From Tight To Tighter, Why Devon Energy Stock Could Double (NYSE:DVN) - Seeking Alpha

From Tight To Tighter, Why Devon Energy Stock Could Double (NYSE:DVN) | Seeking Alpha
In this article, I start with a chart-loaded discussion of the tight oil situation, further amplified by the recent OPEC cuts. My thesis is a prolonged uptrend in oil prices, resulting in triple-digit prices once demand expectations bottom. My go-to pick is Devon Energy, which has the potential to generate high long-term capital gains and very juicy dividends, thanks to efficient operations and its focus on shareholder distributions.

William_Potter

Introduction

Devon Energy (NYSE:DVN) has been on my mind since OPEC announced it is cutting its oil production last week. Not only because I doubled my position but also because the implications of these cuts in light of the bigger picture worry me - at least when it comes to inflation.

After writing that Devon Energy was seriously undervalued in February, I sold some of my non-core oil assets and allocated this money to Devon Energy. It's now my single biggest trade that is not part of my long-term dividend growth portfolio.

In this (chart-loaded!) article, I will elaborate on that decision and explain why the bullish title of this article is not clickbait. Needless to say, we'll incorporate OPEC's interest rate decision and the bigger picture that makes me a long-term oil bull.

So, let's get to it!

Why I Believe In Prolonged Elevated Energy Prices

As I wrote in a number of articles, I am not rooting for my oil thesis to unfold. The many articles I wrote on oil and its drillers and my overweight oil investment are for preparation/protection purposes. Given what high inflation has done to the stock market in 2021 and 2022, I am glad that I am overweight oil and gas, as I believe that we're in a prolonged period of high inflation (multiple waves).

Using the United States as an example, most people have no idea how important subdued energy prices were when it comes to providing the economy with growth and low inflation between the Great Financial Crisis and the pandemic.

While inflation had a few ups and downs, the 2010-2021 period had the lowest average inflation rate in modern history. When adding that this came with several QE programs, it is no surprise that technology stocks did so well.

Federal Reserve Bank of St. Louis

Now, this is changing.

Both oil and gas drillers and metal miners have cut capital expenditures in recent years. In 2014, CapEx was above $300 billion. We can assume that the industry ended 2022 with CapEx below $150 billion.

WorldScope, MSCI, GMO

This is what the oil spending of the five supermajors looks like:

The Transcript

Moreover:

Bloomberg

The CapEx-to-assets ratio can be seen below. Note that it completely ignores the most recent spike in prices (after the pandemic).

TopDown Charts

Meanwhile, this is what global demand looks like (boosted by the Chinese reopening last year):

International Energy Agency

Note that global oil production hasn't risen since 2019.

One reason for lower CapEx is that oil companies have taken matters into their own hands. They have figured out that consistently boosting supply makes it more likely that oil prices show steep declines in times of subdued demand. Both 2015 and 2020 saw steep oil price declines that caused mass bankruptcies among smaller, often weaker players.

Given the increasing trend towards net zero and government policies that come with that, oil companies know they cannot risk becoming financially unstable. Hence, they cut supply growth to focus on shareholder returns instead of production growth.

Moreover, one of the reasons why oil production growth was so high prior to the pandemic is the shale revolution in the United States. However, that revolution is ending. While I would not make the case that we're running out of oil (we're absolutely not), oil supply growth is weakening.

This is what I highlighted in my last Devon energy article:

Wall Street Journal

() EOG Resources (EOG) is boosting production spending by $1.4 billion, resulting in a production growth rate of only 3%.

() Pioneer Natural Resources (PXD) is hiking its budget by $1 billion, yet production is set to increase by less than 7%.

() Marathon Oil (MRO) saw 35% higher expenses, yet oil production is expected to remain flat.

Based on this context, OPEC just made a very interesting move.

Why The OPEC Cuts Matter

Last week, OPEC+ announced a production cut of more than one million barrels per day, abandoning previous assurances that it would hold supply steady.

These cuts have a big impact on supply, as OPEC cut 1.1% of global supply in the next few months. These cuts could rise to 1.6% of output.

Saudi Arabia alone pledged to reduce output by 500 thousand barrels per day, followed by Kuwait, the UAE, and Algeria.

Arjun Murti, who has spent more than 30 years covering global energy for major Wal Street firms, shared some thoughts on what these developments mean for producers and investors like you and me.

While the current situation (including OPEC's latest cuts) cannot prevent oil prices from weakening if economic growth drops further, it has significantly decreased the odds of sub-$60 oil prices in the next 12 months (in a soft-landing scenario). OPEC seems to be focused on defending the $70 to $80 price range. So far, it's doing it very successfully.

Despite an almost guaranteed recession within the next 12 months (according to the yield curve and related indicators), Brent trades at $85 per barrel. That's the same level we witnessed during the 2018 oil price peak.

TradingView (ICE Brent)

According to Mr. Murti:
There are likely many reasons for the surprise cut. First, there is likely a desire to get ahead of potential demand weakness in the event a more meaningful economic slowdown materializes later this year. Clearly, there is a growing confidence within OPEC+ that a non-OPEC supply boom isn’t likely anytime soon and that the elasticity of US shale in particular to higher prices is more muted than in past years. Some OPEC members were likely upset that the US is not refilling its SPR. Finally, several OPEC+ members are possibly having their own production issues, meaning not all of this cut may be voluntary.

It also needs to be said that OPEC's spare capacity is much lower than it was in the 1980s. Moreover, a big part of it consists of Iranian supply. Without it, it's essentially only Saudi Arabia and the UAE.

BN Statistical Review of World Energy, IEA, Super-Spiked

To put it differently, OPEC is further tightening an already tight market.

This isn't necessarily bullish on the mid-term.

Wait, what?

By that, I mean that rising prices in a scenario of falling economic growth could hurt demand, temporarily pressuring oil prices - albeit at levels that are far above prior cycle lows.

Once economic demand bottoms, I have little doubt that oil prices will enter triple-digit dollar territory and remain elevated on a long-term basis, causing a second wave of inflation.

So, how to prepare for this?

I have often made the case that investors need to focus on a number of issues.
Companies with high inventories in high-quality basins. This is to prevent forced M&A and problems related to higher drilling costs. Efficient drilling and (related) low breakeven prices. The higher the price of oil, the more money investors should make through dividends. I am not looking for potential turnaround plays anymore. Companies with healthy balance sheets. These companies do not have to prioritize their balance sheets when it comes to the decision of where to spend free cash flow on. Also, a healthy balance sheet allows companies to reduce hedges, which increases upside potential.

According to Mr. Murti:
For companies, a fortress balance sheet protects against downside volatility as well as the risk that banks and insurance companies may increasingly go away as major sources of financing/support for traditional energy. This is clearly on-track in Europe; we can only hope sanity ultimately prevails in the United States. But hope is not a strategy.

Why I Bought More Devon Energy

I cleaned the house in the past few weeks, selling all oil stocks except for Pioneer Natural Resources (PXD) and Devon Energy. Please note that I kept the energy stocks in my dividend growth portfolio. PXD and DVN are not part of my dividend growth portfolio, as I will eventually sell them into strength.

That said, I decided to concentrate on the best. DVN is in that category.

Devon Energy truly has it all. The company is looking to produce at least 643 thousand barrels of oil equivalent per day in 2023. Half of this is expected to be oil. Most of this will be produced in America's fastest-growing basin, the Delaware Basin.

Devon Energy

The company has at least 12 years of low-risk development inventory, which significantly lowered business risks. However, there's more news, after 12 years, the company doesn't simply go out of business.
[...] we have identified roughly 12 years of high-return development inventory evaluated at mid-cycle prices. This inventory positions us to deliver highly competitive results for the foreseeable future. And secondly, I want to highlight that this inventory does not fall off a cliff at the end of year 12. We expect to systematically refresh this inventory over time as we successfully characterize and derisk the many upside opportunities that exist across our diverse set of assets.

Devon Energy

Furthermore, the company has efficient operations. Before inflation became an issue, the company was free cash flow breakeven at $30 WTI, which was a stunning number. Now, the breakeven is at $40 WTI. The company has witnessed between 30% and 50% inflation (not a typo) in key categories.

This means two things.
A breakeven point of $40 WTI in this environment is still extremely efficient. The entire industry is dealing with rapid inflation, causing breakeven prices to rise. This is bearish for supply, as companies need to be more careful when it comes to growing supply. They are now more prone to falling prices.

That said, the company also has a healthy balance sheet.

The company exited 4Q22 with a net leverage ratio of 0.5x EBITDA. Moreover, it has a BBB credit rating, which is just one step below the mighty A-range.

Devon Energy

Thanks to this balance sheet, the focus has shifted from the debtholder to the shareholder.
Our strong investment-grade financial position provides us the opportunity to return more free cash flow to shareholders and be less aggressive on debt reduction.

Unlike giants like Exxon Mobil (XOM) and Chevron (CVX) - to give you two prominent examples - Devon Energy does not hold back when it comes to hiking its dividend. However, it is also quick to cut the dividend when oil prices fall.

Why?

Because the biggest part of its dividend is variable.

The Board of Directors sets a quarterly fixed dividend that targets approximately 10% of operating cash flow. In addition to the fixed dividend, the company may pay a variable dividend of up to 50% of its excess free cash flow.

For example, on February 14, the company announced an 11% hike in its fixed dividend to $0.20 per quarter. Its variable dividend was cut by 34% to $0.89. This was the result of lower oil prices.

The implied annual forward yield is 8.2%.

So, what can we expect in terms of future dividend payments? If oil prices average $90 WTI, the company has an implied free cash flow yield of 11%. That number rises by 200 basis points in the event of $100 WTI.

Devon Energy

However, these numbers are based on a $74 stock price. DVN shares are currently trading at $53.

In other words, the moment WTI gets back to $90, investors are likely to benefit from a stock close to the double-digit range. Prolonged oil prices above $100 WTI result in double-digit dividends.

The remaining free cash flow is spent on buybacks. The company is currently working on a $2 billion buyback program, which was upsized twice in 2022.

Given my long-term oil thesis, I believe that DVN is an exceptional vehicle to get access to potentially very high cash flows.

So, what about the valuation?

Valuation

Devon is having a tough year. The decline in oil prices and related recession fears have caused the stock to fall roughly 13%. DVN shares are 30% below their 52-week high and 20% above their 52-week lows.

FINVIZ

The tough thing about putting a price target on oil stocks is that analyst estimates are almost always based on current oil prices - or at least the trajectory as published by the EIA.

The EIA sees a prolonged sideways trend between $70 and $80 with a 95% confidence range of $30 to $160 per barrel. On a side note, if this scenario were to become reality, DVN investors would enjoy high dividends on a prolonged basis, even if capital gains would be somewhat subdued.

Energy Information Administration

While I am a big fan of the EIA's transparency and data support, I never care much about its outlook, as it's almost always a low-risk scenario.

The same goes for analysts, who often straight-line current oil prices.

Analysts usually don't take risks when it comes to predicting the oil price. The same applies to other commodity stocks.

That said, based on my view, I expect oil prices to remain in a long-term uptrend (although not without temporary corrections).

If oil prices rise towards $100, which is my base case in an economic expansion, the company will likely do more than $6.5 billion in free cash flow.

This would imply a 19% free cash flow yield. The company is trading at 5.3x $100 WTI implied free cash flow.

TIKR.com

These numbers imply a 91% upside. However, the company will also repurchase shares, which makes the bull case juicier.

Based on everything said so far, I believe there is a very reasonable case to assume that DVN could rise to $100 per share in a scenario where oil prices rise to $100.

The tricky part is timing.

The economy isn't doing so well, and further Fed hikes are reasonable.

So, despite my bullish view, I want investors to be careful. Be aware that we could be in for a lot more volatility until the bull case unfolds. Hence, my strategy is to buy on weakness only. I added during the last dip, and I will continue to reinvest dividends.

I expect that we could see the first signs of a sustainable uptrend somewhere in the second half of this year.

Hence, my bullish rating is a long-term rating.

Takeaway

In this article, I updated my view on oil prices. OPEC's decision to cut output further supports my case that oil prices are in for a prolonged uptrend, especially once demand bottoms.

OPEC seems determined to protect the $60 to $70 Brent in a situation of high recession odds. Output cuts and general underinvestment in supply are causing prices to remain elevated, even though economic indicators scream recession.

While oil prices are set to remain elevated, I am further adding to my oil investments. I doubled my position in DVN, and I expect the stock price to double in my bull case. This isn't based on a clickbait fantasy but on the tremendous earning power of Devon at elevated oil prices.

The company has very efficient operations, large-high-quality reserves, a healthy balance sheet, and a plan to distribute most of its free cash flow to shareholders.

In my $100 WTI scenario, I expect DVN shares to work their way up to $100.

While I will eventually sell into strength, my goal is to keep DVN for high dividend income for the next 5-10 years.

Needless to say, I expect the long-term oil bull case to be volatile. Be aware of the risks that come with buying cyclical stocks. Do not buy any oil and gas assets without doing your due diligence.

Welcome to my Seeking Alpha profile!I'm a buy-side financial markets analyst specializing in dividend opportunities, with a keen focus on major economic developments related to supply chains, infrastructure, and commodities. My articles provide insightful analysis and actionable investment ideas, with a particular emphasis on dividend growth opportunities. I aim to keep you informed of the latest macroeconomic trends and significant market developments through engaging content. Feel free to reach out to me via DMs or find me on Twitter (@Growth_Value_) for more insights.Thank you for visiting my profile!

Analyst’s Disclosure:I/we have a beneficial long position in the shares of DVN, PXD, XOM, CVX 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.

Not financial advice.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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