The stock market rallied strongly from its recent lows, with some market watchers already saying the next bull market is underway. But there's a nuance to the market's advance since there are still material concerns about economic growth around the world. If economic activity picks up, however, it will likely power the markets to greater heights. That would likely be great news for Pioneer Natural Resources (PXD -2.28%) and Devon Energy (DVN 0.19%) and their shareholders.
Powering the world
Energy prices are known for being volatile and they also tend to be highly cyclical. That makes sense, given that demand for energy rises when economic activity is high and declines when economic activity is low. High demand leads to rising energy prices while low demand leads to falling energy prices for these vital commodities. While that's a simplification, it is a reasonable way to frame the energy sector.
Image source: Getty Images.
If there's a bull market coupled with a growing economy, investors should probably expect energy stocks to be performing fairly well. But not all energy companies are the same. For example, pipeline operators largely collect fees for the use of their infrastructure assets. The structure of the relationship with customers is designed to produce reliable cash flows over time. So good times for energy stocks don't generally lead to big changes in profitability for pipeline stocks.
The companies that see the biggest boost to performance are those that are focused most heavily on the upstream (drilling) segment of the energy market. Even here, however, there are some important nuances to consider. And those differences are why Pioneer and Devon Energy are likely to be standout performers when times are good.
Sharing the pain and the pleasure
The story here actually ties back to dividends. Both Pioneer and Devon Energy have variable dividend policies. Each of these drillers has a base dividend that management believes is sustainable over time. However, layered on top of that base dividend is a variable payment driven by each company's financial performance.
When oil prices are high, Pioneer and Devon will pay very large dividends. When oil prices are low the dividend will get cut. This creates extra leverage for energy prices. If a bull market is accompanied by higher energy prices, these two U.S.-focused energy stocks should see big price gains and dividend increases.
The chart above shows how the rise in West Texas Intermediate crude prices, a key U.S. energy benchmark, rose dramatically after the energy downturn in 2020. That downturn was, of course, driven by the pandemic and the economic shutdowns used to slow its spread. But, once the world started to open back up, economic activity took off, stock markets rebounded, and energy prices rose. The share prices and dividends of Pioneer and Devon Energy took off.
Energy prices have pulled back from recent highs as concerns about economic growth have mounted. But if a recession is avoided and economic growth picks back up again, higher stock prices could easily be in the cards. It wouldn't be surprising if Pioneer and Devon Energy both benefit from that in a very positive fashion.
Of the two, Pioneer is probably the more attractive choice. That's driven by the company's more modest use of leverage, with a debt-to-equity ratio of 0.27 times. That's roughly half the leverage that Devon Energy is carrying. That said, while more conservative types will likely prefer Pioneer, neither of these drillers has a particularly worrying level of debt on their balance sheet.
Options for energy sector investment
As noted, investors looking for reliable income will probably prefer to stick with midstream companies. And truly risk-averse investors looking for direct energy exposure might opt for an integrated energy giant like Chevron over a pure-play driller, as Chevron's financial strength and business model have long allowed it to support its dividend through the energy cycle. That said, Pioneer and Devon are highly likely to be more volatile stocks, but when the good times are here in the energy sector they will almost certainly be rewarding investors with fast-growing dividends and rising stock prices.
