Oil and gas companies have poured billions of dollars into acquiring land and drilling new wells in the Permian Basin in recent years. While that trend will continue in 2019, the rate at which drillers are spending is coming down as the industry shifts gears from aiming to grow production as fast as possible toward generating an increasing supply of free cash flow to return to shareholders.
From spendthrifts to thrifty
Diamondback Energy (NASDAQ: FANG) has spent billions of dollars to build a behemoth in the Permian Basin. Last year, for example, the company paid $9.2 billion to acquire Permian peer Energen and spent several hundred million dollars on buying land from other sellers through a series of transactions. On top of that, the company invested $1.36 billion in drilling and completing new wells.
Image source: Getty Images.
This year, however, Diamondback Energy is tapping the brakes a bit. Its spending estimate of $2.7 billion to $3 billion for drilling wells this year is 3% lower than its initial budget. The company also plans to operate a reduced number of rigs in 2019 -- 18 to 22, with 21 working at the moment -- which is a decline from the 24 it had in operation at the end of 2018. A reduction in spending allows Diamondback Energy to generate more free cash flow, which is why it was able to increase its dividend by 50% for 2019.
Concho Resources (NYSE: CXO), likewise, is planning to invest less money into the Permian in 2019. The driller, which also went on a spending spree last year, including buying rival RSP Permian for $9.5 billion, is reducing its 2019 spending plan to $2.9 billion. That's 17% lower than its initial forecast. By moderating its activity, Concho Resources can generate more free cash flow, which will help support its recently initiated dividend.
Pioneer Natural Resources (NYSE: PXD) is also taking a much more conservative approach in 2019. After investing $3.64 billion on drilling and related activities last year, Pioneer Natural Resources expects to spend $2.8 billion to $3.1 billion in 2019. By spending less money, the company can generate more free cash. Pioneer Natural Resources intends to return this money to shareholders through its dividend, which it recently increased by another 100%, and a $2 billion stock-repurchase program.
Image source: Getty Images.
Oil price volatility isn't the only factor driving these moves
The 40% plunge in oil prices during the fourth quarter of last year is only one of the factors driving Permian drillers to reduce spending. Another culprit is that oil companies had been growing so fast that they'd nearly overwhelmed the region's infrastructure. Oil pipelines, for example, were filling to the brim last year because producers had increased production faster than midstream companies could build more pipelines. While the region's capacity issues have started to ease after a new pipeline came on line late last year, they won't go away until more start service at the end of 2019.
However, while the pressure from oil prices and pipeline constraints has factored into the decisions to cut spending, an even more important driver is at play: Investors have grown tired of the industry's inability to create value from shale resources. That's because companies have been so focused on increasing production as fast as they can that their returns on investment have suffered. So investors have been putting pressure on oil companies to change their ways. That's leading more to shift from a focus on growing production to increasing shareholder value.
One of the early leaders of this industrywide pivot was U.S. oil giant ConocoPhillips (NYSE: COP). In late 2016, ConocoPhillips unveiled a differentiated strategy aimed at creating value by driving out costs, improving returns on investments, and returning excess cash to shareholders, which it has done through three dividend increases and a multibillion-dollar share-repurchase program. Those initiatives enabled the company to make more money in last year's third quarter than it did when crude oil was over $100 a barrel. This formula has proven to be a smashing success as ConocoPhillips' stock has vastly outperformed its peers in recent years. Last year, for instance, it delivered a double-digit total return despite the slump in crude prices. That success is leading more oil producers to take a page out of ConocoPhillips' playbook.
Aiming to emulate a winning strategy
Wild spending by Permian-focused oil companies hasn't produced the results that many of these companies anticipated. As a result, they're more frugal this year by aiming to spend below their means so that they can return some of the excess cash they produce to shareholders. That formula has proven to be a winner for ConocoPhillips, which is why more peers are following in its footsteps.
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