Why the variable dividend trend is growing, and how investors should play it

Published Fri, Feb 18 20222:20 PM ESTUpdated Fri, Feb 18 20222:50 PM EST

Variable dividends are becoming increasingly popular for oil and gas companies, as the sector's mentality shifts from one of growth at all costs to prioritizing shareholder returns. The practice of variable dividends hasn't always been the most popular strategy with investors — especially those seeking income — since it can mean unpredictable and variable cashflows. But this time around, it speaks to a fundamental mindset change in the energy patch, according to Ninepoint Partners senior portfolio manager Eric Nuttall. "The codification of variable quarterly dividends is a massive game changer, and it represents how the very ethos of these companies has changed," he said. Goldman Sachs looked at oil and gas companies' payout policies in a note to clients Friday, saying that variable dividends have been implemented from a place of strength. Energy is the top-performing S & P 500 group this year and over the last year, as demand for petroleum products has rebounded, driving oil prices above $90 per barrel and to their highest level in more than seven years. But this strength follows a dismal 2020, which saw the sector drop 37% for its worst year going back to inception in 1989. West Texas Intermediate crude futures , the U.S. oil benchmark, briefly plunged into negative territory in April 2020, as the pandemic sapped demand for petroleum products. Energy companies have emerged from the downturn with a wholly new business proposition: where once it was growth at all costs, companies are now focused on free cash flow and shareholder returns in the form of dividends and buybacks. But the scars from the plunge in oil prices linger. Crude prices are forecast to remain volatile, and since companies want to be able to pay their dividend no matter where oil is trading, they can set the fixed dividend on the low side and use variable dividends as a way to pay out excess free cash flow. "We see potential for variable dividends to be an attractive strategy for income-oriented investors, especially for companies which have a durable FCF profile ... and strong balance sheet," Goldman said. Buybacks are another way for companies to make up the difference between the fixed dividend and cash on hand. Pioneer Natural Resources is one energy company that offers a fixed and variable dividend, and Goldman's had the stock on its conviction list since Sept. 2021. "We believe PXD shares do not completely reflect the value of its deep inventory and low cost position in the Permian, and see the potential for shares to re-rate higher with confidence in current upcycle and PXD's attractive/durable FCF outlook," the firm said. Ninepoint's Nuttall broke down Pioneer's variable dividend as follows: the base dividend this year is at 1.1%, and at $80 oil he expects them to pay a variable dividend of 8% — bringing this year's total to 9.1%. With $100 oil, the total dividend jumps to 12.8%. In November, the company pledged to return 75% of the prior quarter's free cash flow to investors in the form of variable dividends, once capital expenditures and base dividends have been paid. Nuttall described the practice as a "cash sweep," adding that once these policies have been implemented there's no going back. "These companies have pledged this to shareholders and people forget: shareholders are the owners. ... How can a shale company possibly now go back to their owners and say 'we're now going to remove that income stream away from you?'" In other words, this supports his thesis that we're in a multiyear bull market for oil, with prices headed to record highs. Devon Energy is another upstream player with a variable dividend, and Goldman noted that the company was among the first in the firm's coverage universe to implement one. The company was the top-performing S & P component in 2021, surging 178%. Shares have gained another 24% so far in 2022. Based on Goldman's 2022 oil price outlook, the firm expects Devon to post an 8% dividend yield this year between its fixed and variable payout. However, the firm recently downgraded shares of Devon to neutral following the stock's outperformance. ConocoPhillips and Coterra Energy are two other names in the space that offer investors attractive payouts. The former has a three-tier capital return program, which includes a variable return of cash (VROC) in addition to a fixed dividend and buyback program. Goldman said the VROC is a positive move since it allows for a "more balanced overall approach for shareholder returns." "We view the VROC as [a] way to amplify returns while maintaining the company's ordinary dividend, which should remain sustainable, competitive, and growing through-the-cycle, and ultimately will not threaten the balance sheet when the cycle turns," the firm said. Companies in the oil patch aren't the only ones focused on amplifying shareholder returns. Miner FreeportMcMoRan has also instituted a new payout policy, with the company pledging to return up to 50% of its available cash flows to investors outside of planned capital spending and distributions to non-controlling interests. Goldman said the policy makes sense since it allows Freeport to respond nimbly to the copper pricing environment, while limiting balance sheet stress should prices turn lower. —CNBC's Michael Bloom contributed reporting.

Pipes carry water, steam and oil at Devon Energy Corp.'s 35,000 barrel per day Jackfish Projects plant, where Steam Assisted Gravity Drainage (SAGD) is used to extract bitumen from oil sands, near Conklin, Alberta, Canada.

Jimmy Jeong | Bloomberg | Getty Images

Variable dividends are becoming increasingly popular for oil and gas companies, as the sector's mentality shifts from one of growth at all costs to prioritizing shareholder returns.

The practice of variable dividends hasn't always been the most popular strategy with investors — especially those seeking income — since it can mean unpredictable and variable cashflows.

But this time around, it speaks to a fundamental mindset change in the energy patch, according to Ninepoint Partners senior portfolio manager Eric Nuttall.

"The codification of variable quarterly dividends is a massive game changer, and it represents how the very ethos of these companies has changed," he said.