You should always aspire to having a good understanding of the companies you decide to invest in. There are times when Wall Street throws a curveball, of course, but most of the time businesses are fairly easy to understand. The core business model is what you need to think about if you are comparing oil investments Devon Energy (DVN 4.06%) and Chevron (CVX 0.80%). Here's why most investors will probably want to err on the side of caution.
Oil is a volatile commodity
There are subtle differences in the quality of oil depending on where it is drilled, but, for the most part, it is just a commodity product. When supply and demand are out of alignment the price of oil can rise or fall in dramatic, and sometimes swift, fashion. There are other factors that impact oil prices, too, including economic activity and geopolitical events. Oil price volatility is the norm, not the exception.
Image source: Getty Images.
This is likely the single most important fact investors need to know about the oil industry. Once you understand this you can make an educated decision about whether or not you want to own an oil stock. And if you decide you do want oil exposure in your portfolio, you can use this understanding to decide which kind of oil company you want to own.
The broader energy sector is usually broken down into three groupings. Pure play oil and natural gas producers fall in the upstream segment. Pipeline operators, which generally charge fees for the use of their infrastructure assets, are in the midstream. And refining and chemical businesses fall into the downstream. Each segment has its own dynamics, with the upstream and downstream both commodity driven and volatile while the toll-taker midstream is generally a more consistent performer over time.
Devon Energy is an aggressive oil play
With that backdrop, investors can start to consider what it would mean to own Devon Energy, a pure play U.S. oil and natural gas producer. That places the company squarely in the upstream segment of the energy industry, which means that the its top and bottom lines will fluctuate along with oil prices.
To be fair, there are things to like about Devon Energy. For example, it has an investment grade rated balance sheet so it is financially strong. It has generally attractive production costs, which means it can turn a profit even when oil prices are on the weak side. And it has ample opportunities for growth with around a decade of drilling inventory in its portfolio. Add in a nearly 4% dividend yield and Devon Energy could be attractive to investors that have a positive outlook for energy prices.
That said, if you think energy prices are likely to fall or remain moribund, Devon Energy probably won't be a great choice. Those outcomes are highly likely to mean that Devon Energy's financial results will be weak and, thus, its stock price performance will be less than desirable. So goes oil, so goes Devon Energy.
Chevron is the better choice for most investors
While Devon Energy is totally focused on production, Chevron's business is spread from the upstream through the midstream and all the way into the downstream. This diversification helps to soften the ups and downs of the energy sector. That's not to suggest that Chevron's revenues and earnings won't fluctuate along with oil price, just that the highs and lows on the top- and bottom-lines won't be quite as severe as they would be for a pure-play producer like Devon Energy.
That shows up most notably with regard to Chevron's dividend, which has been increased annually for 37 consecutive years. That's a record that Devon Energy doesn't even come close to matching. Chevron's dividend yield is currently around 4.2%, a little bit more than Devon is offering. And Chevron has among the lowest levels of leverage in its peer group, with a debt-to-equity ratio of roughly 0.17x (for reference, Devon's number on this metric is a much higher 0.62x).
Chevron's low leverage is important. It allows the oil giant to take on debt during the inevitable industry downturns so that it can continue to invest in its business and pay dividends. When oil prices recover, as they always have historically, it pays down debt to prepare for the next downturn. Investors benefit from owning a reliable dividend stock that has proven it can perform well through the entire cycle. If you are simply looking to add some oil exposure to your portfolio for diversification purposes, Chevron will be a much better choice than Devon Energy.
If you understand these investments you'll know what stock to pick
There's nothing wrong with Devon Energy and it is, in fact, a well-respected energy producer. But it is only a good choice for investors that have a constructive view of oil and natural gas prices. That's just how its business works, since the top- and bottom-lines are so tied to commodity prices.
Chevron's results will fluctuate, too, but likely not to the same degree. That's because its business is built to handle the ups and downs thanks to its more diversified exposure to the broader energy sector. That will make it a better choice for most investors and particularly for investors looking to live off of the dividends their portfolios generate.
