Oil and gas exploration and production company Devon Energy's (DVN 0.19%) trailing dividend yield of 7.2% is eye-catching, as is its potential to pay substantive dividends in the coming years. Still, is it enough to make the stock a buy? Here's what you need to know before buying the stock.
Devon's earnings, cash flow, and dividend are oil-price-led
There's no point ignoring the elephant in the room. Devon Energy is a stock that will suit energy bulls, but if you are pessimistic about the price of oil, read no further! After all, Devon's dividend is tied to the price of oil.
Devon operates a "fixed plus variable" dividend strategy, with the current fixed portion set at $0.20 a quarter or $0.80 a year. Based on the current price, the fixed part of the dividend alone is yielding 1.9%. That said, even the fixed dividend somewhat relies on energy prices.
Digging into the company's SEC filings, management outlines that it aims to pay 10% of its operating cash flow in fixed dividends and up to 50% of its excess free cash flow in a variable dividend. As such, if the price of oil crashes, as history suggests it can do, then even Devon's fixed dividend may not prove sustainable. Moreover, with the economy weakening, downward pressure on demand will likely increase as activity slows.
High oil prices could be here to stay
That said, there's a robust case for the argument that higher energy prices are here to stay based on three interconnected arguments.
First, having been burnt by the post-2014 slump in energy prices (after investing heavily in assets), major energy companies have been much more disciplined in their capital spending. As you can see below, oil majors like ExxonMobil, Chevron, and BP are still spending significantly less than they did when the price of oil was at these sorts of price levels.
Data by YCharts
Moreover, the political environment around fossil fuels is less favorable than in 2010-2014, and many energy companies are cautious about investing in assets subject to political uncertainty.
Second, the current administration's significant drawdown in the U.S. Strategic Petroleum Reserve not only leaves the U.S. susceptible to an oil price shock but implies pent-up demand for oil needing to be realized in the coming years.
US Crude Oil in the Strategic Petroleum Reserve Stocks data by YCharts
Third, whereas OPEC+ used to be characterized by sharp debates around whether cutting production to support prices is a good strategy, the leading players of OPEC+, Russia and Saudi Arabia, appear to be in step to maintain voluntary production cuts to support the price of oil.
Why Devon Energy stands well placed
The company is attractive as all of its assets are in the U.S., with 61% of proven reserves in the Delaware Basin, 13% in the Anadarko Basin, and the rest across the U.S., which gives the company relatively good geopolitical stability. In addition, Devon has multiyear reserves in place to support production growth in the future.
Image source: Getty Images.
For example, Devon produced 223 million barrels of oil equivalent from Delaware and Anadarko in 2022 but ended the year with 1,438 million barrels of oil equivalent in proven reserves. Meanwhile, Devon is on track to grow production per share by 9% in 2023.
For an indication of what kind of dividend Devon could pay based on the price of oil, management's estimates imply that based on the first half of 2023, a price of $40 a barrel would result in a 2.3% yearly yield (based on the current stock price of $43), rising to 10% at $100 a barrel.
That example highlights the upside exposure to a rising price of oil, and means Devon is a useful stock to have in a diversified portfolio. It's an attractive way to get exposure to energy in your portfolio, and it will suit income-seeking investors.
