Salzman, Avi.Barron's (Online); New York (Sep 29, 2020).
Devon Energy and WPX Energy, two Oklahoma oil and gas producers, unveiled a merger on Monday that analysts think could affect the competitive balance in oil drilling. The deal is also notable because it could change the way that energy companies return cash to shareholders.
The two companies said they plan to change the way they handle dividends in order to give shareholders more certainty about the payments, while giving the combined business more flexibility when oil prices fall. Under the new policy shareholders would get a fixed quarterly payout plus a variable dividend.
The companies are targeting a fixed payout of about 10% of operating cash flow. Right now, Devon's (ticker: DVN) dividend yield is 4.8%, while WPX (WPX) doesn't pay a dividend.
On top of the fixed payout, the variable dividend would be worth up to 50% of the "excess" free cash in a given quarter "if certain liquidity, leverage and forward-looking price criteria are met," according to WPX CEO Richard Muncrief. He is expected to become CEO of the combined company.
To consider a variable-dividend payout, the company would have to have a cash balance of at least $500 million, among other criteria. On a combined basis, the two companies had over $2 billion in cash and short-term investments at the end of the most recent quarter.
But other financial metrics were bleaker. Both Devon and WPX produced negative free cash flow in the most recent quarter, which was one of the toughest quarters for energy companies in history.
The companies said they' will be well positioned to fund the dividend once they merge, however. They could fund the fixed portion organically, or without borrowing, at $37 oil prices, Muncrief said on a conference call following the merger announcement. West Texas Intermediate crude futures, the U.S. benchmark, were trading at $39.41 on Tuesday, down 2.9% on the day.
It's difficult to determine exactly how high the variable payout could be in the future because of all the factors that go into determining whether the companies will pay it.
Depending on their success, this could change energy dividend policies on a more widespread basis. A fixed-variable payout might relieve pressure on oil companies to continually increase their fixed dividends in good times and bad.
Large fixed dividends have hamstrung some companies, causing liquidity problems when the bottom drops out for commodity prices. That has happened twice in just the past six years.
This year, major energy companies like BP (BP) and Royal Dutch Shell (RDS. A) have slashed their dividends in response to low commodity prices. Analysts have also questioned whether Exxon Mobil (XOM) can keep its dividend intact given the low prices. Without attractive dividends, there is little reason to invest in most oil-and-gas companies right now, given that the industry is expected to shrink in the years ahead.
"This progressive dividend strategy is uniquely designed for inherently volatile business, whereby a sustainable fixed dividend is paid every quarter and a supplemental variable dividend is also calculated and reviewed every quarter," Muncrief said.
Muncrief also said the company would consider "opportunistic" buybacks too, another way of returning cash to shareholders.
While Devon and WPX say this is the first time such a fixed-variable policy would be implemented, Pioneer Natural Resources (PXD) said on its most recent quarterly conference call that it will use variable dividends.
There's some evidence that investors like this sort of policy. Pioneer shares rose in the following weeks, notes KeyBanc Capital Markets analyst Leo Mariani.
"Pioneer got a good reaction, the stock had a nice run for at least a handful of weeks after that" he said in an interview. "People seemed to be saying "This sounds pretty good.' So I think it was embraced."
Write to Avi Salzman at firstname.lastname@example.org
Credit: By Avi Salzman