Better Oil Stock: Chevron vs. Devon Energy

You should always aspire to have a good understanding of the companies you decide to invest in. There will be times when Wall Street throws you a curve ball, 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 industry players Devon Energy (DVN -1.22%) and Chevron (CVX 1.31%). 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 crude 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 global economic activity and geopolitical events. Oil price volatility is the norm, not the exception.

This is likely the single most important fact investors need to know about the oil industry. Once you understand this, you can make a more educated decision about whether or not you want to own oil stocks. 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 subsets. Pure-play oil and natural gas extractors fall into the upstream segment. Pipeline and storage operators, which generally charge fees based on volumes for the use of their infrastructure assets, comprise the midstream segment. And refining and chemical businesses are classified as downstream. Each segment has its own dynamics: In the upstream and downstream arenas, performance tends to be more volatile, based on fluctuating commodity prices, while the toll-takers of the midstream are generally more consistent performers over time.

Devon Energy is an aggressive oil play

Devon Energy’s a pure-play U.S. oil and natural gas producer — squarely in the upstream segment — so 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 low side. And it has ample opportunities for growth with around a decade’s worth of drillable inventory in its portfolio. Add in a dividend that yields nearly 4% at the current share price, and Devon Energy could be attractive to investors who have a positive outlook on the future of 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. As goes oil, so goes Devon Energy.

Chevron is the better choice for most investors

While Devon Energy is totally focused on production, Chevron’s businesses are spread from the upstream through the midstream and all the way into the downstream. This diversification helps soften the impacts of the energy sector’s ups and downs on its results. That’s not to suggest that Chevron’s revenues and earnings won’t fluctuate along with oil prices, but the surges and tumbles 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 it has increased annually for 37 consecutive years. That’s a record that Devon Energy doesn’t even come close to matching. Chevron’s dividend yield at the current share prices is 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 0.17. For reference, Devon’s ratio is a much higher 0.62.

Chevron’s low leverage is important. It gives the oil giant more flexibility to take on more debt as needed 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 its debts, leaving it ready to repeat the process when the next downturn arrives. 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 its stock is only a good choice for investors who have a constructive view of oil and natural gas prices. That’s just how its business works, since its top and bottom lines are so tied to commodity prices.

Chevron’s results will fluctuate, too, but likely not to the same degree, thanks to its 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.