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Oil Producers Are Finding Growth at All Costs Too Costly

Matthew DiLallo, The Motley Fool

For years, the focus of oil producers in the U.S. has been on growing their production as fast as possible. Companies trumpeted their growth potential to investors as a sign of strength and their ability to cash in on higher oil prices. But that gusher of new production didn't pay off. It was one of the factors causing oil prices to crash again at the end of last year (after crude supplies ran ahead of demand), sending oil stock prices down with them. 

As a result, more oil companies are swearing off growth at all costs. Instead, they're shifting their focus to living below their means so that they can return excess cash to shareholders via dividends and stock buybacks. That trend could enable the industry to finally start delivering on the promised rewards investors have been waiting to see for years.

Oil pumps working the the background near a drilling rig.

Image source: Getty Images.

Stomping on the brakes

Oil companies in the U.S. have started responding to the renewed slump in oil prices that set in at the end of last year. Last week, drillers dropped 21 rigs from their fleets versus the previous week. That's a 2.5% decline, according to the latest data, marking the biggest weekly decline in the U.S. rig count since early 2016. That might only be the beginning.

In the view of Continental Resources (NYSE: CLR) CEO Harold Hamm, the industry could reduce its activity level by 50% in early 2019 compared to last year in response to the 40% crash in crude that ended 2018. While Continental's CEO calls that figure a "wild guess," he stated at a recent conference that "producers have become more disciplined in their approach to capex." As a result, they're more quickly responding to changes in oil prices so that they can live within the lower cash flow that follows a decline in the oil market.

Other executives have made similar comments. Vicki Hollub, CEO of Occidental Petroleum (NYSE: OXY), stated at the World Economic Forum in Davos this week that "I believe not as much money will be pouring into the Permian Basin this time. I believe investors will hold companies accountable for returns and a lot of this didn't happen previously." 

One reason Occidental's CEO sees spending in the Permian falling is that the company itself aims to reduce its capital budget. After spending $5 billion last year, Occidental unveiled a flexible budget for 2019 that would see it spend up to $4.5 billion if oil remains at its current level around $50 a barrel and would only top last year's level if oil is above $60. Instead of pouring more money into the Permian, Occidental is buying back shares as well as continuing to increase its high-yielding dividend.

Meanwhile, fellow Permian driller Diamondback Energy (NASDAQ: FANG) is also cutting back this year. The company set its drilling budget to a range of $2.35 billion to $2.7 billion, which is enough money to run 18 to 22 rigs this year, down from the 24 it had operating last month. That reduction in drilling activities would enable Diamondback to live below its means at current oil prices so that it can return more cash to shareholders, which it aims to do via a 50% dividend increase for 2019. Meanwhile, Diamondback Energy's CEO Travis Stice stated that "if commodity prices continue to decline, we will further reduce activity to match our budget to expected annual operating cash flow," with the company noting that it could cut its rig count all the way down to 14 and still finish 2019 producing at the same rate at which it ended last year.

A strategy that works

This strategy has already proven effective for ConocoPhillips (NYSE: COP). The U.S. oil giant unveiled its new way forward in late 2016, shifting its focus toward drilling for returns and not growing for the sake of growth while at the same time returning more cash to shareholders. Since then, ConocoPhillips' stock has delivered a more-than-50% total return, including a big win last year despite oil's slump. That's nearly double the return of the S&P 500 and light-years ahead of its peer group, as the average oil stock has delivered a negative total return over that time frame.

Given ConocoPhillips' success, more oil companies are adopting its operating model. It's a change that investors are increasingly demanding companies make, since growth-focused strategies have destroyed shareholder value rather than creating it. As that shift happens, the sector might finally move from being a chronic underperformer to being one that starts fulfilling its potential for enriching investors.

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Matthew DiLallo owns shares of ConocoPhillips. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.