Oil and gas prices can be volatile. Because of that, energy companies have had a difficult time maintaining their dividend payments over the years. Many have had to cut their payouts during pricing downturns to conserve cash, upsetting investors who relied on those fixed payments.
Devon Energy(NYSE: DVN) has learned to embrace the sector's volatility. That led it to introduce the industry's first fixed-plus-variable dividend framework last year. It's a lesson that Plains All American Pipeline(NASDAQ: PAA) could stand to learn from Devon.
Accepting volatility through variability
Devon has experienced the oil sector's volatility firsthand. The oil company had to slash its dividend by 75% in 2016 to a level it could sustain at lower oil prices. It eventually started increasing its dividend as its oil-fueled cash flow improved.
However, instead of letting its dividend grow to a potentially unsustainable level if oil prices declined again, Devon chose to implement a unique dividend policy after closing its merger with WPX Energy early last year. It would pay a fixed base quarterly dividend that it could sustain at lower oil prices.
In addition, it would make variable dividend payments each quarter, capped at up to 50% of its post-base-dividend free cash flow. The company would use the rest of its excess cash to repurchase shares, repay debt, or make opportunistic acquisitions.
The new policy has been a smashing success. Devon has paid a base dividend each quarter. It has already increased that rate a couple of times, due to its increased confidence that it can sustain a higher rate at lower oil prices.
Meanwhile, the company has paid significant variable dividends. While its most recent one was down nearly 13% from the prior payment due to lower oil prices, that comes with the territory of a variable-dividend framework. Devon is on track to pay over $5 per share in dividends this year, giving it a more than 8% dividend yield at the current share price.
Devon's dividend framework has attracted investors who desire steady income plus upside potential. They understand that, at a minimum, they'll collect the base payment, with the potential for a lot more during periods of higher pricing.
Maybe it's time to learn from Devon
Plains All American Pipeline isn't like other pipeline companies. While its crude oil segment produces relatively steady earnings as volumes flow through its pipelines and storage terminals, there's a lot more variability in its natural gas liquids (NGL) segment. That's because only about 35% of those earnings come from stable fee-for-service agreements. The rest of its NGL-related earnings are either from hedging contracts or aren't hedged.
This variability has hurt the company in the recent past, forcing it to slash its distribution several times:
PAA Dividend data by YCharts.
However, instead of embracing the inherent volatility of its NGL-related earnings, Plains All American has chosen to press on with paying fixed dividends. The company recently unveiled a multiyear capital-allocation framework.
It intends to increase its dividend payment by $0.20 per share, starting next year, or by 23%. That would push its dividend yield from 7.6% to 9.3%. Meanwhile, Plains All American plans to target growing its distribution by $0.15 per share each year until it reaches a coverage ratio of 160%.
The concern with this policy is that, given the variability of its cash flow, Plains All American could eclipse its payout cap in a period of low commodity prices. That might force it to reduce its distribution again.
Instead of paying a high fixed dividend that it might not be able to sustain, Plains All American should learn from Devon and adopt a fixed-plus-variable dividend framework. It could set the base at a level it could support from the stable cash flows of its oil segment while providing investors with some upside potential from a variable payment based on its NGL-related earnings.
That would attract investors seeking a firm base payout with upside potential instead of repelling those who expected a high fixed payout, only to see it cut the next time commodity prices decline.
Match the framework to the cash flows
Devon Energy is embracing the energy sector's volatility by implementing a dividend policy that accounts for the variability of its cash flows. Plains All American might do well to learn that lesson.
It has already cut its payout several times, due to the volatility of its NGL-related earnings. Because of that, investors don't have a lot of confidence it can deliver on its dividend growth targets. Instead of making a promise, it might not be able to keep, the company should consider realigning its dividend framework to the variability of its cash flow.
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Matthew DiLallo has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
