Oil prices have been moving steadily higher in recent months. Thanks to OPEC's support, the U.S. oil benchmark, WTI, recently topped $57 a barrel, its highest level since last January. Meanwhile, crude could have more room to run given that demand is just starting to rebound and U.S. producers are preaching restraint.
Oil producers are starting to cash in after spending much of the past year reducing costs. One of the best-positioned oil stocks for the current environment is Devon Energy (DVN -1.77%), making it a top buy right now.
Positioned to thrive at lower oil prices
Devon Energy has worked hard over the past year to drive down its costs so that it could operate at lower oil prices. The company sold higher-cost assets and used the cash to pay down debt, reducing its interest expenses. Those moves had it on track to achieve $300 million of sustainable cash cost savings by the end of last year.
The company has since taken its cost savings initiatives to another level by agreeing to a merger-of-equals transaction with WPX Energy. The deal will enable it to increase its cost savings to $575 million by the end of this year. Devon only needs oil to average $33 a barrel in 2021 to generate the cash to drill enough new wells to maintain its current production level. Add that to a strengthening balance sheet thanks to its debt reduction plan, and Devon can thrive at lower oil prices. It can cover its capital program and 2.5%-yielding dividend with room to spare with oil at less than $40 this year.
The strategy is about to pay big dividends
With crude prices currently well above the level Devon needs to maintain its current operations, it's on track to generate significant excess cash. For example, at $50 WTI, Devon could produce more than $1.25 billion in free cash, with that number rising above $2 billion if crude were to average $60 this year. That's a lot of money for an oil company that currently has a $12 billion market cap.
Devon has a range of options for that money. It could use the funds to pay down more debt, drill additional wells to increase its output, or return it to shareholders via dividends and share repurchases. Since Devon already has $2.1 billion of cash on its balance sheet, it has the funds needed to deliver on its target to reduce debt by $1.5 billion in the near-term. Meanwhile, it doesn't seem likely that the company will ramp up its drilling program any time soon. The oil market doesn't need any new supply given the current demand headwinds and the fact that OPEC is holding back output to prop up pricing. Thus, it seems most likely that Devon will return the bulk of the free cash flow it produces this year to shareholders.
The primary method will be its variable dividend program, which the company intends on implementing this year now that it closed its merger with WPX Energy. That strategy will see the company pay out up to 50% of its excess free cash each quarter, provided it has a more than $500 million cash balance, strong balance sheet, and constructive commodity price outlook. Since the company currently meets those criteria, it should start making these incremental payouts soon. These additional dividends could be substantially higher than the base payout, considering the amount of excess cash the company appears poised to produce this year.
An ideal way to cash in on higher oil prices
Devon Energy's strategy to transform into an ultra-low-cost oil producer is starting to pay off. It's on track to produce a massive amount of excess cash this year thanks to the recent improvement in oil prices. While it's not the only oil stock to benefit from this rebound, it stands out among its rivals because it plans to send a portion of its windfall back to shareholders via its variable dividend program. That ability to immediately reap the rewards of higher oil prices is why Devon tops my list as the best oil stock to buy right now.