ExxonMobil (XOM -1.61%), the nation's largest publicly traded oil and gas company, recently joined a growing chorus of oil majors seeking to slash spending in the face of insufficient returns. Will the company's decision pay off?

Source: Wikimedia Commons

Exxon plans to cut spending
In a presentation on Wednesday, Exxon said it would reduce exploration and capital spending to about $39.8 billion this year, down from $42.5 billion last year, and expects its oil and natural gas production this year to be flat.

Exxon's CEO, Rex Tillerson, cited the loss of production from the expiration of a joint venture contract in Abu Dhabi's oilfields and a decline in its US gas production as it shifts rigs toward more profitable oil-rich opportunities as the two main factors impacting this year's production.

The company also announced that it will reduce its capital spending to about $37 billion per year over the period 2015-2017 and lowered its expectations for future production to about 4.3 million barrels per day in 2017, a sharp downward revision from the 4.8 million barrels per day the company forecast just a year ago and only slightly higher than last year's output of 4.2 million barrels per day.

A new reality for Big Oil
It's a similar story for Exxon's Big Oil peers. Statoil (EQNR -1.62%) has pledged to cut its capital spending by about $5 billion over the next three years and has abandoned its previous production target of 2.5 million barrels of oil equivalent a day by 2020, while Total (TTE -2.03%) plans to reduce its spending to $24-$25 billion over the next few years, down from around $28-$29 billion last year.

Similarly, Shell (RDS.A) says it will slash its spending from $46 billion last year to $37 billion in 2014 as it seeks to improve shareholder returns by focusing only on its highest-value opportunities. Meanwhile, BP (BP -1.08%) will keep spending roughly flat this year at around $24-$25 billion, though it expects 2014 cash flow to rise sharply thanks in part to major new project start-ups.

The new mantra among the oil majors seems to be "value over volume," referring to a greater emphasis on delivering higher returns on investment as opposed to boosting production for growth's sake. This approach is a response to a new reality, in which production costs have risen inexorably while commodity prices have stagnated.

Indeed, marginal production costs -- the expenses associated with producing the last barrel of oil -- among the world's 50 largest public oil companies surged 229% between 2001 and 2010, according to Bernstein Research, as the industry's annual capital spending more than tripled over the period. Yet the sharp growth in spending has failed to yield a commensurate increase in production.

A good move for Exxon?
From this perspective, a reduction in Exxon's capital spending could actually be a good thing as long as it continues to generate strong returns on capital that are significantly higher than its weighted-average cost of capital. Indeed, Exxon has consistently posted higher returns on average capital employed than all of its peers save Chevron (CVX -1.85%).

And despite a reduced capital budget, the company plans to start up ten major projects this year that will contribute some 300,000 boe/d of net capacity. Crucially, many of these new projects will be more heavily weighted toward liquids, which should help improve margins and boost cash flow. By 2017, Exxon expects liquids and liquids-linked natural gas to account for about 69% of its total production.

Though the markets viewed Exxon's announcement unfavorably, sending shares down nearly 3% on the day, I think the company's move will likely pay off in the long run. The reduced budget will only lead to an even more highly disciplined and selective approach to capital allocation, which should allow it to continue generating peer-leading returns on capital and plenty of cash flow to support dividend growth.