Crude oil prices have cooled off considerably in recent months. WTI, the primary U.S. benchmark oil price, was recently around $75 a barrel. That's a dramatic decrease from its peak of over $120 a barrel earlier this summer. The primary culprit is the concern that the global economy is in or barreling toward a recession, which would sap oil demand.

However, even with a recession, crude prices could rally sharply, fueling a rebound in oil stocks. That's because the oil industry's spare capacity is running low. If a major supply issue arises from a natural disaster or terrorist attack, the industry could struggle to meet demand, likely sending crude prices soaring. 

Drilling down into the capacity issue

The oil industry always runs at a delicate balance between supply and demand. If industry fundamentals get out of balance, prices can make big moves. Governments try to keep some spare capacity to provide the market with oil if there's a supply issue, to keep prices from spiking.

One of those stockpiles is the Strategic Petroleum Reserve (SPR). The U.S. Government established it in 1975 following OPEC's oil embargo. Before this year, the U.S. only tapped its emergency stockpile three times: 

  • 1991: A 17.3-million-barrel release during Operation Desert Storm.
  • 2005: A 20.8-million-barrel release following Hurricane Katrina.
  • 2011: A 30.6-million-barrel release following military intervention in Libya.

However, the Biden administration has drained more than 200 million barrels out of the SPR to help stem the rise in oil prices following Russia's invasion of Ukraine. That's 30% of the country's total reserves. It has pushed the country's stockpile to its lowest level since 1984. At the current level, there's only enough oil to meet the country's demand for about 50 days if imports suddenly dry up.

In addition to the ongoing draining of U.S. oil stockpiles, OPEC's spare production capacity has steadily declined. The group of oil-producing nations routinely holds back supply in case of an emergency. In March, the group had about 1.8 million barrels per day (BPD) of spare capacity, equal to about 2% of worldwide demand. 

However, the group has steadily increased its output this year because of higher oil prices, and conservative estimates forecast that OPEC's spare capacity will decline below 1 million BPD later this year. That doesn't leave the market with much wiggle room.

With America's SPR slowly dwindling and OPEC's spare capacity running low, the industry is in a weaker position to handle a supply disruption than it was when Russia invaded Ukraine earlier this year. It might not take much to send crude prices soaring. 

Cashing in on higher crude prices

Higher oil prices would enable producers to generate even more cash. For example, Diamondback Energy (FANG 0.57%) estimates that it can produce more than $3.6 billion of free cash flow if oil averages $70 a barrel this year, about $1.2 billion more than it made last year. However, it could produce $4.3 billion at $90 oil and $4.6 billion if it returned to the triple digits. With the market valuing stock prices on their ability to grow earnings, shares of Diamondback's stock would likely surge with oil prices.

Another reason why Diamondback Energy's stock would likely rally if crude prices rebound is because it plans to return the bulk of its windfall to investors. It set a target to return up to 75% of its free cash flow to shareholders each quarter through its regular dividend, opportunistic share repurchase program, and variable dividend. 

Meanwhile, Devon Energy (DVN 0.78%) has a similar capital return framework. It pays a base dividend that it can sustain at almost any oil price. In addition, it pays a variable dividend of up to 50% of its quarterly free cash flow. With its cash flow rising and falling with oil prices, an uptick in crude would give Devon more money to pay out via its variable dividend.

Pioneer Natural Resources (PXD 0.87%) and EOG Resources (EOG 1.07%) also have capital return programs based on a percentage of their free cash flow. Pioneer Natural Resources aims to return 75% of its free cash flow after paying its base dividend to shareholders through a variable dividend. Meanwhile, EOG targets to pay shareholders up to 60% of its free cash flow. If it doesn't hit that target with its regular dividend, it will make up the difference with a special dividend. As higher oil prices boost their free cash flow, these companies need to make higher dividend payments to achieve their capital return targets.

Primed for a catalyst

While oil prices have steadily declined from their peak, it wouldn't take much to send them soaring again because OPEC's spare capacity and the SPR are running low. Higher prices would enable oil companies to generate more cash, the bulk of which they intend on returning to their shareholders. That potential for even higher cash returns makes oil stocks look compelling these days.