Oil prices have been incredibly volatile this year. West Texas Intermediate (WTI), the main benchmark price for U.S. oil, started 2022 at around $75 a barrel before climbing to over $120 a barrel after Russia invaded Ukraine. While crude prices have since calmed down on fears that a recession could reduce oil demand, WTI is currently hovering around $90 a barrel, pushing it up more than 15% on the year.
While all eyes are on a possible recession, the market is missing the fact that oil supplies remain tight. Oilfield service companies face persistent equipment shortages, which are hampering the industry’s ability to drill more wells. This shortage could further limit supplies. For this reason, some analysts predict that crude prices will rebound to $120 a barrel. This would send oil stocks soar while giving companies more cash to pay dividends.
Investigate the problem
It takes a lot of equipment, personnel and supplies to drill and complete an oil well. Oil service companies like Halliburton (HAL 3.70%) and hugue baker (BKR 2.76%) use powerful truck-mounted engines known as fracturing pumps to fracture underground rock formations, allowing oil and gas to flow through the well. This equipment takes a lot of wear and tear. For this reason, companies must regularly replenish their fleet by investing in new equipment.
However, with the oil price declines of 2020 and 2014 etched in their memories, oil service companies are hesitant to spend the money needed to refresh their fleets. Instead, they choose to refurbish existing equipment while trying to maintain capacity. Unfortunately, there is not enough equipment to meet the demand these days. Add to that steel pipe shortages and the crews needed to operate that equipment, and there are serious questions about whether the U.S. oil industry can meet its production forecast.
This would put even more pressure on supplies. Because of this, oil prices could skyrocket even if demand begins to decline as consumers pull back during a recession.
Take advantage of equipment demand
Halliburton is a big beneficiary of the strength in the oil services market. CEO Jeff Miller said in the company’s second-quarter earnings report that the North American hydraulic fracturing market is “nearly exhausted.” For this reason, Miller expects Halliburton to “deliver profitable growth, margin expansion, strong free cash flow and industry-leading returns in this up cycle.”
The company is using its free cash flow to pay down debt, drawing down about $600 million this year. It also nearly tripled its dividend. Halliburton plans to continue to increase distributions to shareholders as it generates more cash through a higher dividend and likely a share buyback program.
Baker Hughes also expects to capitalize on the strong oil services environment. It sees its cash flow increase, giving it the means to invest in new equipment and its energy transition initiatives. Even with these investments, it expects to return 60% to 80% of its free cash flow to shareholders. This likely means that the company will eventually increase its dividend to complement its ongoing share buyback program.
Enjoy the raw
Another impact of the sold-out North American fracking equipment market is that it limits the ability of US producers to increase production. Since they can’t spend their oil windfalls to drill more wells, many are using that money to pay dividends and buy back stocks. Those payments have jumped this year and could continue to rise if crude prices pick up again.
oil driller Diamondback Energy (CROC 2.74%) recently increased its return on capital program from 50% of its free cash flow to 75%. Diamondback increased its base dividend by an additional 7.1%, declared its second variable dividend payment and doubled its share buyback authorization. The dividend payment combined with its recent price implied annualized growth dividend yield by about 10%. In the meantime, the buybacks should give further impetus to the stock, which is already up more than 20% this year.
Fellow oil producer Pioneer of natural resources (PXD 1.06%) increased its base dividend payout by 40% this year. It also paid large variable dividends, aiming to pay out 75% of its free cash flow each quarter. Its most recent combined dividend payout had an implied annualized dividend yield of around 15%, the highest in the oil sector. He uses most of the remaining balance to buy back shares, helping to fuel his stock price, which has already risen more than 30% this year.
More and more oil companies are opting for variable dividend structures to return part of their oil windfall to shareholders. Because of this, investors can immediately cash in as oil prices rise.
No shortage of cash
The oil industry does not have enough equipment to meet demand. For this reason, service companies benefit from higher prices, which allows them to generate more cash to return to their shareholders. Meanwhile, since oil producers can’t increase their capital spending, they’re flipping their windfall back to investors. With market conditions unlikely to improve any time soon, oil stock prices and dividend payouts look set to continue rising.
