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In the Oil Patch, Bigger Is No Longer Better

The Wall Street Journal. logo The Wall Street Journal. 4/2/2018 Bradley Olson

Big oil is starting to think small.

Once defined by massive spending and ambitious exploration, some of the world’s biggest energy companies have begun to preach frugality. Investors increasingly favor producers that promise to increase cash payouts, rather than boosting spending to drill for more oil.

The best-performing major U.S. oil producer by share price increase in the past year isn’t Exxon Mobil Corp. or Chevron Corp., but ConocoPhillips, a company that has reduced its size and prioritized share buybacks and dividends over growth in recent years. Its shares have risen 29%, beating the S&P 500 and significantly outperforming the company’s U.S. rivals. Shares of Exxon, which recently laid out plans to increase spending by 25% or more beginning in 2020, have fallen by about 9% in that time.

The success of ConocoPhillips suggests that investors are looking for something different from big oil companies these days. Fading are the days when shareholders bought Exxon or Chevron to get exposure to the big profits that could come with rising oil prices, while being insulated somewhat from falling prices through running refineries and petrochemical plants.

An increasing number of investors want conservative, stable returns—not unlike why some look to the utility industry.

“The oil-and-gas industry is on its way to transitioning to a more mature market in the U.S.,” said Tim Beranek, who helps manage more than $18 billion in assets for Cambiar Investors. “Over the last decade, with the evolution of shale, it was an emerging industry and attracted a lot of growth investors. Now, the shareholder base just wants return on capital.”

As surging U.S. crude production continues to threaten price rallies with new supply, investors have become far more skeptical about growth. Instead, the push for cash is catching on.

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Beginning in 2012, ConocoPhillips, once among the world’s biggest oil companies, started to make this transition. It spun off its refining business, closed its deepwater exploration unit, and chose to distribute more of its free cash flow to shareholders rather than reinvesting it.

Few oil chieftains at the time were moving in that direction. It was “a pretty lonely place,” said Ryan Lance, ConocoPhillips’ chief executive, in an interview.

The strategy was shaped by a view that surging U.S. oil output would create a new era of uncertainty. American oil production recently topped 10 million barrels a day, breaking a prior U.S. record set in 1970.

“The cycles are getting shorter, from peak to peak and trough to trough,” Mr. Lance said. Instead of “chasing the cycles up and down,” he said, ConocoPhillips has focused on its “sustaining capital”—the oil price it needs to keep production flat and pay for dividends and new investments.

The company’s “sustaining” price is now $40 a barrel, Mr. Lance said, which means that with U.S. crude selling for more than $60 a barrel, much of the excess can go to shareholders.

While other companies have boosted share buybacks and dividends, few have as low a sustaining price. Many are turning to asset sales in order to balance new spending and cash-return plans with the funds they receive from operations. For example, Hess Corp. increased its buyback program by $1 billion in March, avoiding a proxy fight with an activist shareholder.

The company is expected to generate about $1.6 billion from operations, according to analyst estimates on FactSet. With $2.1 billion in spending planned for 2018, that equates to a cash deficit of $1.5 billion. Hess sold more than $3 billion in assets last year. Hess executives have said they plan to reach a point where they will generate enough cash to pay for new investments by 2020.

Exxon and Chevron, which are much larger than ConocoPhillips and have far higher profits, also have longstanding dividends that neither company cut since oil plunged in 2014. The companies also had a long history of buying back billions of dollars of their shares, but Chevron suspended its program in 2015 and Exxon’s was scaled back significantly. Chevron is expected to resume its buyback program soon.

The recent run of ConocoPhillips hasn’t been without challenges. Once among the industry’s biggest dividend payers, the company cut the payout by about two-thirds in early 2016 as oil prices fell to less than $30 a barrel. It argues that this is all part of its cash-management strategy. While oil prices rise, it returns the bounty to investors, but when prices fall below the sustaining price, it can sell assets, cut dividends or increase debt.

Crude prices are up by about 26% in the past six months, but unlike in the past, oil equities haven’t followed, suggesting that some investors lack confidence in the price rally.

In this climate, shareholders are likely to prefer producers like ConocoPhillips that demonstrate frugality, said Doug Terreson, an energy analyst at Evercore ISI who has championed greater discipline in oil.

“One of the key concerns in the industry is that companies are growing more disciplined today, but if the oil price rises, they will increase spending,” he said.

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