture low-cost acreage in plays that we believe could contain premium-quality rock that would add to our growing 10-year inventory of premium drilling locations." Thomas noted that the company had developed a massive database that "gives us a huge lead in identifying the best rock to add new and better drilling potential to the company." That's a huge competitive advantage given how much cheaper it is to lease exploration acreage versus what it costs to buy after a discovery.
We'll grow prudently to increase shareholder value
By focusing on returns, remaining disciplined, and organically developing new resources, EOG Resources believes it can increase oil production even if oil prices bounce around. As things stand right now, it can boost its oil output by a 15% compound annual rate through 2020 at $50 oil and 25% at $60 oil, which is faster than most rivals. That ability to grow at lower oil prices should, in the words of Bill Thomas, "keep us marching toward our ultimate goal of delivering sustainable, long-term shareholder value."
The right response for these uncertain times
EOG Resources has navigated through the oil market downturn better than most rivals because it values returns over growth. As a result, the company hasn't needed to respond as drastically as some peers that have slashed spending to avoid drilling themselves into a deeper hole. Instead, EOG Resources plans to continue investing within its cash flow to generate returns, which thanks to its low costs should expand output even if oil prices keep falling. This returns-focused growth strategy should increase the value of the company, which would benefit shareholders over the longer term.
