Investing in energy & production companies has historically been extremely difficult because it generally involves making tough macro-calls on energy prices. The last decade of mostly rising prices has created an unprecedented spending spree for new technologies and increased CAPEX, which brings to mind the mentality that created oversupplies in silicon valley during the late 1990's. These investments have bared fruit in many cases, dramatically changing the energy landscape of North America, leading towards a likely energy independence from needing foreign oil or gas. Of course, as supply has increased, prices for natural gas have plummeted making once profitable assets uneconomical in their present state. For companies like Exxon (XOM), after its XTO acquisition at the top of the cycle, this has been extremely value destructive. I don't blame or credit management for high or low energy prices, but instead it is important to evaluate a management team for how they allocate capital throughout an economic cycle. Management that consistently buys high and sells low (unlike-XOM) should generally be avoided, while stewards of capital that keep the company protected even in prolonged periods of lower prices, and that are willing to invest when others are selling to preserve liquidity, should be valued at a premium.
Devon Energy (DVN) falls into the latter category due to its conservative financial structure, and its history of mostly divesting assets during buoyant times while maintaining cash reserves to acquire assets at the bottom of the cycle. While Devon Energy has a very large North American natural gas asset portfolio, which has been crimped significantly by lower natural gas prices, the company has been able to divert production to oil-rich plays that utilize the advanced production technologies cultivated over the last 13 years. This production, which takes advantage of historically wide spreads between oil and dry natural gas, has enabled the company to maintain strong cash flows while being able to retain its asset-base for brighter days. This is in stark contrast to companies such as Chesapeake Energy (CHK) or SandRidge Energy (SD), which made prudent early-stage investments, only to have to sell many of them at unattractive times to preserve liquidity that had been reduced by excessive leverage. Most E&P management teams love to buy assets and are "wildcatters" by nature, willing to mostly bet on rising prices. The problem is that for investors with an interest in protecting and growing capital, the risks of trusting an Aubrey McClendon or Tom Ward with the stewardship of your money offsets the brilliance of their ability to uncover attractive drilling sites.
Despite the improvements in drilling technologies, I believe that energy prices should mostly trend higher over the next decade. A lot of my belief is based on the excessive money printing of most developed market economies, and I like the fact that energy resources are used, as opposed to gold which will sit and stare at you. In times of higher global growth consistent with higher interest rates, gold sitting in a bank vault in Switzerland might not seem quite as smart as high yielding real estate assets, or oil and gas being used to power developing markets. Devon Energy combines an asset portfolio that is primed for above-average production growth, with a prudent balance sheet and management team who I trust to protect the money entrusted to them. If my admittedly questionable macro-call is accurate, then I would suspect that an investment in Devon at or near current prices should be quite successful over time. If prices hold steady I wouldn't expect to lose too much, particularly by employing our regular strategy of selling put options to manufacture cheaper entry prices into the stock.
Like many of its peers, Devon Energy's 4th quarter and full year financial results were negatively impacted by 'ceiling' tests on natural gas assets, which were forced to be written down due to low natural gas prices. These charges are non-cash in nature, and won't be reversed if prices rise and importantly, don't necessarily represent the current net asset value of the assets. On February 20th, Devon reported a net loss of $357MM for the 4th quarter, which equates to $.89 per common share. The results were impacted by an $896MM impairment charge, but excluding that charge, Devon earned $316MM or $.78 per diluted share in the quarter. For the full year 2012, Devon lost $206MM or $.52 per share after impairments, and excluding impairments, the company earned $1.3 billion or $3.26 per diluted share in 2012.
Devon continues to concentrate its drilling efforts on oil while maintaining flexibility to ramp up natural gas production when prices rise higher. The company increased production of oil, natural gas, and natural gas liquids to 250MM boe in 2012. Oil production increased a whopping 20% YoY, which more than offset natural gas declines, creating net growth in boe production from the North American property base of 10 million. In the 4th quarter, Devon's oil production averaged 151,000 barrels per day, which was up 13% from the 4th quarter of 2011. In the United States, 4th quarter oil production was up by 30% YoY.
The Permian Basin continues to be a hot bed for oil-rich production, and in the 4th quarter production increased by 31% YoY, with oil accounting for 60% of Devon's 66,000 boe per day produced in the region. The company brought 10 new wells on production in the 4th quarter in its Bone Spring play in the Permian Basin, which averaged 790 boe per day in their initial 30 days of production. Devon also completed 6 wells in the Midland-Wolfcamp Shale in the Permian during the quarter. This region is seeing some of the best returns in the United States due to the oil-rich resources present, because of the disparity in pricing between oil and natural gas in North America. In the Mississippian Lime play in Oklahoma, Devon utilized its Sinopec joint venture where it retains 57% ownership, to bring 7 wells online in the quarter. Initial 30-day production from these wells averaged approximately 335 boe per day, including an attractive 210 barrels of oil per day. This venture is attractive because Sinopec carried most of the drilling costs reducing the CAPEX burden for Devon.
The Jackfish oil sands projects continues to be a great source of production and future growth. Net production from Jackfish 1 and Jackfish 2 averaged a record 49,000 barrels of oil per day in the 4th quarter, which was up 15% YoY. The company is about 50% done with Jackfish 3 and expects the project to start up towards the end of 2014. Devon brought seven operated Granite Wash Wells online, including 3 Hogshooter wells. The average 30-day production rate from these 7 wells was 1,625 boe per day, including 1,010 barrels of oil per day. It really is amazing at how well this traditionally natural gas-centric company, has transformed itself into a fairly oil heavy operation with the use of these new production technologies. Devon established production from 29 operated wells in the Cana-Woodford Shale play, where the average 30-day initial production rate was 6.5MM cubic feet of gas equivalent per day, including 135 barrels of oil per day and 420 barrels of natural gas liquids per day, which help to offset still weak natural gas prices. 4th quarter production from Devon's Cana-Woodford Shale averaged 326MM cubic feet of natural gas equivalent per day, while liquids production increased 68% YoY to 18,000 barrels per day. Liquids account for roughly 32% of Devon's production from the Cana-Woodford Shale. In the Barnett Shale, Devon averaged $1.4 billion cubic feet of natural gas equivalent per day of production during the quarter, and liquids production increased 3% YoY to 48,000 barrels per day.
Devon ended the year with estimated proved reserves totaling 3.0 billion oil-equivalent barrels, bolstered by a 13% increase in oil reserves, which helped mitigate declines in natural gas reserves impacted by low prices. Devon replaced a staggering 260% of oil produced during the year at attractive costs. Reserve revisions related to lower prices resulted in a decrease in the company's proved reserves of 171MM boe. Devon sold $7.2 billion of oil and gas, while its hedges added an additional $870MM in revenue, helping to offset lower prices for all 3 key products. In aggregate, Devon's pre-tax, cash costs totaled $14.36 per boe in 2012. This 7% increase was to be expected due to the more expensive nature of the oil-drilling business, versus dry natural gas. In the year, Devon entered into 2 exploration-based joint ventures, which brought in $4 billion of value to the company through $1.3 billion in cash payments, and $2.6 billion of drilling carries that cover about 70% of the company's capital requirements in the joint ventures. Cash flow from operations was $5 billion and including the inflows from the joint ventures was about $6.5 billion. Devon closed 2012 with cash and short-term investments of $7 billion, and net to debt to adjusted capitalization of 18%.
At a recent price of $58.70, Devon trades at just over 18 times adjusted 2012 earnings, which doesn't scream of a bargain based on that sole input. This data is very misleading due to lower price realizations from Devon's 3 key outputs. There is very little doubt that the company trades at a discount to its private market enterprise value when you factor in its conservative balance sheet, and strength in key regions such as the Permian Basin and Canadian Oil Sands. Devon possesses over 15,000 miles of pipeline and 64 facilities throughout North America, so a possible divestment and conversion to a tax-efficient MLP could potentially unlock additional shareholder value. Prior to any spin-off, I'd encourage management to take advantage of its strong balance sheet to buy back stock, which I believe offers a cheaper way to increase net asset value per share, than any acquisitions would currently.
Devon has the potential to earn $7 per share with increases in production and higher natural gas prices down the line. Long term the export of liquefied natural gas could be a complete game changer for the global natural gas scene, similar to how fracking was. In addition power plants are increasingly choosing to employ natural gas instead of the dirtier coal, to be the primary energy input. The company has done a good job hedging production over the short-term to reduce risks. The company hedged 115,000 barrels per day of oil production, with 55,000 barrels per day swapped at a weighted average price of $101 per barrel, and the remaining 60,000 barrels per day are hedged through a costless collar with a weighted average ceiling of $113 per barrel and a floor of $90 per barrel. I don't expect energy price to jump radically until we see better and more consistent GDP growth across both developing, and developed economies. Devon is a relatively conservative way to be on long-term energy prices going higher with a management and business model that you can trust.