Oil prices have staged an epic comeback. They've rallied nearly 100% over the past 12 months and are approaching $80 a barrel. They're even higher off their bottom when crude crashed into negative territory during the early days of the pandemic last year.
Oil prices could have further to run, given rebounding demand and the slow return of supply. In short, oil stocks are generating a gusher of cash flow.
Many oil producers are using that money to repay debt and get back on solid ground following a rough patch. Others, however, are starting to return more of their windfall to investors. Devon Energy (DVN -0.54%) is leading the way, which is why it's my top oil stock to buy right now.
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The start of something special
Devon Energy started 2021 by completing its transformational merger with WPX Energy. The combination enhanced its scale and reduced costs, positioning it to produce more free cash flow. Devon set a plan to return a significant portion of this money to investors by initiating an industry-first fixed-plus-variable dividend program. The strategy would see the company make regular base dividend payments to shareholders that it could support at lower oil prices. In addition, Devon would make variable special dividends each quarter based on its free cash flow, financial situation, and oil price outlook.
The company set its variable dividend rate at up to 50% of its excess free cash each quarter. It calculates that number as its free cash flow after covering its capital expenses and base dividend. Devon has the flexibility to use the remaining money to further shore up its already strong balance sheet or repurchase shares.
A growing gusher
Devon couldn't have timed the start of its variable dividend program more perfectly, given the rally in oil prices this year. The company generated $260 million of free cash flow during the first quarter. That allowed it to pay $0.34 per share in dividends (its $0.11-per-share quarterly base plus a $0.23 per share variable dividend). Meanwhile, its excess free cash flow surged to $515 million in the second quarter, enabling the company to increase its total dividend outlay by 44% to $0.49 per share
The main factor fueling that higher dividend was rising oil prices. Devon sold its oil for an average price of $50.34 per barrel in the second quarter, an improvement from $46.15 per barrel in the first quarter. The company would have realized an even higher price if it didn't have oil hedges in place to protect against lower oil prices.
While those hedges will act as a headwind in the near term, they start winding down next year. So Devon's cash flow should continue expanding, even if oil prices give back some of their recent gains.
That sets its shareholders up to receive an even greater dividend gusher in the coming quarters. At $80 oil, Devon could pay a monster dividend in the second half of this year. At its current stock price, it's trading at a 24% free cash yield based on $80 oil. Assuming it paid half of that money out in dividends, and it could have a dividend yield of around 12%. That makes it the highest potential dividend yield opportunity among companies in the S&P 500.
Meanwhile, there's even more cash flow upside in the future as Devon's current oil price hedges roll off, and it benefits from its merger-related cost savings initiatives. At $80 oil, it has a future upside of a 34% cash flow yield. Meanwhile, even if oil dipped to $60 a barrel, its free cash flow yield would be over 20%.
Given that upside, Devon may pay out even more of its free cash via variable dividends in the future. Due to demand uncertainty, the company won't allocate too much capital to growing its production. Meanwhile, it has already achieved its leverage target. That leaves it with fewer options for its free cash. It could repurchase shares, make acquisitions, or pay out more in dividends.
The best way to cash in on higher oil prices
Devon Energy allows investors to benefit from higher oil prices almost immediately. That's because its variable dividend program rises along with oil prices. That near-term payoff and upside potential make Devon stand out as the best oil stock to buy right now amid what seems like a period of sustained higher oil prices.
