Oil prices have been in a rut over concerns about the global economy. West Texas Intermediate, the primary U.S. oil price benchmark, was down about 30% from its peak last year. That has put downward pressure on oil stocks, including shares of Devon Energy (DVN 0.58%), which has followed crude lower, losing about 30% of its value from the peak.
However, a new bull market for crude oil and Devon Energy could be on the way. Here are three reasons to buy the oil stock before its shares recover.
1. The oil market is about to get a lot tighter
Crude prices have been under pressure because of weaker-than-expected demand amid relatively strong supplies. However, the market appears poised for a big reversal. The International Energy Agency (IEA) sees rebounding air traffic and Chinese demand driving oil consumption to a record 102 million barrels per day this year (BPD), according to its March oil market outlook.
While the IEA expects supplies to grow, it predicts demand will outpace them in the second half of the year. That was before Saudi Arabia led a 1 million BPD production cut in response to the U.S. Government's decision not to refill its Strategic Petroleum Reserve this year. This reduction should create an even bigger shortfall between supply and demand. It could drive crude prices up toward $100 a barrel in the coming months.
The shock from the Saudi-led production cut boosted oil prices back above $80 a barrel. Even higher oil prices would enable Devon Energy to produce more cash, which is a big catalyst for its shares.
2. Shares are dirt cheap at $80 oil
Devon Energy's stock price slump has shares trading at a compelling valuation based on the cash flows it can produce at $80 crude oil. Devon Energy trades at about an 8% free cash flow yield at that price point. That's a lot cheaper than the broader market. For example, the S&P 500 trades at about a 5% free cash flow yield, while the Nasdaq Composite sells for around a 4% free cash flow yield.
That cheap valuation suggests Devon Energy has significant upside potential even if oil remains at $80 a barrel. Meanwhile, there's more upside if oil prices head higher. While Devon Energy likely won't ever fetch a market multiple because of the long-term uncertainty about oil demand, it shouldn't trade at this steep of a discount to the broader market.
3. That prospect for higher shareholder returns
Devon Energy launched the oil industry's first fixed-plus-variable dividend framework a couple of years ago. It has been a resounding success. The company paid out a growing gusher of dividends last year from its oil-fueled cash flows:
Data source: Devon Energy. NOTE: Chart by the author.
The company's total dividend outlay did dip alongside crude oil prices in the second half of last year. However, the dividend could rise again this year if oil prices continue rallying.
In addition to potentially paying another dividend gusher this year, Devon Energy will likely continue buying back its cheap stock. The company retains half its free cash flow, giving it lots of money for share repurchases. If oil prices keep rallying, higher dividends and increased share repurchases could fuel strong total returns for Devon Energy investors in the coming quarters.
The fuel for another bull run
Oil prices appear poised to continue rallying in the coming months as demand rebounds amid tightening supplies. That could set off another bull run for Devon since it will enable the company to produce even more cash that it could return to shareholders, including buying back its dirt cheap shares. That trio of factors makes the stock look like a very compelling investment opportunity right now.
