Intrinsic Value: $90 - $100 per share
Accumulation Range: $75 or better
Over the last few years, Devon has executed an interesting (and at this point, effective) two-pronged strategy:
- focus their portfolio in high-quality, low-risk and possibly unconventional assets in stable jurisdictions while divesting themselves of mature assets that stretch their resources
- build a pipeline of high-risk, high-impact prospects with potential to substantially increase reserves
In short, they’ve carved out a nice market position for an independent E&P company, especially in the light of resource nationalization, increasingly-challenging exploration and declining field production worldwide.
This strategy should allow Devon to generate strong, stable cash flow for years to come while having the potential to grow reserves. The low-risk, high-volume base of the Barnett Shale and Canadian operations will anchor the company while the potential of the Lower Tertiary and other prospects propel it into the future.
So what can go wrong?
First, energy prices could collapse. However, even mainstream organizations like the IEA, EIA and the oil industry’s own council have recently released reports warning of tightening supplies so it is hard to realistically project a price collapse due to supply glut. The other possible scenario causing price collapse is a global economic meltdown. In this case, all asset classes will be affected. Energy assets will probably be the first to recover, however, as economic growth (or recovery) is not possible without energy.
Another risk lies with the Lower Tertiary play and its exposure to hurricane risk. The 2005 hurricane season devastated industry capacity. While Devon’s production was impacted by only 3%, new projects in the Gulf of Mexico coming online (Merganzer) or those in planning such as Jack or Kaskida could be affected more severely. In addition, hurricane insurance has dried up and Devon’s coverage has been reduced.
The other main risk to our investment is escalating operating costs beyond inflation. As resources and prospects become scarce, we may find ourselves in a receding horizon scenario where costs rise just as fast, if not faster, than realized prices. For instance, the cost of exploiting the Canadian oil sands has ballooned as environmental damage, labor shortage and ironically, natural gas and water supply issues all converge as production increases. Deepwater exploitation could follow a similar course.
Devon Energy is an interesting company to evaluate from various approaches. From a strict DCF analysis, I land around $72 per share. But I’m doubtful that DCF analysis is the best method of valuing companies like Devon which expend lots of capital to develop natural resources and have no control over pricing.
Devon is required by the SEC to provide a net present value [NPV] of proven reserves using prices at the last day of the reporting period and discounted at 10%. Devon estimates their cost of capital between 6-8%. I used 7.5% as the discount rate, a price-to-cost ratio of 21% per BOE based on year-end 2006 numbers and a time period of 11 years to match their current reserve life. I used a range of prices for oil, natural gas and natural gas liquids (NGLs): Oil price, gas price, NGLs constant @ $30:
$40/bbl, $4/mcf = NPV $56
$50/bbl, $5/mcf = NPV $69
$60/bbl, $6/mcf = NPV $81
$70/bbl, $7/mcf = NPV $93
$80/bbl, $8/mcf = NPV $106
Keep in mind, this is an NPV solely on proven reserves. We get the rest of the operations + probable reserves for free. The marketing and midstream segment generates ~$400M in operating profit annually and is being spun out into a MLP. They also have good prospects in the Gulf of Mexico (Jack, Kaskida, Deep Mission), Canada (Jackfish extension), Brazil (Polvo extension). Then you have the promising exploration plays in China, the GOM Shelf, onshore US, etc. I assign $10 per share for the non-NPV portion.
Throwing away the top/bottom valuations, we get a valuation of $79 - $103 with oil in a $50-70 range and nat gas @ $5-7. The Energy Information Administration (NYSEMKT:EIA), as of July 2007, expect prices to come in @ $65.56 per bbl and $7.91 per mcf. Let’s modify the government numbers to $66 oil and $7 natural gas, we arrive at $91 NPV with $10 bonus for midstream ops & growth prospects. At a range of $90-100, we’re looking at 17-25% margin of safety based on conservative price projections.
Finally, notice our ranges stop at $80 oil and $8 natural gas. While I try to focus on downside risks to capital first and foremost, it doesn’t take much imagination to see prices higher if you examine possible supply constraints on the horizon. If the markets ever come to the conclusion that energy resources are in permanent supply constraints, we will see MASSIVE multiple expansion.