Joe Raedle
With all of the geopolitical and inflationary pressures on the price of oil and gas, Devon Energy (NYSE:DVN) is one of those companies which is benefitting greatly by increased production in the United States.
With a projected surge in oil and gas production in the coming months to offset OPEC’s decision to cut production to aid Russia’s war efforts, Devon Energy is benefitting from the higher sale prices that are offsetting some inflationary pressures.
Furthermore, the demand for barrels of oil will continue even after these issues subside due to the strategic petroleum reserve needing restocking. This should drive demand for the time to come.
But here’s the contrarian view – the United States is heading into a recession at some point over the next few quarters, and as a result we’re likely to see the price of oil dip and hurt the company’s top and bottom lines. Even more so, the company does have a higher amount of debt and with higher interest rates can face some more trouble down the line.
Current Expectations Are Encouraging
Devon Energy, to put it simply, does better sales when demand for oil and gas is high and does better profits when the price of oil is higher, leading to higher margins. Over the past few quarters, the price of oil has skyrocketed on behalf of Russia’s invasion of Ukraine and other pandemic-related pressures.
The war in Russia was a double whammy for the oil markets. On the one hand, the price of oil skyrocketed because of supply issues related to the invasion of Ukraine, which were exacerbated due to the COVID-19 pandemic closures. On the other hand, Russia is one of the major suppliers of oil and gas in the European Union and the United Kingdom, causing surges in global demand.
That’s where US oil companies came in, as they increased supply from the Permian Basin and other shale areas across the country to try and meet global demand. Furthermore, the Biden Administration has been releasing millions of barrels of oil from the strategic petroleum reserve to combat these higher prices, which will eventually need restocking.
So as a result of these factors, the company has enjoyed both ends of a booming oil market – the increased demand for oil and gas due to shortages and supply issues, which drove up their revenues to near record levels, as well as the higher overall price of oil boosting the company’s profit margins.
Even though these factors are set to continue for the next several quarters, I believe, there are also some negatives which need to be taken into account.
The Problems Are A Many
There are several major issues I think the company needs to contend with. And not only are these issues quite worrisome individually but they compound one on another to create a somewhat volatile environment. (More than usual).
First: Recessionary Fears
The recessionary fears are simple. Even with increased demand from global countries which once relied on the oil and gas flowing from Russia, global inflation, including gas prices, has hindered longer term demand as people spend more at the pump and at the grocery store, on rent etc. This means that if people (or consumers) stop spending as much, the economy contracts and goes into a recession.
As we know from previous slowdowns, recessions and near-depressions, once these early indicators flash bright red, consumers stop spending as much, they stop traveling as much, they make less trips, they fly less, they take less cruises, they spend less time on vacation during the winter, and the list goes on. All of these things effect the demand for oi and gas – which is why the price of oil goes down sharply in an event of a recession.
Second: Geopolitical Tensions
I’m no geopolitical expert, but Russia’s invasion of Ukraine won’t last forever. And with the possibility of a global recession hitting Russia further, there is going to potentially be excessive pressure on the President of Russia to declare some form of fake victory and pull troops out in order to save the Russian economy. In that event, there may be a slow trickle of sanction relief, which can bring back their oil and gas production online, which in turn will further put pressure on the price of oil, which affects the company’s profit margins.
With further negotiations between the United States and Iran, to recover from the previous US administration pulling out of the Iran nuclear deal, which led to the nation’s increase in development of nuclear-capable missiles, a deal negotiation will almost certainly curtail market volatility and can further add to the downwards pricing pressure on oil and gas.
Third: Recessions Yield Change
As renewable energies become less and less expensive than traditional oil and gas in order to generate power, heat homes and power our facilities, a recession in which companies must reevaluate their spending priorities, they tend to use those to write off increased spending in efficiency. We’ve seen this in the COVID-19 downturn and before that in the 2008 recession – companies took the time to change out systems to solar panels, large government spending pushes for jobs and economic stimulus generally leads to more renewable energy operations popping up around the country and the world.
For Devon Energy, and the industry as a whole, this means that demand will not fully return to where it was before a possible recession, leading to lower overall production capacity need.
Fourth: Company Not As Attractive
The fourth and final part of this is simple: the company isn’t an attractive investment relative to other players. In the Permian Basin major player lists, the companies average a significantly higher dividend payout for those who want to get paid to wait out a recession or just general uncertainty, as well as the company’s debt and income volatility.
While Devon Energy pays less than a 0.95% annual dividend yield, companies like Chevron (CVX) pay out 3.25% annually, Exxon Mobil (XOM) pays out 3.37% annually and ConocoPhillips (COP) pays out nearly 1.5% annually.
All companies mentioned are expected to more or less report no significant growth to earnings per share over the next few years, with growth declines projected in 2023 and 2024. With these factors in mind, I don’t see much of a fundamental difference between them other than their respective dividend yield.
This means that there are plenty of other companies which should grow at more or less the same rate over the next 3-4 years but almost any other energy company will pay you more to hold and wait for more developments.
Conclusion: Strong Business But Unattractive
The increase in production is not going to stop any time soon and with the price of oil remaining over the $80.00 per barrel, the company will continue to make a lot of cash and hopefully put that towards reducing costs and interest expenses and long-term debt.
But until they do any of that, or increase their dividends, they’re simply not as attractive relative to their peers, even before taking into account that the industry may face some tough long term challenges as we potentially head into a recession in the United States and around the world and companies and industries continue to divest from fossil fuels and into renewable energies.
As a result of these factors, I hold a contrarian view on Devon Energy and believe that they will underperform both the broader market and their respective peers over the next 24 to 36 months.
I am cautiously bearish on Devon Energy’s near to long-term prospects.
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