1 Oil Stock I'm Watching Closely This Week

By Markets Fool.com

Image source: Getty Images.

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Over the past several months, shale producers in the U.S. have made one thing quite clear: They no longer need triple-digit oil prices to fuel growth. In fact, many are in the position to restart their growth engines as long as oil is sustainable over $50 a barrel. For example, leading shale driller EOG Resources (NYSE: EOG) said that starting next year it can grow its production by 10% annually through 2020 at a flat $50 oil price. Meanwhile, both Encana (NYSE: ECA) and Pioneer Natural Resources (NYSE: PXD) are gearing up for double-digit production growth at $55 oil. That said, one leading shale driller that has been strangely absent from this return to growth is Devon Energy (NYSE: DVN). However, that could change when the company reports its third-quarter results this week, with that report giving it the perfect opportunity to announce its long-term oil growth plans.

The fuel driving these forecasts

Three factors are fueling the decisions of EOG, Encana, and Pioneer Natural Resources to restart their production growth engines next year. First, and most importantly, oil prices are improving due to a noticeable shift in market fundamentals. Demand for oil remains robust and, according to the International Energy Agency, should grow by another 1.2 million barrels per day next year. Meanwhile, supplies continue to decline, with U.S. production off by 1.2 million barrels per day since peaking in March of last year while production has also dropped in several other major oil producing countries. These improving market fundamentals should keep oil prices relatively stable, if not drive them higher in the future.

The second factor driving these growth forecasts is that fact that all three companies have strong balance sheets and therefore the financial capacity to fund growth. For example, EOG Resources maintains an investment-grade credit rating backed by a net debt-to-total capitalization that is below the peer group average. Pioneer Natural Resources, likewise, has an investment-grade rating thanks to its ultra-low leverage, evidenced by a microscopic net debt-to-operating cash flow metric of just 0.2 times thanks to asset sales and equity issuances. Finally, similar cash infusions have enabled Encana to slice more than $3 billion in debt from its balance sheet since the end of 2014. Because of their balance sheet strength, all three companies can quickly pivot back to growth at a time when many other drillers remain focused on fixing their balance sheets.

Finally, all three companies have a vast inventory of drilling locations that are highly economical to drill ata $50 oil price. For example, EOG Resources has 6,000 premium drilling locations, which can generate a 60% after-tax rate of return at $50 oil. Meanwhile, Encana can drill 10,000 premium wells on its acreage and earn a 35% after-tax rate of return at $50 oil. Finally, Pioneer Natural Resources is sitting on 20,000 drilling locations, with its best wells delivering 45% to 60% rates of returns assuming oil rises from the low to mid-$50s over the next few years.

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Image source: Getty Images.

Drilling down into Devon Energy's ability to grow

The reason Devon Energy could join them in announcing a long-term oil growth forecast is that its metrics compare very favorably to those peers. For example, after selling $3.2 billion in assets earlier this year, Devon has vastly improved its balance sheet. In fact, net debt is down 45% over the past year. Furthermore, the company has a $4.6 billion cash balance and a $3 billion undrawn credit facility. That war chest gives the company tremendous financial flexibility to significantly ramp up capital spending next year should it choose to do so.

Also, Devon has a similarly extensive inventory of lucrative drilling locations. The company currently has more than 12,000 locations across its four core oil plays that can deliver more than 20% after-tax rates of returns at $50 oil. Add it up and Devon has the capital and the inventory to fuel tremendous production growth in 2017 and beyond.

Investor takeaway

Devon Energy is currently positioned to deliver stable production at its current spending level by the middle of next year. However, given the improving oil outlook, its strong balance sheet, and lucrative drilling inventory, the company could join its peers and aim much higher. That is why I would not be surprised if it announced a long-term oil production growth outlook when it reports earnings this week, likely joining rivals and targeting a double-digit annual production growth rate through 2020.

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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.