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 (EOG 3.49%) and ConocoPhillips (COP 2.83%), 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 (OVV 4.40%) 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.
Growing the value of each share
ConocoPhillips, meanwhile, has disrupted how the industry measures production growth. Instead of aiming to increase output by an absolute rate, such as from 100,000 to 110,000 barrels of oil per day, or by 10%, the company strives to grow production on a debt-adjusted-share basis. This metric considers the difference in the production rate, as well as the change in debt and the share count. The goal is to increase production per debt adjusted share because that should create more value for investors than by targeting an absolute growth rate.
The strategy also focuses on investing in the highest-return opportunities, while also giving the company flexibility to allocate capital toward paying down debt and buying back stock. It has been a wildly successful approach. In the first quarter, ConocoPhillips increased output 26% on a debt-adjusted share basis, which was significantly higher than its absolute growth rate of 4%, thanks in part to $3.5 billion in share repurchases over the past year and a nearly $10 billion reduction in debt.
Several producers have followed ConocoPhillips' lead and started allocating more cash toward buying back stock and retiring debt to fuel higher debt-adjusted production-per-share growth rates. Anadarko Petroleum (APC) was one of the first to follow its lead late last year when it unveiled a $2.5 billion share buyback. That repurchase program, when combined with some debt reduction, has Anadarko on pace to increase its oil production at a debt-adjusted rate of 15% this year, which is better than its anticipated 13% absolute increase.
The proof is in the outperformance
EOG Resources and ConocoPhillips have disrupted the way the oil industry values and measures growth. Their trailblazing ways have been wildly successful so far since both stocks are up 40% over the past two years versus 30% for the S&P 500 and less than 10% for the average energy stock. Given that outperformance, more oil companies likely will follow their lead in the coming years, which could fuel big-time gains for investors as the oil market continues recovering.