The oil industry has been where capital has gone to die over the past several years. Oil companies have invested billions of dollars in drilling new wells over the past decade, which has nearly doubled the country's oil output. However, they have little to show for all that spending: The average oil stock has lost almost 75% of its value during the last decade, as measured by SPDR S&P Oil & Gas E&P ETF returns.
Clearly, the sector's growth strategy hasn't been paying dividends for investors. That's leading Devon Energy (NYSE:DVN) to take a new approach by launching an industry-first "fixed plus variable" dividend program. This new plan puts returning cash to shareholders at the forefront, making it my top oil stock to buy right now.
A bold new strategy
Devon Energy recently announced its plans to combine with WPX Energy (NYSE:WPX) in a merger of equals. Among the key aspects of the deal is that it will be immediately accretive to earnings, increase Devon's cost savings to $575 million by the end of next year, and reduce its 2021 maintenance capital requirements to the cash flow it can produce at $33 oil. Because of all that, Devon expects to generate significant free cash flow.
Usually, oil companies earmark the bulk of their free cash toward investing in new oil projects. However, Devon is upending that legacy blueprint by embarking on a new way forward centered around returning free cash flow to shareholders. It's doing that by launching a fixed plus variable dividend program.
Under this plan, the company aims to pay out a fixed base dividend -- currently set at $0.11 per share -- that should average about 10% of its annual operating cash flow. Devon also plans to distribute up to 50% of its excess free cash flow each quarter via a variable dividend as long as it meets certain criteria. The formula for determining the payout would be its operating cash flow minus capital spending and the base dividend. Meanwhile, the requirements for paying that distribution would be that it has a more than $500 million in cash, a strong balance sheet with leverage at its targeted levels, and a constructive outlook on commodity prices.
Why this strategy could be a game changer
The U.S. oil industry has historically spent all its free cash flow and then some to grow production. While that has helped turn the country into one of the world's leading oil producers, it hasn't paid dividends for investors. That's because it has overloaded the industry with too much supply, which has sparked intense oil price volatility and price wars with OPEC.
That's leading Devon Energy to chart a new course. Instead of investing the bulk of its free cash on growing its production, the company plans to invest enough money to maintain its current output level. That will free up cash to return to shareholders.
As noted, Devon plans to return as much as 50% of the excess cash flow it produces each quarter to investors via a variable dividend payment. Because of that, investors would immediately benefit from an improvement in cash flow from higher oil prices since that would likely fuel a higher variable payment for that quarter.
Meanwhile, the company has the flexibility to allocate the remaining free cash flow across three buckets:
- Invest in select growth projects. The company plans to limit reinvestment by growing its production by only a maximum of 5%. It also wouldn't earmark capital toward growth projects until oil prices are above $45 a barrel.
- Return it to shareholders via opportunistic share repurchases.
- Use it to maintain a top-tier balance sheet by paying off additional debt. This will likely be the primary use of its remaining excess cash when oil prices are in the range of $40 to $45 per barrel.
Devon's decision to deemphasize growth in favor of returning its free cash flow to shareholders could enable it to generate strong total returns for its investors. For example, one analyst believes that Devon Energy could produce more than $1 billion of free cash flow next year after paying its base dividend if oil prices improve to the upper $40s. That suggests it could pay up to an additional $500 million in variable dividends next year, which implies a 7% dividend yield on the current combined market caps of Devon and WPX. Add that to the company's already sizable 4% base payout, and investors could earn a substantial cash return next year on a marginal improvement in oil prices from the current level in the low $40s. Meanwhile, Devon has the potential to create additional shareholder value with its remaining free cash, as it could pay off more debt, repurchase its beaten-down stock, or invest in targeted growth projects if the oil market demands more volumes.
Immediately capturing the windfall
The oil industry has historically increased capital spending at the first sign of higher oil prices in hopes of cashing in on the rebound. Unfortunately, this increased spending has never paid any dividends, as the higher output weighed on pricing and investment returns. That's leading Devon to take a new approach by rewarding investors at the first sign of higher prices through a variable dividend program. This plan will allow them to immediately and tangibly benefit from any improvement in oil prices. That bold approach makes Devon stand out as one of the only oil stocks offering a compelling buy thesis these days.