In early 2021, Devon Energy (DVN -0.11%) closed its merger of equals with fellow oil producer WPX Energy. Since then, shares of Devon have soared more than 280%, while the total return is approaching 310%. That's impressive, considering the S&P 500's total return is a mere 5%. While higher oil prices have helped fuel Devon's monster returns, the merger helped lower its costs, enabling it to generate more cash. It's returning the bulk of that windfall to shareholders through a growing base dividend, variable dividends based on its free cash flow, and share repurchases.
Devon's success is leading other oil producers to follow in its footsteps. Lesser-known producers Whiting Petroleum (WLL), Oasis Petroleum (CHRD 0.02%), and Centennial Resource Development (PR -0.76%) are all currently pursuing merger of equals transactions. Once those deals close, these oil stocks should generate more free cash, the bulk of which they plan to return to shareholders. That upcoming catalyst is something investors won't want to miss.
Oasis Petroleum and Whiting Petroleum agreed to combine in a $6 billion merger of equals transaction in March. The deal will create a larger-scale U.S. oil producer with a premier position in the Williston Basin of North Dakota. The oil companies expect the transaction to be accretive to the combined company's key per-share metrics while enabling them to reduce costs and generate more free cash flow.
The transaction structure will also allow the combined company to maintain a strong, relatively unlevered balance sheet. That's important to note, given that both companies have gone bankrupt in the past.
By combining, the oil producers believe they can generate sustainable free cash flow in the future. They estimate the proforma company can produce about $1.2 billion in free cash flow per year at an oil price of around $85 a barrel, well below the current price.
They also plan to follow Devon Energy's blueprint by delivering enhanced capital returns to shareholders. They plan to pay out 60% of their free cash flow via a compelling base dividend and a combination of variable dividends and share repurchases. Those variable dividends could be sizable.
For example, Devon Energy -- which distributes 50% of its post-base-dividend free cash flow to shareholders via variable dividends -- recently made a combined payment implying an annualized dividend yield of around 8%. If oil prices remain high and the Whiting/Oasis combination opts for dividends over repurchases, it could make sizable future dividend payments.
Following the gameplan
Centennial Resource Development recently unveiled its plans to combine with privately held Colgate Energy in a $7 billion merger of equals transaction. The combined company will be one of the largest pure-play exploration and production companies focused on the oil-rich Delaware Basin in Texas and New Mexico.
They expect this deal to be accretive to their key financial metrics while maintaining a strong balance sheet. The combined company also expects to generate significant free cash flow. The combo would produce over $1 billion in free cash flow next year at the current projected pricing level.
With a strong balance sheet and a business positioned to produce significant free cash flow, the Centennial/Colgate combo expects to increase its shareholder returns framework once the deal closes. Centennial doesn't currently pay a dividend, and while it did launch a $350 million share repurchase program last year, it hasn't yet tapped into that because it's using free cash flow to reduce debt.
However, the combined company will likely pay a base dividend -- Colgate already pays one -- and start utilizing the share repurchase authorization. On top of that, the combined company will be in a strong position to return additional cash to shareholders, potentially through the addition of a variable dividend program.
Merger-driven capital returns programs could fuel big returns for shareholders
Devon Energy's successful merger of equals transaction last year has more energy companies following in its footsteps. The deal boosted Devon's cash flow, enabling it to return its growing gusher to shareholders, fueling eye-popping total returns. Whiting, Oasis, and Centennial believe their deals will deliver similar benefits to shareholders. That makes them interesting energy stocks to watch as those mergers could prove to be big catalysts in the coming quarters.