Since the oil and gas crash of 2014 and 2015, free cash flow (FCF) has been the name of the game across the energy sector. By focusing on FCF, an investor can stress-test an oil and gas company to see if it is just bringing in cash when times are good or if it can also earn positive FCF even when oil and gas prices are relatively low.
ConocoPhillips (COP 0.10%), Devon Energy (DVN 0.19%), and Hess Midstream LP (HESM -0.09%) are three energy stocks that are generating large amounts of FCF to support sizable dividends. Here's what makes each company worth a look.
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ConocoPhillips is a free-cash-flow machine
Daniel Foelber (ConocoPhillips): If you're a fan of income investing, chances are you know a stock's dividend yield is simply the return on investment from dividends alone in a year's time. Put another way, it's the annual dividend per share over the price per share of the stock. But what you may not have heard of is FCF yield.
FCF yield is just the FCF per share over the share price. It shows how much FCF a company is yielding. In other words, it shows how much the company could pay in dividends if it gave out all of its FCF.
The metric is useful for non-dividend-paying companies, too. For example, Google's parent company, Alphabet (GOOG 9.96%) (GOOGL 10.22%), is famous for being a cash cow. Despite the stock's massive run-up, it has an FCF yield of 3.9%. But it doesn't pay a dividend, preferring instead to use that FCF to reinvest in the business.
Dividend-paying or not, a company with a high FCF yield is a sign of an efficient and well-run business. In the case of upstream exploration and production (E&P) company ConocoPhillips, its FCF is so high that it could afford a staggering 9% dividend. And the yield was much higher before the stock price shot up.
COP Free Cash Flow Yield data by YCharts.
Granted, a lot of E&Ps are generating boatloads of FCF right now. That's not surprising, given how much oil and gas prices have gone up. What's impressive about ConocoPhillips is that it can generate strong FCF even when oil and gas prices are far lower.
The company has an extremely efficient asset portfolio. It has spent years selling plays that can only do well at a high oil price in favor of investments that can turn positive FCF even at low oil prices. The company is conservative with its spending. Its long-term goal is to be FCF breakeven even when oil is just $35 per barrel -- which gives the company a massive margin of error. It also makes the existing dividend secure and leaves room for future raises. ConocoPhillips doesn't need a growth cycle to be a cash cow. And that differentiates it from riskier E&Ps that are more boom or bust.
ConocoPhillips stock has been on a tear and is currently hovering around an all-time high. But it's arguably the highest-quality E&P out there. In a volatile industry like upstream oil and gas, it makes sense to pay more for quality to have the confidence necessary to ride out a downturn.
There's upside potential in Devon Energy's dividend
Lee Samaha (Devon Energy): Investors in the oil and gas company were left disappointed when it recently slashed its dividend. While it's never good news when a dividend gets cut, it's important to stay rational and look at the investment proposition in front of investors now.
Doing so would reveal a relatively positive outlook for investors looking for exposure to oil and a stock with a good dividend yield. The company's dividend comprised a fixed dividend and a variable dividend. The latter is paid by up to 50% of the excess free cash flow (after capital expenditures and the fixed dividend have been taken out of operating cash flow) generated by the company.
The company's operating cash flow is led by income, and that's led by the company's earnings. In common with much of the oil and gas sector, Devon's earnings are energy-price-led, so the correction in oil and gas prices from over $100 a barrel in the summer of 2022 to a low of around $67 a barrel. In addition, management has raised capital expenditures in 2023 and expects to spend $3.6 billion to $3.8 billion this year compared to $2.5 billion in 2022.
However, several factors suggest Devon's free cash flow will improve. First, the price of oil is back above $90 a barrel, the price of gas has stabilized, and Devon Energy is seeing deflationary trends in its costs. Meanwhile, the capital expenditures are to increase production (oil production set an all-time high at 323,000 barrels a day in the second quarter).
Annualizing the second quarter's dividend results in a full-year dividend of 3.7%. That's attractive enough, and there's a good chance Devon's dividend will increase next year.
Don't be deceived by how much cash Hess generates
Scott Levine (Hess Midstream): When it comes to searching through the energy sector for attractive dividend stocks, there are the usual suspects -- I'm looking at you, oil supermajors. But Hess Midstream is a pipeline partnership that often flies under the radars of many investors despite its enticing ultra-high forward dividend yield of 7.5%. Even more alluring about the company is the prodigious free cash flow it generates to help support its generous dividend.
Although Hess Midstream relies on its water services business for some of its revenue, the lion's share of its sales comes from the company's midstream assets located in the Bakken and Three Forks shale in North Dakota, which help the company to generate steady revenue -- revenue which, ultimately, translates into substantial free cash flow.
Granted, a cursory glance at Hess Midstream's free cash flow will not necessarily awe investors. Over the past three years, Hess Midstream has averaged $532 million in annual free cash flow, according to Morningstar. But savvy investors know to dig deeper than to take mere cursory glances. The free cash flow that Hess Midstream has produced over the past few years represents a large percentage of the company's revenue. From 2020 through 2022, for example, Hess Midstream's annual free cash flow represents an average of 44.2% of overall sales.
Management forecasts free cash flow to grow 10% in 2024 and 2025, and expects the company's strong cash flow to adequately cover the company's planned annual dividend per share growth of 5% during the same time period.
