Oil prices have moved sharply higher in recent months. The price of West Texas Intermediate (WTI), the primary U.S. oil benchmark, was recently above $90 a barrel. That's a more than 30% gain in the last three months and comfortably above its $65 to $80 a barrel trading range over the past year.
Higher crude prices typically entice oil companies to ramp up their drilling activities to increase production. However, that's not what leading oil companies Devon Energy (DVN 0.19%) and Occidental Petroleum (OXY -0.15%) are planning. They expect to keep a lid on spending. That would enable them to produce even more free cash flow that they'll likely return to shareholders.
A likely surge in cash flow and cash returns
Devon Energy expects its total capital spending to be between $3.6 billion and $3.8 billion this year. That's over $1 billion more than it spent in 2022. The main factors fueling that increase are inflation and the impact of two acquisitions.
The higher capital-spending rate, along with lower oil prices, have cut into Devon's free cash flow. That affected Devon's dividend since it bases the variable component on its free cash flow.
Data source: Devon Energy. Chart by the author.
Devon's free cash flow should bounce back next year. CEO Rick Muncrief recently said he expects the company's capital spending to decline, driven by deflating well costs. In an interview with Bloomberg TV, Muncrief noted that the cost of drilling rigs and the steel used for oil wells had fallen recently. However, instead of reinvesting these savings into drilling more wells, Devon plans to spend less next year. That's partly due to tight labor-market conditions, which are holding back its ability to ramp up its drilling activities.
On top of that lower capital spending, Devon's cash flow should get a big boost from higher oil prices. That positions the company to produce significantly more free cash flow.
Devon will return a big chunk of this windfall to shareholders in dividends. The company's current dividend framework targets paying up to 50% of its post-base-dividend free cash flow in variable dividends. In addition, Devon will likely continue using some of the remaining excess free cash flow to buy back its shares. Given the nearly 40% decline from their 52-week high, it could gobble up a boatload of shares.
Not balanced enough to grow
Occidental Petroleum also plans to keep a lid on spending by maintaining its current production rate despite the recent run-up in crude prices. CEO Vicki Hollub recently noted the factors driving that decision in an interview with Bloomberg Television. She stated: "We don't increase oil significantly in a market where we don't see the balance. Only in a market where we see balance would we increase our production -- and even then, it would be at a moderate pace."
OPEC is the primary factor causing the current imbalance in the oil market. The group is curtailing its output by an extra 1 million barrels per day through the end of the year to push up prices. If U.S. producers like Occidental and Devon started ramping up their production to fill the gap, it could cause another price war with OPEC, which might pause its cuts to drive down prices.
U.S. producers have gotten burned in the past by ramping up their drilling activities into higher oil prices. That's leading them to be more disciplined these days. They'd rather sit back and cash in on the higher prices than ramp up their activities for some incremental growth that could trigger a price decline.
Instead of increasing its capital budget to boost production, Occidental will likely return more of its incremental cash flows to shareholders through dividends and share repurchases. That would likely trigger the continued redemption of Berkshire Hathaway's preferred stock investment in the company. Once Occidental returns more than $4 per share to its investors over a 12-month period via dividends and buybacks, it must redeem an equal amount of Berkshire's preferred stock for any excess distributions it makes to shareholders. Those redemptions will save the oil company money in the long run since it pays an 8% rate on that preferred stock.
Poised to generate and return more cash
While oil prices have rallied, that won't cause Devon or Occidental to ramp up capital spending or their drilling activities. They plan to remain disciplined. Because of that, they'll likely produce a lot more free cash over the coming year, which they'll undoubtedly return to shareholders through higher dividends and share repurchases. That combination of increased cash flow and cash returns could enable these oil stocks to produce strong total returns, making them intriguing oil stocks to consider buying right now.
