Oil stock dividends have been almost as volatile as oil prices in recent years. Many oil producers slashed their payouts following crude price crashes in 2014 and 2020. While some companies boosted them as oil rebounded between those downturns, several had to cut them again on the subsequent sell-off.
That led Devon Energy (DVN -1.77%) to take a new approach by launching the industry's first fixed plus variable dividend framework. It features a reasonable base payout that Devon can sustain at lower prices and additional cash payments when crude prices rebound. The company recently declared its first variable dividend, which was a gusher thanks to higher oil prices.
A solid base with significant upside
Devon has been paying a base quarterly dividend of $0.11 per share, which it can sustain at sub-$40 a barrel oil. It's an attractive payout, yielding roughly 2.1% at the current share price, which is comfortably above the S&P 500's average dividend yield of 1.5%.
However, the company wanted to supplement that payout by returning additional cash to shareholders when it generated excess funds on an eventual rebound in the oil market. Traditionally, Devon and its peers used share repurchases to return spare cash to investors. However, that hadn't created value for shareholders since the industry often bought back shares when they were high, only to see them plunge when oil prices tumbled.
That led it to implement a new dividend strategy to return a portion of its excess cash to investors via an additional variable dividend that it could pay quarterly depending on its balance sheet and the state of the oil market. The framework would allow Devon to pay out up to 50% of its excess cash after funding its capital projects and fixed base quarterly payout.
Off to a gushing start
Devon recently declared its first variable dividend, setting it at $0.19 per share. That works out to about 48% of its excess free cash flow during the fourth quarter of 2020. Overall, the company is distributing an additional $128 million in cash to shareholders via its first variable dividend, which is on top of the $42 million base dividend outlay for that period.
That first payment is only the beginning of what Devon appears poised to distribute this year. At $50 oil, Devon estimates that it can produce $3 billion of operating cash flow. However, the company only expects to spend $1.6 billion to $1.8 billion on capital projects to keep its production flat this year. That implies it could generate as much as $1.4 billion in free cash flow this year at $50 oil. However, with crude oil currently around $60 a barrel, Devon could produce even more excess cash in 2021.
Fueling the likelihood of even bigger payouts in the coming quarters is that Devon doesn't have much other use for this cash. Despite rising oil prices, the company isn't likely to increase its capital budget and ramp up its drilling program because the oil market doesn't need any additional crude. Demand remains tepid because of the COVID-19 outbreak, which led OPEC and other producers to curtail some of their output, which they plan to bring back as demand recovers. Meanwhile, the company has a cash-rich balance sheet (it had a cash balance of $2.6 billion at the end of 2020) with minimal near-term debt maturities. Devon plans to use some of that money to redeem $1.5 billion of its debt this year to further reduce interest costs. Given its variable dividend cap of 50% of its excess cash flow, Devon appears likely to maintain a strong cash position this year, even if it maxes out this payout in 2021.
A potential gusher of dividends in 2021
Devon Energy's new dividend framework aims to provide investors with a reliable base dividend while immediately rewarding them with higher payouts if crude prices improve. That was certainly the case with the company's first variable payout, as it was more than double its already attractive base level. Meanwhile, the company appears poised to pay out a gusher of variable dividends in 2021 since it's on track to produce a massive amount of excess cash at the current oil price. That makes it one of the more compelling income stocks in the oil patch these days.