There has been a notable strategy shift within the oil patch over the past several months. Several leading producers have adjusted their message to investors from how fast they can grow production in the current pricing environment to how much they can increase shareholder returns.
This shift could be a difference-maker for shareholders, because it means companies would spend less money trying to produce more oil that the market doesn't need at the moment, which would give them more cash to return to shareholders through dividends and buybacks. The ramp-up in cash returns alone should boost stock prices, while the potential reduction in production growth should help keep the oil market balanced, which has the potential to send oil prices and producer profitability higher and could take oil stock prices up with it.
Each quarter, David Demshur, CEO of oil reservoir specialist Core Labs (NYSE:CLB), uses the company's quarterly conference call to provide a unique glimpse into what's going on beneath the surface of the oil market. However, in the third quarter, instead of giving insight from what the oil fields were telling him, he provided a "little look at industry trends we're seeing," stating: "Core has witnessed and is encouraged by the increasing focus of its major clients regarding capital management, return on invested capital, free cash flow, and the return of capital back to the shareholders as opposed to just growing production at any cost and destroying capital."
In other words, instead of obsessing on how quickly they can grow production, customers are getting serious about how they can best allocate capital on behalf of their investors. One of the ways Core's CEO said they could do that is by paying for its technologies, since they have proved to boost returns on capital and free cash flow. That's why Core believes its revenue and profitability will pick up in the fourth quarter.
Ramping up returns
So far, several large producers have unveiled plans to ramp up cash flow growth and return more capital to investors. U.S. oil giant ConocoPhillips (NYSE:COP) was one of the first out of the gate when it unveiled a new strategy to create value for investors last fall. Two key ingredients of that plan was a three-year, $3 billion share-buyback program backed by planned asset sales and the intention to increase its dividend each year. The company announced its first dividend increase at the end of January, boosting it 6%, and has already repurchased $2 billion of its stock this year, retiring 4% of shares outstanding. Meanwhile, it sold more assets than initially planned, which led it to double the buyback to $6 billion, with plans to repurchase $3 billion in stock by year's end. That increased buyback shows how serious ConocoPhillips is about creating value for investors, which it believes it can do better by repurchasing its stock than by drilling more wells.
Meanwhile, Anadarko (NYSE:APC) recently announced plans to use a portion of the $6 billion cash war chest it built up through asset sales during the downturn to repurchase $2.5 billion of its stock instead of accelerating production growth. Furthermore, Anadarko CEO Al Walker said that "we will continue to demonstrate financial discipline with a focus on returns." The company's 2018 plan will generate substantial free cash flow after funding oil and gas investments at $50 oil, with the intention of using that excess cash to expand its midstream business instead of to increase output further.
Another example of the changing mindset within the industry is at Encana (NYSE:ECA). At its investor day last fall, the Canadian shale driller unveiled a new five-year growth strategy, highlighted by a plan to boost production 60% by 2021, which it could deliver within cash flow as long as oil averaged $55 a barrel. However, Encana adjusted the focus of its message this fall, stating that it's on pace to increase its return on capital employed from 10% to 15%, which will help fuel a 25% compound annual growth rate in cash flow through 2022 and produce a cumulative $1.5 billion in free cash flow over that time frame at $50 oil. While the company hasn't said what it plans do with that excess cash, it will probably allocate it in whatever way creates the most value for shareholders.
Setting the stage for the next gusher
This shift from growth at all costs to growing shareholder returns could change the entire outlook for the oil market if more oil companies jump aboard the bandwagon. That's because it could help keep excess oil off that market, which could drive crude prices higher and provide a huge boost to producer cash flow. Those higher profits, when combined with increasing cash returns to investors through buybacks and dividends, could fuel big-time gains for investors over the next couple of years.