Devon Energy Is Undervalued

Mar.22.12 | About: Devon Energy (DVN)

A month ago we presented an annual report on the performance of our pricing model for ConocoPhillips (NYSE:COP) and found an excellent agreement between the predicted and measured monthly closing prices since 2000. Here we compare the overall behavior of the COP model and a model estimated for Devon Energy Corporation (NYSE:DVN) by the same technique.

Our simplest model links share prices of energy companies with the difference between the headline and core CPI. In essence, we were trying to use the core CPI as an energy independent (dynamic) reference to the headline CPI which includes energy and, in turn, is related to oil price. Then the difference between these CPIs might be manifested in the energy pricing power relative to all other goods and services.

Formally, our original pricing model states that a share price, for example, that of Devon Energy, DVN(t), can be approximated by a linear function of the difference between the core CPI, cCPI, and headline CPI:

DVN(t) = A + B[cCPI(t) - CPI(t)] (1)

where A and B are empirical constants (as obtained by linear regression); t is the elapsed time. Figure 1 shows the observed and predicted DVM share prices since 2000. The best fit model is characterized by A=$93, B=-7.5, and a standard model error, sterr=$11.51, for the period between January 2000 and February 2012. One can observe a good agreement between January 2000 and April 2011, when the predicted curve started to deviate from the observed one. The period after May 2011 has introduced the largest model error and is absolutely different from the behavior of the COP model which has proven its predictive power. (We have been reporting on its performance since 2009.) Figure 2 depicts the observed and predicted monthly closing prices for ConocoPhillips since 2002 with A=$75 and B=-5.5. The standard model error is only $8.31 for the period between 2002 and 2012.

Comparing the COP and DVN models one can conclude that the current price of Devon Energy is undervalued by about $15. In February 2012, the price closed some portion of the gap and this process should extend into March and April.

(Click to enlarge)

Figure 1. The observed DVN price and that predicted from the core and headline CPI. A=$93, B=-7.5; sterr=$11.51.

(Click to enlarge)

Figure 2. The observed COP price and that predicted from the core and headline CPI. A=$75, B=-5.5; sterr=$8.31.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.