This has been just an awful year for oil companies as the price of oil remains stubbornly low because the oil market remains over-supplied with oil. However, what is interesting is that this market dynamic is creating two very different responses from oil companies. On the one hand, we have oil companies like EOG Resources Inc (NYSE:EOG) that simply refuse to grow their oil production until conditions improve. Then, on the other side we have companies like Devon Energy Corp (NYSE:DVN), which have actually accelerated production growth this year despite the over-supply. While both have valid reasons for employing their strategy during the downturn, there is a clear case to be made that one of them is making a mistake.
Showing restraint vs. pedal to the metal
Early on in the oil market downturn EOG Resources made the bold decision to slash its capital spending by 40%, which would be just enough to keep its production flat. In commenting on the decision, the company said in a press release that it "has no interest in accelerating oil production at the bottom of the commodity cycle." That restraint was even more evident later on as its costs fell to the point that the company could accomplish that goal while spending $200 million less than planned. Instead of reinvesting that money into additional wells, EOG Resources said that it was, "choosing to refrain from growing oil production into an over-supplied market" and would therefore just leave that money on its balance sheet.
Devon Energy, on the other hand, put together a capital plan that initially was expected to grow its oil production by 20% to 25% this year. While that plan did cut its spending by 25% year-over-year, it certainly wasn't as conservative a plan as the one put together by EOG Resources. Further, when Devon was able to push its costs lower than it initially expected, the company decided to use those savings to accelerate its growth to 25%-35% over last year's production rate.
Part of the problem, not the solution
While that was growth the company could afford, the question was whether this was the prudent move to be making. For that, I want to first point out the chart at the bottom of the below slide.
As that chart shows, at the midpoint of the company's production growth guidance it will grow its oil production by a net 61,000 barrels of oil per day. That's not a trivial amount of oil and in fact, is a real part of the problem when the oil market was projected to be over-supplied by roughly 2 million barrels of oil per day this year as it represents roughly 3% of the market's over-supply.
Not only is Devon Energy among the many oil companies contributing to the market's problem, but it is doing so at its own expense. That's because the return it could earn on that incremental oil supply would be far greater at a higher oil price than what we're seeing in the market today. That's abundantly clear by looking at the following slide from EOG Resources.
As that slide notes, at a $50 oil price the company can earn a pretty solid 35% direct after tax rate of return across a lot of its drilling portfolio. However, those returns skyrocket to 95% if those wells are brought online once oil prices hit $65 a barrel. That's a game-changing difference and is largely driving EOG Resources' decision not to grow production in the current environment. This suggests companies like Devon Energy are not only leaving a lot of money on the table by accelerating production growth, but they are part of the problem as they are accelerating oil supplies into an already over-supplied oil market, thus delaying a recovery in the oil price.
Growing oil production into an over-supplied market has turned out to be a bad strategy during the oil market downturn. Not only is it likely prolonging the downturn, but it's leaving a lot of money on the table. That's why EOG Resources is the clear winner on strategy as it is leaving its oil in the ground as it waits for a better price, which should really benefit shareholders when conditions do finally improve.
Matt DiLallo has no position in any stocks mentioned. The Motley Fool owns shares of Devon Energy and EOG Resources,. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.