Devon Energy: Returning Capital Through A Unique Dividend Program Yielding Over 8.5%

Jul. 01, 2022 9:30 AM ETDevon Energy Corporation (DVN)46 Comments35 Likes

Summary

  • Devon Energy has increased its dividend significantly and is now producing one of the largest dividends from oil & gas exploration and production companies.
  • Devon Energy is rewarding shareholders by paying a dividend that consists of a fixed and variable amount, and as more FCF is generated, more is returned through the variable amount.
  • Based on Devon Energy's proven reserves, asset locations, and my interpretation of drilling data on a global scale, I believe Devon is a buy.
  • I do much more than just articles at Barbell Capital: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

Rise in gasoline prices concept with double exposure of digital screen with financial chart graphs and oil pumps on a field.

peshkov/iStock via Getty Images

As crude soared to over $100 per barrel and natural gas cruised past $5 per MMBtu, exploration and production (E&P) companies within the oil patch became gold mines. Investors flocked toward traditional energy plays such as Exxon Mobil (XOM), and Chevron (CVX) to capitalize on the uptrend as technology and other sectors crumbled. Berkshire Hathaway (BRK.A) continued to validate the energy trade, adding to its position in Occidental Petroleum (OXY). A sector that was left for dead in 2020 came roaring back with overwhelming free cash flows (FCF) generated and large dividends paid to shareholders. In a period where investors couldn't mitigate downside risk in names such as Apple (AAPL), energy companies became a shining spot in the market as many companies appreciated in value while producing larger dividends than many companies throughout the S&P 500.

Devon Energy (NYSE:DVN) isn't the most well-known energy company, and unless you follow the sector, you may have never heard of DVN. DVN is a leading independent energy company that engages in producing oil and natural gas. DVN operates in some of the best oil & gas basins with assets in the Williston, Powder River, Anadarko, Delaware, and Eagle Ford basins. Just like many E&P companies in the oil patch, DVN had an outstanding 2021 as shares rose from roughly $16.59 on 1/4/21 to $44.05 on 12/30/21. Upside appreciation continued into 2022 as shares topped out around $78 on 6/6/22. Over the previous 2 weeks, shares have declined roughly -29% as they are now trading around $55.11. The pullback has made DVN's share price attractive, but their dividend policy is the icing on the cake. DVN has implemented a unique dividend program that is comprised of a fixed dividend and a variable dividend based on the level of FCF produced. DVN's dividend program is unorthodox, but after learning about what DVN is doing, this dividend-producing machine may earn a spot in your portfolio.

Crude chart

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There is the traditional way to allocate capital toward a dividend policy then there is the Devon Energy way

FCF is often looked at as one of the best measures of profitability as FCF excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet. To some investors, FCF is more important to analyze than net income because it's harder to be manipulated as it is a true indication of the cash a company generates. FCF is also the pool of capital that companies can utilize to repay debt, pay dividends, buy back shares, make acquisitions, or reinvest in the business.

Companies that pay dividends to shareholders are often regarded as well-established organizations and have created a track record of distributing earnings to their shareholders. Dividends are a part of an organization's profit that it provides to its shareholders for a specific financial period. Traditional dividend-paying companies such as Johnson & Johnson (JNJ) or The Coca-Cola Company (KO) take a simplistic approach toward their dividend policies. Their future earnings are predictable to a degree, allowing them to develop financial forecasts several years into the future. Management typically decides a payout range they would like to stay within to reward shareholders with a portion of their profits for taking an ownership stake in the company. Using KO as an example, KO has grown its dividend annually for the previous 59 years and currently pays $1.76 per share of its earnings in the form of a dividend to its shareholders. KO has a current payout ratio based on their EPS over the TTM of 73.64% as their paying $1.76 of their $2.39 in earnings in the form of a dividend. This allows flexibility and room for future dividend increases in the future. Companies such as KO have established a fixed dividend that is predictable and dependable.

KO consistency grade

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DVN, on the other hand, has taken a different approach toward its dividend policy in recent years. Due to the windfall of FCF generated, DVN has taken a 2-part approach toward its dividend policy. In 2020 DVN shifted from an entirely fixed dividend where it paid out a fixed percentage of its profits to a combination of paying a fixed and variable rate.

Dividend growth

Devon Energy

DVN has implemented a fixed plus variable dividend payment methodology. This return-driven approach prioritizes FCF generation and allocates a larger portion of its FCF to DVN's dividend, share buybacks, and debt reduction. When DVN has a strong quarter, so do the shareholders, as a larger amount of FCF is returned on the variable side of the dividend.

The first part of DVN's dividend is fixed at $0.64 per share on an annual basis. This is an annual increase of 45.45% YoY from the $0.44 fixed portion of 2021's dividend.

In 2020, DVN started paying out additional FCF as a variable portion of its overall dividend. With commodity prices at elevated levels, E&P companies such as DVN are generating more FCF than in previous years. DVN has rewarded shareholders by distributing additional FCF through the variable portion of its dividend. In 2021 DVN's annual dividend amounted to $1.97, of which 77.67% ($1.53) came from excess FCF distributed through its variable dividend.

Cash Flow

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The picture above indicates the amount of cash from operations generated and CapEx spent on a quarterly basis since Q3 2019. FCF is calculated by deducting CapEx from the company's operations generated cash. Over the previous 4 quarters, DVN has been generating considerably larger amounts of FCF, which is represented by the grey line in the chart below.

Devon Energy

Steven Fiorillo, Seeking Alpha

The fixed plus variable dividend payout methodology has been a massive success for DVN's shareholders. DVN's quarterly dividend has grown by 270% YoY from Q1 2021 to Q1 2022. Assuming $100 WTI for the remainder of 2022, DVN is projecting that its 2022 full dividend will exceed $4.75 per share. This is the ultimate profit-sharing program for shareholders as DVN is projecting to pay an additional $4.11 per share on the variable side of its dividend in addition to $0.64 from its fixed dividend.

Metrics

Devon Energy

Investors who didn't invest in DVN back in 2021 didn't miss all the rewards. DVN's 2022 fiscal year has just begun as DVN went ex-dividend on 6/10/22, and its Q1 2022 dividend will be paid on 6/30/22. When you deduct the Q1 $1.27 dividend per share from DVN's projected $4.75 dividend (fixed + variable), shareholders can still look forward to $3.48 (73.26%) of DVN's projected 2022 capital allocation back to shareholders from its dividend. The remaining $3.48 of DVN's projected dividend in the fiscal year 2022 is still an effective yield of 6.32% on its $55.11 share price. The real question is can DVN remain a free cash flow generating machine well into the future?

DVN and the energy landscapes future

Nobody can accurately predict what will occur tomorrow, let alone forecast what will happen in 5 years from now. All we can do is look at the data and make the best decision based on the information provided to us today. When I look at DVN, I see a company that has an amazing dividend program that's aligned with shareholders. I wish more companies took DVN's approach to return capital to their investors. DVN looks like a great investment right now but will it be able to sustain the current dividend level or grow the dividend in the future? This is the million-dollar question I want to wrap my head around because I am a long-term investor and like to have at least a 5-10 year investment horizon on equities.

I love DVN's assets as they are in some of the most sought-after basins in addition to having extensive takeaway capacity when looking at maps of pipeline assets from companies such as Energy Transfer (ET), Kinder Morgan (KMI), and Enterprise Products Partners (EPD). After looking at where a company's assets are placed, I always look at the proven reserves. Proved oil and gas reserves oil, gas, and NGLs, which can be estimated with reasonable certainty to be economically producible from known reservoirs under existing economic conditions, operating methods, and government regulations. To be considered proved, oil and gas reserves must be economically producible before contracts providing the right to operate expire, unless evidence indicates that renewal is reasonably certain.

Reserves

Devon Energy

Above are DVN's assets and statistics as of 12/31/21. There are 2 key terminologies to understand, MBoe/d and MMBoe.

  • MBoe/d means thousand barrels of oil equivalent per day
  • MMBoe means million barrels of oil equivalent

As a reference, DVN generated $13.12 billion of revenue in 2021 and $14.94 billion in the TTM.

Each day, DVN produces 567 MBoe/d which is equivalent to 567,000 barrels of oil. Over the course of a year, DVN will produce 206.95 million barrels of oil based on its current production. In 2021 the average price of Brent Crude was $71 per barrel. At $71 per barrel DVN's 206.95 million barrels produced would generate $14.69 billion in revenue, which is well within their revenue generated in 2021 and the TTM. Based on not knowing how much oil was hedged at specific prices, I am confident in the math.

DVN has 1,598 MMBoe in proved reserves, equivalent to 1.6 billion barrels of oil. At $60 per barrel, DVN is sitting on $95.88 billion in proved reserves, at $70 per barrel, their reserves are worth $111.86 billion; at $80, they are worth $127.84 billion.

In the TTM, DVN has produced $4.1 billion in FCF from $14.94 billion in revenue which is a 27.43% FCF margin. At a 25% FCF margin and $60 per barrel price, DVN's $95.88 billion in proved reserves would generate $23.97 billion in FCF. At an average price of $80 per barrel, a 25% FCF margin would generate $31.96 billion in FCF. With a current market cap of $38.17 billion, DVN looks mighty attractive to me at these prices based on their proven reserves and current production levels.

The next question is will oil & gas prices stay elevated or will they subside? These are questions that the answers are based on variables that are impossible to predict. There is a very real possibility we could see oil over $150 a barrel this winter based on the energy crisis in Europe. There is also a scenario that I believe is unlikely, but there is still a possibility that oil recedes to under $80 a barrel. We won't know what will occur until the winter. What I can do is interpret the drilling data, and government energy estimates and try to come up with a prediction.

BP plc (BP) just released its 2022 Statistical Review of World Energy 71st edition and should serve as a complete eye-opener for anyone who believes an energy transition to renewables is occurring. In 2021, renewables made up roughly 20 exajoules of the world's energy consumption from roughly 590 exajoules which is 3.39%. With all of the hype around renewables, they are barely making a dent in the global energy mix.

Energy Consumption

BP

Something I want to highlight is the actual drilling data for 2021. The United States was once again the largest oil-producing nation in the world. The United States produced 16,585 MBoe/d (16,585,000 barrels per day) while Russia produced 10,944 MBoe/d and Saudi Arabia produced 10,954 MBoe/d per day. The entire world produced 89,877 MBoe/d of oil. The United States made up 18.45% of the world's oil production in 2021. The laws of economics haven't changed, and supply-side economics are real. When demand outpaces supply, prices rise. In 2021 the entire world consumed 94,088 MBoe/d of oil. Demand outpaced supply by 4.21 MBoe/d or 4.69%. The spread in 2021 was the largest it has been over the past decade on an annual basis between how much oil is produced and consumed.

Spread between production and consumption

Steven Fiorillo, BP

The spread between consumption and production is a good indicator of oil prices. If you look at the grey line above or the raw data, then look at a 10-year chart of oil below, it's an interesting correlation. In 2011-2013 we saw prices between $80 - $110 per barrel while the spread was significantly large. In 2014 then 2015, the spread declined, and so did oil prices, as oil dropped to roughly $29.44 on 2/7/16 before getting back to the high $40 range, which correlates to the spread going from -727 to -2,116 MBoe/d. Oil prices rebounded through 2017 as the spread increased then in 2018, prices dipped a bit as the spread tightened. We saw a slight recovery in oil prices as the spread increased into 2019, and in 2020 prices dropped off a cliff as the spread was the lowest it's been in a decade between production and consumption. The spread between consumption and production reached its widest point in 2021, and oil prices skyrocketed. Based on looking at how the spread has correlated to oil prices, it seems as if under 3,000 MBoe/d is where we need the spread to be to have oil between $50-$70 per barrel.

Oil

BP

Oil

BP

In the 3/3/22 Annual Energy Outlook 2022 report, the EIA projected that oil and gas would see their consumption levels slightly increase over the next 3 decades in the United States. The EIA released its international energy outlook on 10/6/21. In their baseline case, the global energy demand would increase by 50%, growing from 600 quadrillion BTUs in 2020 to 900 quadrillion BTUs in 2050. In a low economic growth environment, there would be a 25% increase to 750 quadrillion BTUs, and in a high economic growth rate scenario, the global energy demand would increase to 1,100 quadrillion BTUs (83.33%). The EIA is also projecting that liquid fuels will remain the largest source of primary energy by 2050.

Energy

EIA

Energy

EIA

Based on the drilling data and the EIA projections, I think oil and gas companies like DVN will do considerably well. With the global energy demand increasing, there is certainly a possibility of the spread maintaining a level above 3,000 MBoe/d between consumption and production for many periods over the next 3 decades, driving energy prices higher. If I had to make a bet, I would say that I would lean more toward oil having an average price of $80 per barrel over the next decade than $60 per barrel.

Conclusion

I think the -29% reduction in DVN's share price is an opportunity to start a position. It may decline further, but I like the recent sharp decline as an entry point. Investing in DVN is a gamble on energy prices as DVN's large dividend is based on excess FCF as most of it comes from the variable component. If you believe energy prices will stay elevated, then DVN should continue to be a cash cow, returning enormous amounts of its earnings back to shareholders. I love the variable dividend, and while there is a risk of lower amounts in the future, I like the methodology of when a company succeeds, the shareholders are rewarded with additional capital in the form of larger dividends. The oil patch isn't for everyone, but I believe oil is likely to stay above $60 per barrel for a long time, and even at $60 per barrel, DVN will generate more than enough in future FCF to make this a good investment. There are many moving pieces to DVN, but when you look at Wall Street's ratings, it has 13 strong buys, 7 buys 9 holds, and 1 strong sell. I don't own DVN yet, but I am planning on starting a position as I believe high oil prices will be with us for quite some time.

Buy ratings

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This article was written by

Steven Fiorillo profile picture
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Author of Barbell Capital
Build your portfolio utilizing growth, value, dividends and options

I am focused on growth and dividend income. My personal strategy revolves around setting myself up for an easy retirement by creating a portfolio which focuses on compounding dividend income and growth. Dividends are an intricate part of my strategy as I have structured my portfolio to have monthly dividend income which grows through dividend reinvestment and yearly increases. Feel free to reach out to me on Seeking Alpha or https://dividendincomestreams.substack.com/

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Disclosure: I/we have a beneficial long position in the shares of XOM, KO, ET, KMI, EPD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Disclaimer: I am not an investment advisor or professional. This article is my own personal opinion and is not meant to be a recommendation of the purchase or sale of stock. Investors should conduct their own research before investing to see if the companies discussed in this article fit into their portfolio parameters.

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