1 Potential Game-Changing Oil Market Trend From This Quarter You Won't Want to Miss

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Earnings season in the oil patch recently ended. Overall, oil companies delivered solid results, with large shale drillers from Devon Energy (NYSE: DVN) to EOG Resources (NYSE: EOG) to Marathon Oil (NYSE: MRO) all beating expectations despite the impact of Hurricane Harvey.

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However, what stood out this quarter wasn't how well these companies performed in the current market environment but the notable change in philosophy among the industry's larger drillers. Instead of proclaiming how fast they can grow production, most highlighted their ability to produce returns. It's a shift that could fuel game-changing returns for investors in the coming years.

Not necessarily a new idea but it's now priority No. 1

One of the central themes on the third-quarter conference calls of most major shale drillers was the importance of earning high returns on the capital these companies plowed into new wells. For some companies, this was nothing new. EOG Resources CEO Bill Thomas, for example, reminded investors that his company has a history of "discipline, return-based capital allocation." As a result, EOG chose not to "patiently wait for commodity prices to improve and allow the cycle to drive our profitability." Instead, it "redefined [its] investment hurdle rate" and then "reset the company to be successful in a low commodity price environment." In EOG's case, it set a return hurdle of 30% at $40 oil and then went through its entire drilling inventory and separated out the wells that would meet that premium return level. Those premium-return locations would give it the fuel necessary to profitably grow at lower oil prices.

Encana (NYSE: ECA), likewise, set its own premium return standard, which it defined as wells that could achieve a 35% return at $50 oil. Meanwhile, other drillers either bought land in high-return locations or focused their attention on drilling in areas where they could earn lucrative returns. 

That said, while many drillers have talked about drilling for returns in the past, several made it crystal clear this quarter that this was now their top priority. Devon Energy CEO Dave Hager, for example, unveiled his "2020 Vision" for the company, which has a "top objective... to deliver attractive, peer-leading returns on invested capital for our shareholders." Hager even noted that "while the disciplined pursuit of returns is not new at Devon, our "2020 Vision" will further refine our focus on maximizing full-cycle returns at the corporate level." Marathon Oil CEO Lee Tillman noted that it's "capital allocation philosophy" for 2018 remains the same in that the company expects to "deliver a returns-focused program" that will see it grow production while living within cash flow at $50 oil.

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Realigning incentives

However, many of these companies aren't just talking about returns because it's the popular thing to do these days. Rather, they are taking their returns-focused approach a step beyond stated policy by tying it to compensation. That's something EOG Resources has done since its founding, with Thomas saying that it has a "transparent return based incentive structure that runs through the entire organization." It's a structure that more rivals plan to implement. 

Marathon Oil's Tillman said that after getting feedback from investors, he "fully expect[s] to integrate both the returns-based metric and a per share metric into our compensation structure." Doing so will "enhance alignment between management incentives and long-term value creation." Devon's Hager also stated that the company plans to "discuss incorporating return-oriented measures into our compensation metrics for the upcoming 2018 budgeting cycle." By doing so, Hager noted that Devon's approach would be "in contrast to the industry's historical behavior of aggressively chasing top-line growth at the ultimate expense of shareholders. This is not a populist philosophy that we are paying lip service to. We are absolutely committed to doing business differently in the E&P space and we are taking the appropriate steps to become an industry leader with our disciplined approach to capital allocation. In short, we can lead, and we will lead." 

That historical approach Hager referenced is one of the things that got the industry into its current mess because so many companies continued drilling even as oil prices crashed. That's partially because growth-based metrics played a considerable role in how drillers compensated executives. However, with many deemphasizing those misaligned incentives, companies are less likely to "drill, baby, drill" and more apt to allocate capital that will grow shareholder value.

This mind-set change also has drillers shifting their messaging to investors. For example, at its investor day last month, Encana didn't emphasize production growth. One of the objectives of its updated five-year plan was to grow cash flow by a 25% compound annual rate. Furthermore, the company noted that its strategy would generate $1.5 billion in free cash flow over the next five years if oil averages $50 a barrel, which shows that spending to increase production isn't its top priority. That's important since the growing cash flow stream, not the underlying production, is what should create value for Encana's investors.

Drilling ATMs instead of money pits

Shale drillers have spent years chasing growth, which has done more harm to investors than good. However, those days appear to be in the past since more drillers are planning to drill wells that deliver high returns instead of just a high growth rate, while also putting the right incentives in place to back that approach. It's a philosophical shift that could pay significant dividends down the road because it should enable drillers to pull the most value out of their resource base while at the same time keeping excess oil off the market to ensure prices don't collapse again. Those two factors could help shale drillers fuel big-time returns for their investors in the coming years.

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