Devon Energy (DVN +1.85%) launched the oil industry's first fixed-plus-variable dividend framework last year. It designed that strategy to return more cash to its shareholders during periods of higher energy prices. With those prices surging in the past year, the variable payout had risen sharply.
However, the downside of the variable dividend structure is that Devon's payout will fall when commodity prices decline, which happened in the third quarter. That lower dividend payment might have some investors wondering if it's now time to sell.
NYSE: DVN
Key Data Points
Cash flow falls as oil prices cool off
Devon Energy produced $2.1 billion of operating cash flow in the third quarter, up 32% year over year. It reinvested 33% of those funds to maintain and grow its operations, leaving it with $1.5 billion of free cash flow.
While those were strong numbers for the oil and gas producer, they're off the record highs it achieved in the second quarter. Cash flow from operations totaled $2.7 billion in that period, while free cash flow was $2.1 billion, the highest level in the company's 51-year operating history.
The primary reason cash flow declined in the third quarter was lower oil prices. Devon sold its oil for an average price of $84.38 per barrel in the third quarter. That's down from $95.80 per barrel in the second. In addition, its production was down slightly from the sequential quarter, though it did exceed the company's guidance by 2%.
Expect variability
Devon Energy's fixed-plus-variable dividend framework has two parts. It pays a fixed base quarterly dividend. Devon aims to steadily grow that base payment and sustain it at low oil prices. That payment is currently $0.18 per share each quarter. In addition, Devon pays out up to 50% of its free cash flow after covering all capital expenses and its base dividend. With Devon producing record free cash flow in the second quarter, it was able to pay a record dividend of $1.55 per share.
However, with free cash flow declining in the third quarter because of lower oil prices, it's paying out a slightly lower dividend at $1.35 per share, about 13% less than the second quarter's level. That payment consists of the same $0.18 per share base and a $1.17 per share variable dividend payment.
On the one hand, a lower dividend payment is never something an investor likes to see. However, by definition, Devon's variable dividend framework will see the payment ebb and flow each quarter. Because of that, it's essential to see the recent reduction in that light.
Further, it's also worth noting that even though the dividend has come off its peak, the third-quarter payment is 61% above the year-ago level. Additionally, the third-quarter dividend payment has an implied annualized dividend yield of 7.1% at Devon's recent stock price. That's well above the energy sector's average of around 4% and the S&P 500's roughly 1.7% dividend yield.
Devon also recently took steps to enhance its ability to generate free cash -- and pay dividends -- in the future. It spent $2.5 billion to acquire two cash-flowing oil properties in the third quarter. Those deals should boost its free cash flow even if oil prices remain flat this quarter. That would allow Devon to pay a higher dividend in the current period.
A different kind of dividend
Devon Energy's dividend isn't for everyone. The oil company established its fixed-plus-variable dividend framework to provide its investors with the upside to collect more income based on its oil-fueled cash flows. With those cash flows surging to a record during the second quarter, Devon had the funds to pay a record dividend.
However, this structure has its downside: The variable component falls as cash flow declines. That was the case in the third quarter. This lower payment doesn't make Devon a sell. It's the risk investors need to be willing to take for the company's higher yield and upside potential if oil prices rise in the future.
