Devon Energy: 3 Reasons To Be Bullish On This Energy King

| About: Devon Energy (DVN)

In an industry as high-risk as oil & gas, good management is a cornerstone for keeping the risk at a minimum, and the balance sheet strong enough to withstand significant swings in the price of oil and natural gas. Devon Energy (NYSE:DVN) consistently demonstrates the forward-thinking policies indicative of good management, which is critical to be successful in its industry.

Historically, Devon's primary commodity had been natural gas, but it made strategic moves over the past four years to switch more of its business to liquid energy resources, a move that has helped to cement its reputation as a company with forward-thinking management. Execution of this business strategy has allowed Devon to maintain a solid financial statement, and have the cash available for new land leases without significantly raising its debt to equity ratio.

Why Devon Changed Its Business Strategy

With the introduction of new techniques in drilling horizontal wells and shatter rocks over a mile deep, there has been a dramatic rise in the supply of natural gas on the market. This increased supply, in turn, has lead to decreased prices for natural gas in the USA, recently hitting a new low over the last ten years of $2 per 1,000 cubic feet. This is a 58% drop from the $5 per 1,000 cubic feet price set in June, 2011, and a good distance from the $13 per 1,000 cubic feet price set in calendar year 2008.

Devon began switching its focus from gas to liquids in calendar year 2009, at the same time retaining its diversification into midstream assets (production plants and pipelines). It also continued its business strategy to mitigate the risks built into this industry, including high-risk exploration and the geopolitical climate.

Devon's divestiture included its operations in deep-sea oil and gas exploration. This end of the exploration chain carries a very high risk, and, to be fair, can also deliver a very high return. In tandem with switching to liquid drilling and exploration, Devon also made some very strategic moves to concentrate on land operations. In a solid piece of management decision-making, as well as incredibly good timing, Devon sold its deep-sea drilling interests in the Gulf of Mexico just prior to British Petroleum's Macondo disaster.

To reduce the geopolitical risks, as well as its remaining deep-sea drilling interests, Devon also sold its interest and assets in most of its international drilling operations, including those in Azerbaijan, the South China Sea, and Brazil. These are areas where the geopolitical climate has a history of being unfavorable to foreign interests, which can include the practice of "nationalizing" existing industries through seizure of the operations and assets of foreign companies. Combined with the sale of its Gulf of Mexico interests, after-tax revenue generated from the sales of international holdings totaled $8 Billion cash to Devon.

Devon's Interest in the Canadian Oil Field

Devon's remaining international endeavor is now posing its biggest risk. The Jackfish project in the sand oil fields of Alberta, Canada, is moving forward into phase 3 with the announcement of regulatory approval by the Canadian government on December 15, 2011. The biggest question mark for this project remains the royalty cost (tax), which is subject to the political climate of the region. In calendar year 2009, the royalty for oil & gas extraction in Alberta took a 20% jump, which was a direct hit to Devon's bottom line.

Canadian royalties can be complicated, with the rate variations dependent on the repayment of capital expenditures and the price of oil. While capital, pipeline delivery issues and the price of Canadian oil all play into how the royalty is set, the biggest, and most unknown factor, is still politics. The debate for raising the royalty has been cropping up in news reports such as those from The Mail & Globe. On April 23, 2012, the province of Alberta (and the location of the sand oil fields), will have its elections. With $309 million generated in royalty revenue from the sand oil fields, it is a rich source to raise additional revenue for the government.

On top of the uncertainty of which way the political hammer will fall, are the very active voices of environmentalists. Currently, most new, proposed pipelines in Canada are on hold as environmental issues wend their way through legislative halls and the courts. While Devon has its own, already established pipeline, it has nevertheless implemented a "green program" both in Canada and the USA, to project a more "environmentally friendly" stance, and mitigate the risk of a pipeline shutdown.

Still, with a very healthy balance sheet and strong cash position, Devon is set to withstand unexpected events, such as increased taxes and environmental issues, due to political pressure from within Canada or the USA. Jon Richels, CEO of Devon reaffirmed its corporate strategy and strong financial position in announcing the calendar year 2011 results, including a $507 million profit reflecting a 23% increase over the previous year. This was driven by an 8% increase in the company's North American production numbers.

Devon's Competition

Some of Devon's immediate competitors have taken a slightly different route, and now find themselves in a very different position.

Cabot Oil & Gas (NYSE:COG) and Chesapeake Energy (NYSE:CHK), have the same, natural gas emphasis that Devon had over the past decade. This will prove problematic as the price of natural gas continues to fall in the domestic market, and with the increased supplies, may stay at the lower price point for an extended period of time. This places both companies in the position of having to deal with the added costs of selling on the international market where the prices for natural gas are higher, but transportation, competition from foreign companies, and various import and export taxes can add to the erosion of the bottom line.

Cabot certainly has some of the best production acreage for natural gas in North America, and is one of the lowest-cost producers in the country, which will certainly help its competitive position in the international as well as domestic market. It also underwent a 2 for 1 stock split in January, 2012 and is currently selling at around $31 per share. It's debt to equity ratio is at .45 which is higher than the industry average of .34, but hardly enough at this point to raise alarms. However, it still lacks enough diversity out of natural gas to shelter it from the pricing storm going on in that area of the industry.

Another aggressive competitor of Devon's in the natural gas field, Chesapeake Energy, is selling at $18 per share, but it has a debt to equity ratio of .59, which is also higher than the industry average of .34. In addition to being more dependent on natural gas revenues, it also has to deal with internal issues regarding an inquiry on the borrowing practices of its CEO.

Currently selling at around $67 per share, Devon has now placed itself into a strong, domestic position, with a debt to equity ratio at .46, in line with Cabot Oil, and above the industry standard. Devon's debt to equity ratio rose from a .3 in calendar year 2010 as it utilized its cash to purchase new domestic leases in Texas, and invest in the sand oil fields in Canada.

Two other competitors, Apache (NYSE:APA) and Andarko Petroleum (NYSE:APC), also have diversified interests in natural gas and liquid energy. However, both also retain interests in foreign and deep-water wells.

Andarko announced a recent win for its exploration side, when exploratory wells in the Sierra Leone region hit water bearing reservoirs with indications of underlying oil. Andarko has about a 50% interest in the operator blocks at or near the drilling sites. In calendar year 2011, Anadarko reported it had an impressive 80% successful drilling rate. However, Anadarko maintains heavy international interests in South Africa, Mozambique, Kenya, China and Brazil among others, which may be spreading its resources and capital a bit thin. This is supported by Anadarko's debt to equity ratio of .80, which leaves it little breathing space for sudden price fluctuations, deep-sea drilling accidents or political upheavals.

Closest to the model Devon is moving into, Apache has a balanced portfolio of oil and gas properties. However, Apache also remains in the international and off-shore drilling business, although not as spread thin as Anadarko, but which has been pretty well abandoned by Devon. Selling at $92 per share, and at .25, Apache's debt to equity ratio is better than Devon's and the industry average. This places the company in the very good position of adequate cash available for development. It will be interesting to see whether the domestic-centered or international-diversified approach comes out as the clear winner between these competitors over the next several years. With deep-well drilling interests as well as operations on foreign shores, Apache is taking the bigger risk, but may also reap the greater rewards. In my opinion, Devon's strategy seems to be more forward thinking in today's geopolitical environment, as well as the changing technology which is breathing new life into domestic oil fields.

On its own, Devon has a solid balance sheet, a good management strategy to move ahead into calendar year 2012, and an acceptable debt to equity ratio to give it breathing room for price fluctuations in an election year. Although nothing in politics is ever certain, there does not seem to be any real effort underway in Canada to raise its royalty tax, which is good news for Devon. Overall, Devon looks to be a good bet for investment in the coming year.

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