Before oil prices plunged a few years ago, shale drillers generally pursued production growth at all costs. That led most to outspend cash flow by wide margins, with many piling on a mountain of debt to drill more wells.
However, after getting singed by that aggressive approach when prices crashed, many drillers are being much more conservative this time around, now aiming to grow production within cash flow around current oil prices. That said, some oil companies have taken a different approach, putting the priority on drilling to increase cash flow, instead of drilling through their cash flow. One of the leaders of this new breed of oil stocks is Encana (NYSE:ECA), which is emerging as a top-tier choice for investors.
Drilling for cash
About a year ago, Encana unveiled a five-year plan that would return the company to a growth mode. The Canadian driller estimated that by 2021 it could boost production 60% by focusing on drilling high-return wells. It set a hurdle rate of 35% after-tax at $50 oil for wells it planned on drilling going forward, which it seemed to model after EOG Resources' (NYSE:EOG) premium return strategy. Though, in EOG's case, its hurdle rate for new wells is a 30% after-tax return at $40 oil. That difference aside, the point is that by drilling these premium return wells, both companies could grow production and cash flow at a healthy clip at lower oil prices.
However, last month Encana released an updated five-year plan. This time its focus wasn't on how much it could grow production. Instead, the company highlighted its ability to increase cash flow. CEO Doug Suttles pointed that out in the company's recent third-quarter conference call:
Looking forward over the next five years, our plan now delivers a cash flow compound annual growth rate of approximately 25%. In 2018, we expect total capital and cash flow to be in balance. From 2019 on, we expect to generate significant free cash flow, approximately $1.5 billion over the planned period, demonstrating that our business works at a flat $50 WTI oil price and a $3 NYMEX gas price.
What's noteworthy about that strategy is that Encana expects not only to increase cash flow at a rapid rate, but to generate significant excess capital in the coming years even if oil slips from its current mid-$50-a-barrel level. That puts Encana in a very elite group, as rivals plan to spend all their cash flow on new wells and ramp spending and their production growth rate as oil prices improve. For example, EOG Resources' current long-term plan is to deliver 15% compound oil production growth through 2020 if oil stays around $50 a barrel. However, if crude rises to $60, EOG said it could increase its output by a 25% compound annual rate over that same time frame.
A catalyst on the horizon?
While Encana hasn't yet said what it plans to do with that excess cash, it will likely return some of it to shareholders. Currently, the only money it sends their way is a paltry dividend that yields a mere 0.5%, which is a fraction of what it once was because the company slashed its payout in 2016 to conserve cash flow. More than likely, Encana will allocate some of its excess cash toward boosting the dividend. In addition to that, its also entirely possible that it will authorize a share repurchase program, which is what several rivals have done with the cash they had left over from selling assets during the downturn.
Those future cash returns to shareholders could provide a significant boost to Encana's stock price in the coming years. That has been the experience of other oil companies since they announced plans to send more cash to shareholders. For example, last fall ConocoPhillips (NYSE:COP) announced that it would increase its dividend each year and repurchase $3 billion in stock over the next three (and recently, it boosted its repurchase program up to $7.5 billion through 2020). That announcement has paid big dividends for investors considering that ConocoPhillips' stock has risen 12.5% since then, while the average energy stock as measured by the return of the Vanguard Energy ETF is down 4.5%. Anadarko Petroleum has also enjoyed similar outperformance since announcing its intention to repurchase $2.5 billion in stock two months ago. Anadarko stock has risen 8% since then, while the Vanguard Energy ETF is only up about 0.5% over that time frame.
It won't flatline for long
Encana is just getting started on a long-term strategy that should significantly increase its cash flow, which in time should leave it with plenty left over to return to investors. So far, the market isn't paying much attention since the stock has basically flatlined this year. However, as the cash from the company's high-return drilling program starts piling up, it should eventually catch the eye of the market, especially when Encana starts returning some of that money to investors. That combination of rapidly rising cash flow and increasing shareholder returns could fuel significant gains for investors over the long term, even if oil dips a bit from here, which is why it's a top oil stock to consider owning for the long haul.