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Summary

  • Devon has sold all of its natural gas assets after signing a deal with Linn Energy for a consideration of $2.3 billion.
  • At the same time it is expanding its oil production and reserve base by acquiring a stake in Cimarex’s assets for $248.7 million.
  • The company’s current liquidity position is not strong due to a payment of $6 billion for Eagle Ford Shale assets, but it will improve with higher production.

Company Overview

Devon Energy (NYSE: DVN) was engaged in the exploration and production of oil and natural gas but it has recently diverted its focus by selling its natural gas assets. The company has labeled its natural gas assets as "non-core" and has been following a plan to divest them. Devon has managed to give a return of almost 39%, for the past 52 weeks, with a dividend yield of 1.20%.

Sale of Natural Gas Assets

Devon has been going through a transition phase as it is changing its operations to focus solely on oil production. To achieve this it had to sell its natural gas assets while raising capital in order to improve its financial statements and also acquire oil assets along the way. Moreover, there are speculations that natural gas prices have not been giving good margins to oil and gas producers after the sudden increase in shale production. For this reason many oil and gas producers have moved towards crude oil, which has a price seemingly more regulated than that of natural gas.

Devon has announced the sale of its natural gas properties in Rocky Mountains, Texas, Louisiana, Wyoming, Utah, Oklahoma, and Kansas; which combine to make up about 900,000 acres. These assets provided Devon with 275 million cubic feet of gas equivalent per day, around 80% of which was natural gas. Linn Energy has acquired these assets for $2.3 billion as it is focusing on increasing its gas reserves and production. We are expecting a significant improvement in Devon's bottom line at the deal's closure, in the third quarter of this year, because the company plans to use the proceeds to reduce its huge debt load of $4 billion.

A few months ago Devon sold its Canadian assets to Canadian Natural Resources for $2.85 billion. The company plans to use $2.7 billion of this consideration to pay off its long term debt. The said assets produced around 383 million cubic feet of natural gas (per day) along with 10,800 barrels of light crude oil and 12,000 barrels of natural gas liquids (per day). The acquisition of these assets will increase Canadian Natural Resources' production by 1% to around 780,300 barrels of oil equivalent per day.

Wells Fargo Securities has commented that Devon has been better off in terms of proceeds from both sales as it expects "proceeds from sale to be stronger than anticipated".

This shows that the company has not been forced to agree to any bad deals in order to follow its transition strategy. We believe that these proceeds will not only generate finances but will also enable the company to acquire new oil assets in order to improve its crude oil production and reserves. More focus on crude oil production will generate good cash flows, through better margins as compared to natural gas, and also spur Devon's growth.

Oil Assets to Drive Growth

Cimarex inked a sale and purchase agreement to acquire oil and gas assets in the Cana-Woodford Shale for $497.4 million in cash payments. At the same time it also entered an agreement with Devon Energy to sell a 50% stake for $248.7 million.

Through this deal Devon will benefit from around 5,800 barrels of oil equivalent per day and increase its proven and probable reserve by approx. 23 million barrels. The agreement will also increase the company's acreage in the Cana-Woodford Shale to 300,000 acres.

Devon Energy has also been developing its Eagle Ford Shale assets, which it acquired in 2013 for $6 billion. The company's recently released performance report for these assets stated that the average daily production has reached 49,000 barrels of oil equivalent for the month of March. This is in line with Devon's aim to ramp up production to around 70,000 to 80,000 barrels of oil per day within the first 10 months of its ownership. The company also stated that it plans to double the average daily production to 100,000 barrels of oil equivalent by 2015.

Financials

Devon reported a growth of almost 90% in its revenue on a yearly basis during the first quarter of 2014. This has been due to a 7% increase in production along with the improved average realized prices of oil and natural gas. At the same time the company has also considerably improved its net income to $324 million from a net loss of $1.3 billion in the first quarter of 2013. These positive results were translated into an improvement in operating cash flows, from $1 billion to $1.4 billion, year over year.

Devon incurred a significant net cash outflow during the first quarter of 2014 due to acquisition payments of $6 billion for the Eagle Ford Assets. Because of this the company's current and quick ratio fell from 1.20x to 0.66x and from 1.14x to 0.61x respectively. Even though such low liquidity ratios are a concern, we believe that Devon will easily improve its liquidity position through the operations of its acquired assets.

Debt to equity ratio increased on a quarterly basis to 0.57 or 57% as the long term debt level increased to $11.7 billion. This will result in considerable interest expense and narrow profit margins. Moreover, if the company tries to get more debt for a project it will have to pay a higher interest rate due to the increased risk of the business as its debt burden keeps piling up. Devon has generated around $5.15 billion in total from the sale of its non-core assets. In my view the company will be using around $5 billion to reduce its long term debt to $5.7 billion. This will improve its debt to equity ratio to 0.28 or 28% and will be achieved when the sale of assets to Linn Energy is closed in the fourth quarter of this year.

Conclusion

Devon's transition has kicked in as it is improving its production from the Eagle Ford Shale and plans to double it by 2015. Furthermore, by shedding off non-core assets the company will be able to reduce its long term debt. This will reduce business risk and increase the profit margins that were once affected by high interest expenses. Even though the company's current financial position is not looking strong, it is spending its cash in the right areas which will not only improve its financial statements but also spur its rate of growth. For these reasons we believe that Devon has a lot more to give in the future continuing the past positive trend in the stock price making it a Buy.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Devon Can Grow With High Margin Production Strategy