Oil companies made deep cuts earlier this year as oil prices crashed. All of them slashed capital spending on new oil projects, while most also cut back on shareholder distributions like dividends and buybacks.
However, with oil prices stabilizing in recent months, oil companies are feeling a bit more confident about their financial situations. What's interesting this time around is how they're using their increased flexibility. Instead of ramping up capital spending like they typically do following a deep price downturn, they're rewarding shareholders first. That's a welcome sign for a sector that has done a terrible job allocating capital in the past.
Immediately returning excess profits
This week, Devon Energy (DVN -3.64%) made headlines for agreeing to combine with WPX Energy (WPX) in an all-stock merger of equals. Most investors focused on the deal, which could become a blueprint for further consolidation in the sector. One item that seemed to get lost in the shuffle was Devon's plans to initiate an industry-first variable dividend program.
The "fixed plus variable" dividend strategy would see Devon continue to pay out its current base dividend level of $0.11 per share each quarter, which amounts to about 10% of its operating cash flow. On top of that, the company plans to make a variable distribution to investors each quarter of up to 50% of its remaining free cash flow, which is its operating cash flow minus capital expenditures and the base dividend. It plans to make these payments quarterly as long as it has a cash balance of more than $500 million, a strong balance sheet with leverage ratios in line with its target, and a constructive oil price outlook.
This dividend strategy is a notable capital allocation shift. Usually, oil companies allocate the bulk of their free cash flow toward drilling more wells. However, with the sector saturated in oil due to COVID-19 and previous growth attempts failing miserably, Devon is shifting its strategy to returning cash to shareholders first and growing production second. If more companies follow this blueprint, it could help the sector finally create value for investors.
Restarting the buyback
ConocoPhillips (COP -3.15%) also made a move this week aimed at returning more cash to shareholders as it plans to restart its share buyback program. The oil company initially wanted to repurchase $3 billion of its stock this year, targeting to spend $750 million a quarter. However, it suspended that program when oil prices nosedived earlier this year.
It's now restarting the buyback thanks in part to the improvement in crude oil prices over the past few months. It plans to repurchase $1 billion of shares during the fourth quarter, funded with cash on hand, which stood at $7.2 billion at the end of the second quarter.
ConocoPhillips is the first oil company to bring back its buyback program, which, like many dividends, was among the first things oil companies cut when crude prices crashed earlier this year. What's notable here is that ConocoPhillips is prioritizing returning cash to shareholders instead of ramping up its capital spending program. That focus on delivering value to investors before spending money on more wells in an oversupplied market is a positive development. It could lead others in the sector to follow a similar shareholder-first approach.
Returning value instead of returning to the way things were
Devon Energy and ConocoPhillips made a statement this week by unveiling plans to return more cash to their investors now that oil prices have stabilized. It's a shift in the typical industry approach of ramping up drilling as soon as market conditions improved. The hope is that more oil companies will follow their lead in putting shareholders first since the prior growth-focused strategy hasn't paid any dividends for investors in many years.