Devon Energy: Risks To The Dividend, But This Is Still Attractive

Investment Thesis

Devon Energy (NYSE:DVN) is an onshore oil and gas company. About 70% of its revenues are tied to oil prices.

Here I put a spotlight on the current oil price and laid out an investment thesis where Devon’s variable dividend gets cut further in 2023.

And how even in that case, Devon is a compelling investment.

What’s Happening With Oil?

As you can see in the graphic below, Devon makes the vast majority of its revenues from oil.

These figures move around quarter to quarter depending on key energy prices, but it provides us a snapshot for us to think about Devon.

This time last year everyone talked about how the oil market was tight. And then, a black swan happened in February that drove the energy markets into a tailspin.

And yet ironically, at the time of writing oil prices are no higher than $74, which is significantly below this time last year. So what happened?

I believe that in the same way as investors overreacted to the Russian invasion and the potential fallout from the unforeseen event, I believe that in 12 months we’ll look back to this period with similar bewilderment. How is it possible that energy prices got so cheap in early 2023?

For my part, I believe that investors are overreacting to the potential global slowdown. I believe that oil is critical to our well-being. To our survival. To our flourishment.

Moreover, I believe that oil consumption will not be curtailed in 2023, irrespective of an economic slowdown. For one, China is now reopening its country. But beyond China, there’s a whole world out there that relies on oil for its cheap, flexible, reliable energy source.

Anecdotally, I find our ability to cut back on oil in 2023 is substantially more muted than in the 2000s. Why? Because I believe that our total energy consumption per unit of GDP is coming down. Put simply, we can cut back on other areas of GDP, but oil consumption is less discretionary than many investors assert.

Accordingly, putting aside the near-term vicissitudes in oil prices, let’s now understand the bull case for Devon further.

2023 Balance Sheet Starts From Strength

The great advantage of investing in highly cyclical oil and gas companies in 2023 is that the past couple of years have been so strong, that Devon has succeeded in getting its balance sheet into shape.

What you see above is that Devon’s net debt position is substantially below its through-the-cycle target.

For investors, this is key. It provides Devon with breathing room. More specifically, Devon’s balance sheet now carries under $5 billion of net debt.

On the other hand, I suspect that even though the graphic above shows Devon’s net debt to EBITDAX at 0.5x, it’s probable that when Devon reports its Q1 2023 results, this figure may be retraced higher, given the current weakness in the energy market.

That being said, I don’t believe that there will be a meaningful retracement to the point that Devon’s balance sheet will be more leveraged than the point it ended at in Q4 2021.

Consequently, this is my contention, even though there are some headwinds and uncertainties in the energy market, the fact that the prior two years have been so strong for Devon, has allowed Devon’s balance sheet to enter this part of the oil cycle with a much stronger balance sheet. Thereby providing investors with a margin of safety.

Could a Further Dividend Cut be on the Cards?

While I don’t believe that Devon will reduce its variable dividend further, we have to leave room for the possibility. This is a prudent working assumption.

Let’s make the case that Devon’s dividend gets reduced by a further 7% sequentially on top of the prior reduction last quarter.

In that case, Devon’s annualized dividend payout in 2023 would be approximately $5 per share. That amounts to an 8.2% total yield. Is that seriously so bad?

I genuinely don’t believe it is. Devon is not a small company where investors might have to be troubled about potential compliance issues or poor fiduciary duties.

There are risks to the investment case. But those risks pertain more to the overall energy sector, than some nefarious idiosyncratic characteristic bubbling within Devon.

The Bottom Line

Some near-term uncertainty weighs down oil prices. But the medium-term bull case remains intact and investors would do well to consider DVN for its clear capital returns policy.

While investors wait for clarity and stability in the oil market, investors can collect a dividend yield of approximately 8%. That’s not a bad place to be in.

Devon Energy will release its Q4 2022 results on Wednesday, 15 February, after hours. Stay tuned for this.