Are Oil Stocks In Their Prime?

After three challenging years, the oil market is showing real signs of improvement. Oil prices, which many in the industry expected would be at or below $50 a barrel this year, are now above $70. Crude might not be done running higher due in part to the fact that oil producers in the U.S. are taking a much different approach to how they allocate their oil-fueled cash flows.

That trend was one of the central themes on the first-quarter conference call of oil-field technology company Core Labs (NYSE:CLB), where CEO David Demshur provided his take for why things are different in the oil market this time around.

Buying into a new way of thinking
Demshur led off the call by diving into some industry trends, saying, “Core is encouraged that operating companies are buying into living within free cash flow and emphasizing returns on invested capital as demanded by today’s investors.” What he means is that most oil producers are setting their drilling budgets to live within anticipated cash flow as opposed to their previous approach of outspending their means to grow faster. Furthermore, they’re focused on drilling wells that earn high returns on capital instead of drilling just to drill.

Because of that shift to drilling for returns as opposed to simply increasing output, industry spending levels remain well off their peak. Demshur pointed out that expected U.S. capital spending in 2018 is “still 45% below 2014 peak levels,” which was “when record amounts of capital were being employed but destroyed, leading to over 130 U.S. E&P bankruptcies.” One stunning example of this came from Chesapeake Energy, which stated that more than 50% of the wells it drilled in 2012 weren’t even profitable.

Today, however, many drillers are setting a high bar for new wells. EOG Resources (NYSE:EOG) has been one of the leaders in disrupting the former way of thinking by establishing a high return hurdle rate for new wells of 30% after-tax at $40 oil. Others followed with similar return-focused approaches, including Encana (NYSE:ECA), which needs locations to achieve a 35% after-tax return at $50 oil to meet its premium hurdle rate.

Producers are also setting their budgets to the cash flows they can generate at lower oil prices. EOG Resources and Encana are among the many that set $50 oil as the baseline for their budgets. As a result, both are generating excess cash at current prices, which they’re allocating toward other things like returning more money to investors via dividends and buybacks as well as paying off debt.

More oil for less money is a game changer for profitability
The trend of investing to generate high returns has significantly improved capital efficiency because oil companies are now producing more oil while drilling fewer wells. Demshur put numbers behind it, saying, “Core projects that in the U.S., in 2018, we will drill 18,000 less wells when compared to 2014 but still add about 1 million barrels a day of production to our 10-plus million barrels of oil being produced per day. The industry is drilling fewer wells but better more efficient wells.”

That efficiency was evident in the first quarter when companies like Devon Energy (NYSE:DVN) and Marathon Oil (NYSE:MRO) drilled record-breaking wells. In Devon Energy’s case, it completed two of the highest-rate wells ever drilled in the nearly 100-year history of the Delaware Basin. Those wells, when combined with some prolific ones in the STACK shale play, enabled Devon to produce a huge profit in the first quarter. Marathon Oil, meanwhile, drilled record-setting wells in two formations of the Bakken region as well as several high-rate ones in the STACK, which fueled strong profits for the driller in the first quarter.

Drillers, however, are only just starting to scratch the surface according to Demshur, who noted that his company is working to help them increase the amount of oil and gas they pull out of a shale reservoir from an average of 9% of what’s there to a low to mid-teens percentage. While it would cost drillers about an incremental $2 million per well to implement some of these changes, they can add 500,000 barrels of additional oil production over the life of a well, boosting total output by 50%. That’s a “real return winner” in Demshur’s view.

Just getting started
Oil companies have shifted their focus from drilling just to grow production to investing in wells that will earn lucrative returns at lower oil prices. That’s a real difference maker for profitability, which is soaring, especially with oil prices currently well above their baseline levels. With more efficiency gains still in the works, oil company profitability could continue rising in the coming years, even if crude comes back down a bit, which would create significant value for investors, making return-focused drillers ideal oil stocks to hold for the long haul.