Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Devon Energy Corporation (NYSE:DVN)

Q3 2007 Earnings Call

November 7, 2007 11:00 am ET

Executives

Vince White - Vice President, Investor Relations & Communications

J. Larry Nichols - Chairman of the Board, Chief Executive Officer

Stephen J. Hadden - Senior Vice President - Exploration and Production

John Richels - President, Director

Analysts

Brian Singer - Goldman Sachs

Tom Gardner - Simmons & Company

Gil Yang - Citigroup

Joe Hofer - Wachovia Capital Markets

Mark Gilman - The Benchmark Group

David Heikkinen - Tudor, Pickering & Co.

Operator

Welcome to Devon Energy’s third quarter earnings conference call. (Operator Instructions) I would like to turn the conference over to Mr. Vince White, Vice President of Communications and Investor Relations. Sir, you may begin.

Vince White

Thank you, Operator and good morning to everyone. Welcome to Devon's third quarter 2007 conference call and webcast. Today’s call will follow our standard format; that is, starting with our Chairman and CEO, Larry Nichols, who will provide his perspective on Devon and the quarter; and following Larry, Steve Hadden, our Senior Vice President of Exploration and Production, will cover the operating highlights; and then Devon's, John Richels, will conduct the financial review.

As usual, we will open the call up to questions and we will try to hold the call to about an hour.

A replay of the call will be available later today through a link on our website. That is devonenergy.com. We will also be posting to the website a new issue of Devon Direct. That’s our electronic report that includes highlights from the webcast and includes links to supplementary information.

During the call today, we are going to update some of our estimates based on actual results for the first three quarters of the year and our outlook for the balance of the year. In addition to the updates that we’ll provide in today’s call, we plan to file a Form 8-K later today and that will document all the details of our updated guidance.

Also, please note that the references in today’s call to our plans, forecasts, estimates and so on are forward-looking statements as defined by U.S. securities law. There are a number of factors that could cause our actual results to differ from those estimates, so we would encourage you to review the discussion of risk factors that accompany the estimates in the Form 8-K.

One other compliance note; we will make reference today to certain non-GAAP performance measures. When we use these measures, we’re required by securities law to provide certain related disclosures. You can see those disclosures. They are available on our website. Again, that’s devonenergy.com.

Finally, I want to remind you that our decision to sell our assets in Africa triggered the discontinued operations accounting rules. Under those rules, we exclude oil and gas produced from the assets selected for divestiture from reported production volumes for all periods presented. The related revenues and expenses for the discontinued operations are collapsed into a single line item at the bottom of the statement of operations.

However, in the spirit of full disclosure, you will find an additional table in today’s news release that includes a detailed statement of operations and the related production volumes attributable to the properties that we are divesting.

I also want to point out that net earnings from discontinued operations were $91 million in the third quarter. However, that does not mean that the discontinued operations would have contributed the full $91 million of additional earnings if we were not selling them. That’s because the accounting rules for discontinues operations require us to stop recording depletion expense on the sale properties once we make the decision to divest them.

Had we not chosen to exit Africa, we would have reported net income associated with the divestiture properties of $66 million, or $25 million less than the $91 million of income from discontinued operations for the quarter.

Accounting for these discontinued operations also complicates the comparability of earnings estimates. Most of the analysts that reported estimates to First Call this quarter excluded the impact of the discontinued operations. The mean estimate of earnings per share from the analysts that excluded it was $1.39 per share. That compares to our non-GAAP earnings from continuing operations of $1.41 per share.

The mean estimate for analysts that included discontinued operations in their estimates was $1.47 a share, and that compares to our non-GAAP diluted earnings of $1.55 per share for the third quarter, including discontinued operations. So in either case, our non-GAAP earnings beat the street expectations.

With those items out of the way, I will turn the call over to Larry Nichols.

J. Larry Nichols

Thanks, Vince. The third quarter was another excellent one for Devon. We made progress both from an operational standpoint, a financial standpoint, and some important strategic actions, of which I’ll comment on in a moment.

For the third quarter, oil and gas production exceeded our expectations and our guidance. Our production grew 10% over the third quarter of 2006, which provides us with our sixth consecutive quarter of organic production growth.

We outperformed our third quarter forecast by nearly 2 million equivalent barrels, which allows us to increase our full year production forecast. John Richels will discuss the drivers of this production outperformance and the revised guidance in a little bit.

The financial results for the third quarter were also very positive. Net earnings were $735 million and earnings per share exceeded street expectations, both with and without discontinued operations.

Cash flow before balance sheet changes increased 15% to $1.8 billion, bringing the year-to-date cash flow to $5 billion. We funded total capital expenditures of $1.6 billion and we repurchased 120 million shares of our common stock and ended the quarter with $1.7 billion of cash and short-term investments. We ended the quarter with net debt to adjusted cap at its lowest point in 10 years at 19%.

Following the end of the third quarter, we moved forward with our Africa divestiture program by closing the sale of the Egyptian operations in early October. As of the closing date, the adjusted sales price was $341 million, and we do not expect to pay any income tax on this transaction.

We are finalizing purchase and sales agreement and getting the necessary partner and governmental approvals for the remaining African assets. Although the process has been complicated and time consuming, we are optimistic that we can complete all of these transactions by the end of the first half of 2008.

In today’s release, we’ve provided an update on our previously announced MLP, our master limited partnership. As noticed in the release, we have reconsidered our plans to form a marketing and midstream MLP. This decision reflects our views about the current condition of the public market for yield-driven instruments. The market today is just less receptive than it was when we announced our plans, so we are putting that project on hold.

With Devon's marketing and midstream business generating more than $450 million in operating profits, we believe it is prudent to be very cautious with any decision affecting this important and strategic part of our business. Although we have no firm timeline for revising the project, we will reconsider it in the future should market conditions change.

Before I turn the call over to Stephen Hadden, I want to share with your our perspective on the royalty situation in Alberta. As you probably know, in late October, the Alberta Government announced a change in the royalty regime in that province. With Canada providing a quarter of Devon's current oil and gas production, and with most of that in Alberta, any change in the royalty structure is of course a concern.

The new structure is somewhat complex and we are still evaluating the impact of the changes on our Canadian operations, but it does seem likely that there will be some economic impact.

Devon's capital investments are of course based not just on royalty rates but rather on expected full cycle returns. Those expected returns are impacted by our expectations for production, realized oil and gas prices, capital costs, operating costs, foreign exchange rates, and a host of other things .

On a positive note, last week the Canadian Federal Government announced a budget proposal which, if enacted, would reduce corporate income taxes, which would have a positive impact on our Canadian returns. You can be assured that our future investment allocation decisions will continue to take into account not only the implications of the Alberta Government’s decision to change the terms under which we operate, but also all of the return criteria we evaluate.

Fortunately, Devon has a very large and diverse portfolio which will allow us to reallocate capital, both within capital and between -- both within Canada and between Canada and across all of our other operating divisions. We of course will choose those areas which generate the most favorable return.

At this point, I will turn the call over to Stephen Hadden. Stephen.

Stephen J. Hadden

Thanks, Larry and good morning to everyone. Let’s start with a look at our 2007 capital spending. During the third quarter, our exploration and development CapEx totaled $1.4 billion, bringing year-to-date E&P capital expenditures to $3.8 billion. As we noted in last quarter’s call, we expect full year E&P capital to come in near the top of our forecasted range at about $5.3 billion.

At the end of the third quarter, we had 150 rigs running company wide, with 89 of those rigs drilling Devon operated wells. We drilled 599 wells company-wide during the quarter. Twenty-four were classified as exploratory, of which 92% were successful. The remaining 575 wells were development wells and about 98% of those wells were successful, giving us an overall success rate for the quarter of roughly 98%.

Now let’s move to our quarterly operational highlights, beginning with the Barnett Shale field. We reached a significant milestone during the third quarter by drilling our 1,000th Devon operated Barnett Shale well. It was just about five years that Devon pioneered horizontal drilling in the Barnett. Due to the superior economics and reduced surface impact, almost all the wells being drilled in the Barnett today are horizontal.

Horizontal wells make up about one-third of our Barnett producers, but account for about two-thirds of our Barnett production. Our Barnett Shale production averaged a record 856 million cubic feet of gas equivalent per day in the third quarter. This was a 7% gain from the second quarter and up 32% compared with the third quarter of 2006.

In our last call last quarter, we revised our year-end target rate to 875 million cubic feet of gas equivalent per day and we are well on the way to hit that goal. We had also previously announced a longer term net target rate of 1bcf per day by the end of 2009. Given our progress to date and the pace we are on, we now expect to reach the 1 bcf mark per day by early 2009. This is more than twice the forecasted production of our next closest competitor.

This leading position in the play has been well established through our first mover advantage. That advantage has given us unmatched size and scale in the play. Since 2001, with our acquisition of Mitchell, we built a lease position of over 735,000 acres with very favorable lease terms. Devon has an average royalty burden of under 20% on these leases. This compares to a royalty burden on most leases taken in the Barnett over the last several years of 25% or greater.

The economic impact of a lower royalty burden is dramatic. On a typical 2.5 bcf Barnett well drilled for about $3 million in a $6 per mcf realized gas price environment, a well with a 20% royalty burden has about 1.4 times the present value of a well with a 25% royalty burden.

A large portion of our acreage is concentrated in the better areas of the play, such as the core area in Johnson County. Accordingly, we have a superior acreage position and years of additional drilling inventory in the better portions of the play.

Our history of being the first to identify new applications of technology has been well-established since the beginning. Devon was the first to unlock the early potential of the play with light sand fracs and horizontal drilling. While all of the major operators in the play have the same drilling and completion services available to us, the various operators choose to complete wells differently. Various lateral lengths and number of frac stages can impact IPs per well, recoveries per well, and ultimately well economics.

Rather than focus on maximizing per well production or reserves, Devon has chosen to optimize return with our well designs. We now have 3,000 wells in the play and we are drilling at a rate of over 500 wells per year, by far the largest in the play. This scale allows us to establish an in-depth knowledge of the reservoir, as well as very strong, long-term relationships with the leading drilling and pumping service providers in the country, providing reliability, performance, and value.

We have been asked recently if we plan to integrate vertically in the play through the purchase of drilling rigs or completion related assets. It’s always been our view that it’s best to allow the specialists to do what they do best while our team stayed focused on combining innovation and our deep understanding of the Barnett Shale to deliver the best value growth and return for our shareholders.

These relationships have allowed Devon to hold our well costs flat over the past year, despite the cost escalations experienced by our industry over the same period. We accomplish this while ramping up activity from 385 wells in 2006 to over 500 wells this year, growing our production 32% compared to the third quarter of 2006.

Devon will keep its focus on maintaining the lead position in the play with the best acreage position, the best lease terms, and the most consistent execution, and we’ll provide an early achievement of our 1 bcf per day goal.

During the third quarter, we completed a total of 127 Barnett wells, 50 of which were in the core and 77 were outside the core. We remain on pace to drill 500 wells in the Barnett Shale this year and we are running 32 Devon operated rigs, nine in the core area and 23 outside the core.

Our non-core drilling program in Johnson County continues to shine. In the third quarter, we put 39 new wells online in Johnson County at an average rate of 2.5 million cubic feet per day. Four particularly strong wells each had 24 hours sustained initial production rates averaging above 5 million cubic feet per day.

North of Johnson County in Southern Wise County, we brought two exception wells online at 5.4 million and 6 million cubic feet per day, so we continue to see solid results from our non-core horizontal drilling with typical yields between 1.5 and 2.5 bcf per well, with some as high as 8.4 bcf.

In addition to expanding the play in new directions, an important part of our activity in the Barnett Shale is in-fill drilling or down-spacing in areas that have already been fully developed on primary spacing. These in-fill wells are usually referred to as 20 acre in-fill wells. However, I’ll remind you that with horizontal drilling, one well can replace several 20 acre vertical well locations. Consequently, from a surface development perspective, 20 acre in-fill horizontal wells actually occupies 80 surface acres.

Since we began this horizontal in-fill program, we’ve completed a total of 139 of these in-fill wells. A total of 127 that have been connected to the producing grid are horizontal with average initial production of 2.2 million cubic feet per day. Economics from the horizontal in-fill wells we’ve drilled to date are very solid at an average drilling and completion cost of about $2.9 million and approximately 2.1 bcf per well estimated recovery.

In addition, we’ve been experimenting with further horizontal down-spacing. We have completed a total of 11 operated wells that are spaced to result in two wells per 80 acres, or 40 surface acres per well. Seven of these have been tied into production, with an IP of 2.5 million per day. This down-spacing is one of the ways we expect to convert into crude reserves more of the 13 trillion cubic feet of potential, represented by Devon's 735,000 Barnett acres.

While we are very encouraged by these early results, we’ll need to see more production data before developing large areas based on one horizontal well per 40 acres.

It the Woodford Shale in eastern Oklahoma, we currently have five operated rigs drilling in the play. We brought a total of eight new operated wells online during the third quarter with individual well production rates as high as 4 million cubic feet of gas a day. We now operate 46 wells in the Woodford, with gross operated production running about 38 million cubic feet per day.

Our net Woodford Shale production averaged 20 million cubic feet per day in the third quarter, up almost 70% compared with the third quarter of 2006. On average, our Woodford Shale wells are costing between $4.1 million and $4.3 million to drill and complete, and yielding about 2.5 bcf of reserves per well.

Moving to the Rockies and the Washakie Basin in Wyoming, we had five rigs running throughout most of the third quarter. During the quarter, we drilled 16 wells and brought 15 on production. Devon's net production at Washakie averaged about 100 million cubic feet per day in the third quarter.

Shifting to east Texas, we continue with a seven-rig vertical Cotton Valley drilling program in the Carthage area. In the third quarter, we drilled 25 vertical wells and continued an active recompletion program. At the end of the quarter, we were drilling with 66 wells in a 95 well vertical program that’s planned for this year. Looking forward, we have a significant drilling inventory with as many as 420 additional vertical locations available, including about 65 20-acre in-fill locations.

We also continue to see good results from our three-rig horizontal drilling program in the Carthage area. We drilled and completed five new Cotton Valley horizontal wells during the third quarter, including the 100% working interest Davis 4H well that averaged 6.6 million cubic feet of gas per day for the first 30 days of production.

Since we first tested the horizontal drilling concept in the Carthage area about one year ago, we’ve drilled 11 out of 11 successful horizontal wells. These wells cost from $5.5 million to $7 million per well to drill and complete, with estimated ultimate recoveries of 3 to 6.5 bcf per well.

We have as many as 96 additional horizontal locations to drill at Carthage. In total, our net Carthage production average 260 million cubic feet of gas equivalent per day for the third quarter, up 5% from the second quarter average and up 8% from a year ago. With a lot of running room for both the horizontal and vertical well programs, we believe we can continue to grow Carthage production well into the future.

Shifting to the Gulf of Mexico and our deepwater production operations, we established production from the two subsidy wells at Merganser in the third quarter. These gas wells are flowing into the independent hub and are currently producing at a combined rate of more than 68 million cubic feet of gas per day net to Devon's interest. This rate is 36% better than our forecasted rate, so we are obviously very pleased with the early performance of these wells.

In our deepwater [inaudible] and exploration program, we expect to begin drilling on the Sturgess North prospect located in Atwater Valley Block 138 in early 2008. We made an initial discovery at Sturgess in 2003, encountering over 100 feet of net oil pay. Sturgess North is located adjacent to the Sturgess discovery but will test a separate geologic structure. Devon has a 25% working interest in this Chevron operated prospect.

Our lower tertiary exploration program was in full swing during the third quarter. Early drilling on our Chuck prospect located in Walker Ridge 278 has gone slowly as the Ocean Endeavor rig was being debugged by Diamond Offshore. We believe that most of the start-up issues have been resolved and we are currently drilling below 21,000 feet. Chuck is targeting a large sub-salt structure in about 6,500 feet of water and Devon is the operator of Chuck, with a 39.5% working interest.

We expect to begin drilling an exploratory well on the Green Bay prospect around year-end. This lower tertiary exploration prospect is located on Walker Ridge 372 in approximately 6,300 feet of water. The prospect is about 20 miles north of the St. Malo discovery and about 18 miles east of the Chuck prospect. Devon has a 23.4% interest in Green Bay.

We are continuing with appraisal and development activities on the four significant lower tertiary discoveries which we’ve participated in to date. Last quarter, we began drilling a location on our Keathley Canyon Block 244 in the Kaskida unit. This location, previously known as Cortez Bank, is located about 12 miles west of our 2006 Kaskida discovery. The well was drilling in a side-tracked hole to a proposed depth of 33,000 feet when mechanical issues forced the well to be abandoned before reaching the target objective.

While it is always a disappointment to spend capital on a well that fails to reach its intended objective, this result does not dampen our enthusiasm for the unit. The Kaskida discovery well clearly encountered a very significant oil column and we have a lot of work left to do to fully understand the potential of the unit.

The joint owners are now integrating the results from the two wells, along with seismic data to determine our next location in the unit. Devon has a 20% working interest in the unit, which is operated by BP. The next well operation is expected some time in the first half of 2008.

At Cascade, our lower tertiary development with Petrobras in the Walker Ridge area, we sanctioned development during the third quarter. We have submitted operating and development plans to the MMF and we have awarded the FPSO and shuttle tanker contracts. We now anticipate initial production at Cascade to likely be in the first half of 2010.

Our approach to development at Cascade will allow us to produce the first wells over a sustained period. Reservoir information gathered during that initial period phase will help us determine the optimum number and placement of producing wells and allow optimization of full field facilities for the project. Devon and Petrobras each have 50% working interest at Cascade.

At Jack, also in Walker Ridge deepwater lease area, Devon and our co-owners expect to finish drilling operations on a second delineation well, the Jack Number Three, in the first half of next year. The well will be operated by Devon and drilled with the Ocean Endeavor rig.

Finally, at St. Malo, also in the Walker Ridge deepwater area, we are currently drilling our second delineation well and we hope to have the results in the first quarter of 2008. These additional Jack and St. Malo wells will providing important data that will help the partners determine the optimum development approach to these discoveries.

I will remind you that Devon has a 25% working interest in Jack and a 22.5% working interest in St. Malo.

Moving to Canada, in the Lloydminster oil play in Alberta, we have increased production by over 50% over the past 12 months to 34,600 barrels of oil per day. We continues to have an active five rig program in the third quarter, as we drilled 125 new Lloydminster wells. A second 10,000 barrel a day expansion at our [Manitokin] plant is underway and we expect to complete that work by the end of 2008.

At the Devon operated Jackfish thermal heavy oil project in Eastern Alberta, we began steam injection in the third quarter. We are wrapping up final pre-commissioning activities and expect to see first production from Jackfish around the end of this year. As previously indicated, production will then ramp up toward an expected, sustainable rate of 35,000 barrels per day.

At Jackfish 2, engineering and budgeting work continue and we expect to receive regulatory approval around mid-2008. At that point, we will make a formal decision about the project. This project would add another 35,000 barrels of day of thermal oil.

Moving to the international arena, development drilling at the Devon operated Polvo project on Block BM-C-8 in Brazil continued during the third quarter. We achieved first oil on July 26 and have completed the first three of a total of 10 planned producing wells, which reach a combined growth rate of 9,500 barrels per day. The field’s first lifting of 385,000 barrels occurred on October 21st. The fourth well is currently drilling. The additional wells will be drilled and tied in throughout the remainder of this year and into 2008 as we ramp up the field’s production.

In Azerbaijan, where Devon had a 5.6% working interest in the ACG oil field, our share of ACG production averaged about 28,000 barrels per day in the third quarter. As expected, there were about 17 days of downtime at ACG in the third quarter to perform facility upgrades to both offshore and onshore infrastructure. Field production has since been brought back online.

In China, we expect to drill our Watermelon prospect located on Block 4205 in the first quarter of 2008. You might remember Block 4205 is adjacent to Block 2926, where Husky and CNOOC announced a multi-pcf gas discovery. However, this well has all the typical risks of an exploration well. Devon operates Block 4205 with 100% working interest.

That concludes my comments on our operational highlights for the quarter. I’ll now turn the call over to John to review our financial results. John.

John Richels

Thank you, Steve and good morning, everyone. This morning, I will take you through a brief review of the key drivers of our third quarter financial results and take a look at how they impact our outlook for the remainder of the year. You can find the details of our updated forecast in the form 8-K that we’ll be filing today, as Vince mentioned earlier.

As a reminder, we have reclassified the assets, liabilities and results of operations in Africa as discontinued operations for all accounting periods presented. As a result, I’ll focus my comments only on our continuing operations, which exclude the results attributable to the divestiture properties.

Let’s begin with production. In the third quarter, we produced 56.8 million equivalent barrels, or approximately 618,000 barrels per day. This exceeded our guidance by about 3% or nearly 2 million barrels.

Approximately three-quarters of this outperformance was due to better-than-expected results from several of our core properties in North America and the remainder of the outperformance was attributed essentially to the absence of anticipated downtime for hurricanes in the Gulf of Mexico and the postponement of planned facilities repairs at our offshore [Puguang] project in China. Thankfully, we’ve had an uneventful hurricane season and the repair work at [Puguang] is now scheduled to begin in the fourth quarter of 2007.

When you compared our third quarter results to the same quarter a year ago, you’ll find that company-wide production increased by 10%, or approximately 55,000 barrels per day. This reflects year-over-year growth in our U.S. onshore, Canadian and international segments. Production from the U.S. onshore region grew by nearly 40,000 barrels per day, or 12% when compared to the third quarter of 2006.

Continuing a trend, the leading driver of our U.S. onshore performance was strong production growth from our Barnett Shale assets. We also experienced significant growth in the international sector, almost entirely attributable to increased production from the ACG field in Azerbaijan.

In Canada, total third quarter production increased 2% over the third quarter of 2006. This was achieved in spite of significantly scaling back on our Canadian conventional natural gas program. Growth in Canada was driven principally by drilling on our Lloydminster oil properties.

Looking ahead to the fourth quarter, we expect to grow company-wide production for a seventh consecutive quarter. In total, we anticipate fourth quarter production of approximately 57 million equivalent barrels. Key growth drivers will be our U.S. onshore assets, a full quarter of production from Merganser and Polvo, and an uninterrupted quarter of production in Azerbaijan.

However, this growth will be offset somewhat by the rescheduled downtime for equipment replacement in China, along with anticipated declines from our conventional gas fields in Canada.

Based on strong performance for the first nine months, coupled with a bright fourth quarter outlook, we are now increasing our full year production forecast to 223 million equivalent barrels. This will add another percent or two to the 10% year-over-year growth target we had previously forecast for 2007.

Although we expect to finish 2007 ahead of our previous production forecast, we are not increasing our guidance for 2008 at this time. We typically finalize our capital budget in the fourth quarter and submit it to our board of directors in December for approval. Following board approval, we provide updated production guidance. Until we complete the budgeting process and determine the optimal level for our 2008 capital spending, we’ll stick with our previous forecast for 2008 of 240 to 247 million barrels equivalent.

Moving on to price realization, starting with oil, in the third quarter the benchmark WTI oil price rose to an average of $75.21 per barrel. That’s a 16% increase from the second quarter of 2007.

In addition to higher benchmark prices, regional differentials remain tight with the results of price realizations in all of our producing regions where we are above the midpoint of our guidance ranges.

Our company wide realized price came in at $67.41 per barrel, or about 90% of WTI. That’s a 12% improvement in realized prices over the last quarter.

Although differentials have widened recently for heavy and sour crudes as benchmark prices have increased, we are still comfortable with our full year guidance for oil price differentials. I’ll remind you that since none of our oil volumes are hedged, we are benefiting from further increases in oil prices that we are seeing in the fourth quarter.

On the natural gas side, the benchmark Henry Hubb index averaged $6.16 per MCF in the third quarter, some 6% below last year’s third quarter. Our company-wide gas price realizations were generally in line with guidance at approximately 86% of Henry Hubb.

Strong price realizations in the Gulf of Mexico and in Canada were mostly offset by continued price weakness within the Rocky Mountain producing area. You’re probably aware that the price differentials in the Rockies have widened significantly over the past several months, due primarily to constrained regional export capacity.

The impact on Devon, however, has been limited because the Rockies represent less than 10% of our company wide natural gas production.

Looking ahead to the fourth quarter, we expect natural gas price differentials to be very similar to the third quarter.

Turning now to our marketing and midstream business, once again marketing and midstream operations delivered excellent results. Marketing and midstream operating profit for the third quarter came in at $133 million, $21 million more than in the third quarter of 2006. The increase is due to higher gas processing margin in the 2007 quarter.

Based on the strength of the first three quarters, we’re again increasing our 2007 operating profit forecast. We now expect Devon's marketing and midstream full year operating profit to come in between $460 million and $490 million. At the midpoint, this represents an increase of $35 million from the midpoint of our previous guidance range.

Moving to expenses, third quarter lease operating expenses were at the low end of our guidance range, coming in at $457 million, or $8.04 per equivalent barrel. This was essentially flat to our average LOE rate for the first half of the year.

For the quarter, unit LOE costs remain steady or decreased in most of our major operating regions with the exception of Canada. In Canada, LOE remains under pressure from the strength of the Canadian dollar.

In the fourth quarter, we expect a moderate rise in LOE costs due to new development projects ramping up production and also a seasonal increase in operating costs in Canada.

For the full year, we expect lease operating expenses to be near the top of our previous guidance range.

Our reported third quarter DD&A expense for oil and gas properties came in at $12.41 per barrel. This was $0.16 above the high end of the guidance range we provided in our second quarter conference call. The higher-than-anticipated depletion rate is entirely due to low spot gas prices in the Rockies at September 30th. This resulted in a temporary reduction in reserves for the calculation of depletion. We expect this situation to correct itself in the fourth quarter and accordingly, we expect our DD&A rate to return to where it otherwise would have been.

However, due to the higher-than-expected rate in the third quarter we now expect our full year DD&A rate to come in near the top of our previous forecast range.

Moving on to G&A expense, G&A expense for the third quarter was $126 million. This result is a couple of million dollars above the quarterly range implied by our full year forecast, and $13 million higher than last quarter. Higher employee related costs were the primary driver.

Looking ahead, based on our year-to-date results and in anticipation of continued upward pressure on personnel costs, we’re now increasing our full year G&A guidance by $30 million to a new range of $490 million to $510 million.

A final expense item I want to touch on is income taxes. After adjusting out the items that are generally excluded from analysts estimates, income tax expense for the third quarter came in at 33% of pretax income. The current tax position is roughly 10% of pretax earnings and the deferred tax piece came in at about 23% of pretax earnings. This brought the adjusted income tax rate for the first nine months of 2007 to 32%, with half current and half deferred. The 32% overall income tax rate, with roughly half deferred, reflects our expectations for the fourth quarter and full year 2007.

In today’s 8-K, we are providing updated guidance that reflects the lower percentage of taxes that are classified as current.

After backing out income tax expense, our reported earnings from continued operations for the third quarter totaled $644 million, or $1.43 per diluted share. Earnings from discontinued operations added another $91 million, or $0.20 per diluted share in earnings. In aggregate, after backing out the items that are usually excluded from analyst estimates, our adjusted net earnings for the third quarter were $700 million, or $1.55 per diluted share.

This translates into cash flow before balance sheet changes for the third quarter of $1.8 billion, bringing the total year to $5 billion. We used cash flow to fund third quarter capital expenditures of about $1.6 billion, leaving roughly $200 million of free cash flow for the quarter. We used the majority of this free cash flow to return more than $180 million to shareholders through share repurchases and dividends. We also received $106 million of exchange requests related to our Chevron exchangeable debentures and we chose to retire those obligations with cash rather than to redeem them with the Chevron shares that we hold.

Even with the redemption activity, we concluded the quarter with a healthy cash balance of $1.7 billion and with our net-debt-to-capitalized ratio, or net-debt-to-capitalization ratio under 20%.

Looking forward, we expect cash flow from operations to roughly cover our capital demands. This will leave us with after-tax proceeds from the African divestitures to repay short-term borrowings and to continue to repurchase our stock.

All in all, this was another outstanding quarter for Devon and with that, we’ll open the call up for Q&A.

Vince White

Operator, we’re ready for the first question.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Brian Singer from Goldman Sachs.

Brian Singer - Goldman Sachs

Thank you. Good morning. A question on Canada; if you look at your overall portfolio beyond Canada, what area do you see that has the greatest combination of opportunity and capacity to take capital, should you further reduce drilling in Canada? Or would you look toward the acquisition market in part?

Stephen J. Hadden

We have a, as you mentioned, a very deep portfolio. Mainly where we would look is in the U.S. onshore business. John mentioned that strong 12% growth that we’ve seen happening in that aspect of the business. We would probably redeploy it into areas like we have in the Barnett where we are now drilling 500 wells where we initially estimated we would drill 385 at the beginning of this year.

And we have good opportunities in the Carthage area and some of the east Texas areas, so generally, that give us -- those are some examples of the areas that give us some of that swing. The U.S. onshore is a good opportunity for us.

I will mention that within Canada, we have both a very viable thermal oil business but we also have the Lloydminster area and some very good cold flow heavy oil opportunities that I think you heard earlier in our comments that we’ve been able to grow about 50% year over year.

So within Canada, we can actually -- we have a pretty good portfolio in Canada that allows us to redeploy capital within Canada away from maybe some of the lower returns we may be seeing in the Canadian conventional gas business, and those are very good and solid returns that we get in the Lloyd area.

We can optimize within Canada first and then as we look across our portfolio, we have other areas where we can go to for that near-term growth.

J. Larry Nichols

I might add that within Canada, you need to realize that the royalty rates are different between oil and gas and they are different between different types of gas and different types of oil, and a lot of those are sliding scale type royalties, so it’s a fairly complicated situation that can result in that reallocation within Canada.

Brian Singer - Goldman Sachs

Absolutely. Shifting to the Barnett, based on the strong results that we’ve seen, it would seem like you could reach your 1 bcf a day target a littler earlier than early 2009. Do you feel like you are conservative there? Do you seen any constraints in bringing wells online? Following up on the previous question, what do you think is your capacity to drill in the Barnett in terms of the number of wells per year?

Stephen J. Hadden

You know, Brian, we’re very comfortable where we are now. We are at about 32, 33 rigs in the Barnett and that’s probably an activity level we would feel good at [inaudible]. At that rate, we drill about 500 wells a year and as we look forward, we’re not having -- as a matter of fact, if you looked in the history over this year, our inventory of wells to hook up, for instance, has actually gone down dramatically, [continue] to trend downward. So even at that accelerated rate, because of our very strong midstream presence, the good partnership we have with [CrossTex] and the relationships we have in the field, we’ve been able to operate at this high level of accelerated activity pretty comfortably.

As we look forward to the bcf a day, we’re going to continue to do the right things for value and core [returns] and we’re going to want to really take a close look at that as we go in through our budgeting process, which we’re in right now. Probably have a little clearer picture of when we get that bcf a day sometime maybe in December or January.

J. Larry Nichols

I might add that the bcf a day is of course not the peak rate that we foresee out there. We are working through on our budget for that process. It was merely the target that we picked which at the time seemed pretty aggressive, but we are clearly way ahead of schedule on meeting that and there is additional growth beyond, after that.

Brian Singer - Goldman Sachs

Thank you.

Operator

Our next question comes from Tom Gardner from Simmons & Company.

Tom Gardner - Simmons & Company

Larry, I appreciate your comments concerning the difficulty working your way through the Canadian royalty change.

J. Larry Nichols

We’re having trouble hearing you. Can you speak up?

Tom Gardner - Simmons & Company

Sure, I’m sorry. I believe one of you all’s microphones cut out as well, but with regard to Canada and the royalty change there, at Jackfish, any idea of the long-term implications to thermal SAGD development in Canada? What oil price is required now for economic return there for SAGD or thermal?

John Richels

As you know, forecasting the oil price that we need in order to optimize the returns from the thermal heavy oil project is really difficult because there are many variables. It’s oil price, natural gas price, since we’re burning natural gas to create steam. There’s the differential, which is an important aspect of it. The cost of [inaudible] and the transportation costs and they all move in different directions.

So if you tell me what the oil price is and we can factor in some of those other variables, then we can come up with that. But that varies a lot, so that’s a tough question to answer.

As far as the royalty effect in Canada, I think there’s two things that are important to realize. As Larry pointed out and as Steve did, the royalty effect is variable among different kinds of assets in Canada. When we look at our Jackfish 2 project, our initial view of the legislation or the proposed royalty changes doesn’t change the returns on that project materially.

Had the royalty review panel recommendations been enacted, it would have, but the way it has now been proposed, it doesn’t change it a lot and frankly, the project remains sensitive to capital cost, foreign exchange rate and all of the other things that it previously did.

The good thing about our Jackfish 2 project is we did some things at Jackfish 1 that will create some benefits for Jackfish 2 if we go ahead with it, most notably the access pipeline. So the costs of that access pipeline was really taken into consideration in Jackfish 1 and Jackfish 2 will benefit from it.

So a preliminary look or a preliminary view of it is that that project still looks pretty good and we are still doing all of our engineering and capital analysis of that project and we’ll probably make a decision on that in the middle of next year.

Tom Gardner - Simmons & Company

Just using a normal relationship between oil and gas prices, can you bracket the oil price required for the thermal project?

John Richels

You know, what we’ve used in the past, Tom, is -- it was interesting. When we approved our Jackfish 1 project, when our board took a look at it, oil was $24.50, the differential was $7.50, gas price was roughly $3, and the return was about the same as it was a year ago when we looked at it again and we are kind of doing a look back into the project halfway through the construction of it, and at that time, oil was $63, the differential was $23, and gas was $7 -- had about the same return.

So the relationship that we think is the most important is the relationship between WTI and the Lloyd heavy with a differential about 30% to 33% of WTI. That’s the kind of differential that you need and frankly, we think that given that differentials have historically been in that 30% to 33% range, we think that over the long term, that’s where they’ll settle because either third party processors and refiners will move into that space, or if they don’t, the E&P sector will continue to move into that space to get the differential to that level, at which you can make a real good return on the upgrading side.

Tom Gardner - Simmons & Company

How are the economics then of the thermal different from those who are mining the oil sands in Canada? Would you think that the mining is more cost challenged or less?

John Richels

I’m sorry. I couldn’t hear that, Tom.

Tom Gardner - Simmons & Company

I’ll speak up. There must be some problems with the line here, but just comparing thermal with mining oil sands in Canada, how would the economics compare between the two?

John Richels

Well, they are very different, obviously because they -- I mean, in the mining projects, they’re not burning gas, first of all, and so it’s a fairly -- it’s a completely different equation. Also, all of those mining projects have an upgrader attached and are producing a quality of oil that trades up with or sometimes above WTI, as you know.

Without getting into all of the details, we would take a lot of time on it, they are just very different types of projects.

Tom Gardner - Simmons & Company

One last question, moving over to the Gulf of Mexico regarding the decision on the MMS royalty case. Did Devon agree to the royalty threshold and do you stand to benefit from the recent federal court decision on royalties?

J. Larry Nichols

The federal recent court decision was at the federal district level. It is not a surprising decision at all because if you read the legislation that Congress enacted that provided some royalty relief for the expensive deepwater, there is -- just a plain reading of it shows that there is no real authority for the MMS to do what they tried to do. Therefore, we were not the least bit surprised that Congress, that the federal court dispatched with that case in a fairly short, summary argument. But that’s just a district court. We’ll wait and see what happens, whether it’s appealed and if so what the appellate court rulings are.

I might go back to one -- the comment on heavy oil. Even within steam-assisted gravity drainage projects, there is a wide variety of costs that those projects can incur. They are not all one-cost structure. What we are happy about in Jack is that -- and why we are proceeding on it, is among heavy oil projects, it is a very high quality, low cost project relative to many others.

Tom Gardner - Simmons & Company

Thanks, guys.

Operator

Our next question comes from Gil Yang from Citigroup.

Gil Yang - Citigroup

Good morning. Could you talk, Steve, a little bit about the acceleration in the Barnett? Obviously you said that you are drilling more wells, but is there some -- and obviously you’ve drilled some good wells as well. So how much would you say the acceleration is due to the increased activity level versus the better performance of the wells?

And then, with respect to the better performance, is it not only IPs but are the decline rates doing anything unusually positive for you? Hello?

Operator

Sir, your line is open for your question.

Gil Yang - Citigroup

Can you hear me?

Stephen J. Hadden

Can you hear us, Gil?

Gil Yang - Citigroup

No, I can’t hear you -- I can barely hear you. I can hear you a little bit.

Stephen J. Hadden

Can you hear us now?

Gil Yang - Citigroup

A little bit.

Stephen J. Hadden

Back on the question on the Barnett Shale, it’s actually both things driving the acceleration of our activity. If you remember, back in about a year, year-and-a-half ago, we were running a lot of seismic, getting some good processing, and really going about better characterizing the non-core area so we could get good, solid repeatable results with our wells.

We’ve also had some process improvements on the drilling side that allowed us to reduce our drilling days, so we actually get more wells per rig. And we are getting better results. That’s partly driven by those factors.

So as we’ve built up our confidence in really being able to deliver a repeatable and improved results on average, we continue to accelerate the program.

An aspect of the drilling activity that we have is the 20-acre in-fill. Now, those 20-acre in-fill wells, I think we started off at about -- estimating about 1.7 bcf per well. When we initially talked about the 20 acres and we were in the pilot stage, I think you saw now we are about 2.1 bcf per well with the larger program that we are drilling.

Again, those are areas where we can even go back into the core and drill those types of wells. So we are seeing improved performance, part of it is reservoir characterization, part of it is the drilling efficiency that we are gaining, and part of it is the integration of that reservoir characterization with our completions.

So those factors are all driving the ramp-up that we have from about the 385 wells to the 500 well activity level.

Gil Yang - Citigroup

Okay, thanks, that’s helpful. Have you seen any change in decline rates?

Stephen J. Hadden

No, not materially. We are still looking at about the same exponents. Of course, we continue to monitor performance and that’s how we make our reserve estimates and we are pretty happy and comfortable where we are right now with those decline rates that we have.

Gil Yang - Citigroup

Could I just ask the same question for Merganser? What is the -- those wells are outperforming. Is it just greater permeability? Are the reservoirs larger than you thought? What’s going on there?

Stephen J. Hadden

I think, as you probably know, Gil, when we drill these wells, we get a lot of static information. In other words, we can look at core information. We can look at log information and of course, our engineering and geologic teams make estimates of what we think those wells can flow and it’s basically on a risk basis. To actually see how the well will perform, some of these larger intervals will perform under dynamic flow. You actually have to flow the wells, so we are simply -- I think we are simply just seeing better performance as it relates to our risk estimate of what the permeability and the contribution of the well would be.

Gil Yang - Citigroup

Do you have any indication yet that the reservoirs, that there’s no concern that they are compartmentalized in any fashion?

Stephen J. Hadden

It’s still too early to really make any other definitive conclusions on that, since it’s still early in the production life. We haven’t seen anything negative to date.

Gil Yang - Citigroup

Thank you.

Operator

Our next question comes from Ross Payne from Wachovia Capital Markets.

Joe Hofer - Wachovia Capital Markets

Hello? Can you hear me? This is Joe Hofer for Ross Payne. I was just following up on the Barnett Shale, just looking at -- what is the average well life you have there? And as you look to potentially deploy additional cash flow to the area, how would you characterize the cost environment that you are facing in the region?

Stephen J. Hadden

Let me take the first issue first. As we look at the life of these wells, these are wells that they initially come on and have a pretty good decline rate initially. Then they go what we call exponential, so they begin to flatten out in their production profile. Some of these wells, you can estimate them to produce for as long as 40 years, so the well lives are very -- can be very, very long.

If you look in terms of our cost environment, we are actually -- we have actually seen the cost of our wells on a year-over-year basis remain flat. Now that’s driven by the drilling efficiencies that we’ve been able to gain and partly by some of the softening in the acceleration of cost escalations that we had seen starting in about early 2005 and through 2006.

From a cost standpoint, we are very comfortable in the environment that we are in. The average well is going to be around $2.7 million to about $3 million a well, and we are getting about 2.5 bcf on average out of each well.

Joe Hofer - Wachovia Capital Markets

Thank you.

Operator

Our next question comes from Mark Gilman from Benchmark.

Mark Gilman - The Benchmark Group

Good morning. Can you hear me? A couple of things, Steve, if you wouldn’t mind. First, I think when you were discussing Chuck, you talked about a side track hole having run into mechanical problems. What about the original hole?

Stephen J. Hadden

Actually, Mark, that was on the Cortex Bank well, the well we were drilling in the Kaskida unit.

Mark Gilman - The Benchmark Group

I’m sorry, Steve.

Stephen J. Hadden

We were in the process of side-tracking to gain some more reservoir information. The initial well we drilled to its total depth and we are in the process of looking at that information and working through that information.

The side track that we had was a distance away from the original hole. We were trying to get some more reservoir information but we didn’t reach the objective and are disappointed with that, but we are still very excited about the Kaskida unit.

Mark Gilman - The Benchmark Group

Okay, with respect, Steve, to Cascade, do you have any numbers in terms of development cost, reserve numbers, and estimated production?

Stephen J. Hadden

No, I don’t think we’ve put that out yet.

Mark Gilman - The Benchmark Group

Okay, Polvo, it looks as if, just on a pro rata basis, that the performance of the first three wells doesn’t necessarily get you to what the plateau estimate was. Is that evaluation premature?

Stephen J. Hadden

We think it’s premature to draw that conclusion. On the first initial wells, we are drilling in the [macha a] carbonites and those carbonites can be a little bit tricky over time and you can have some variability.

We are still very early in the drilling program. We have seven more wells to drill and we are still sticking by about that 50,000 barrels a day. If that changes once we get a few more wells under our belt, we’ll let people know.

Mark Gilman - The Benchmark Group

Okay, and finally with respect to Carthage, if I recall correctly, last conference call you were talking about actually pulling back a little bit in terms of the drilling program, as you better assessed horizontal performance. Now you are moving the rig count back up to 13. What’s really changed?

Stephen J. Hadden

Mark, actually in east Texas, the area where we were having problems was looking at the Groesbeck area and we were having some mechanical problems in getting into the full extent of the horizontal section and making sure that we had the completions going off and getting the number of stages of fracs that we wanted to have in the horizontal sections.

We’ve had a very good effort with a team of people working on that. We actually have had some pretty good results. We brought one well on in the Groesbeck area, came on about 17 million cubic feet a day in the [Nantsugill] Field. So you can probably see us begin to ramp that back up as we move into 2008.

On Carthage, that’s been working very well. We have not had any of the mechanical problems and we are continuing to run three horizontal rig lines as we continue to move forward with that horizontal program.

Mark Gilman - The Benchmark Group

Okay, Steve, thanks a lot.

Vince White

Operator, we’ll take one more question and then terminate the call.

Operator

Thank you. Our last question comes from David Heikkinen from Tudor, Pickering.

David Heikkinen - Tudor, Pickering & Co.

Just a follow-up; volume lifted at Polvo in October?

Stephen J. Hadden

The number was 385,000 barrels.

David Heikkinen - Tudor, Pickering & Co.

And then a schedule for liftings from here forward?

Stephen J. Hadden

Right now, we have another scheduled in December.

David Heikkinen - Tudor, Pickering & Co.

Okay, and then just a reminder on the production sharing contract at ACG, volumes versus oil price and how that works, looking forward at today’s oil prices?

Stephen J. Hadden

It’s a pretty complex PSC but the bottom line is as the oil prices get higher, we are going to have less cost oil coming to the contractor, and as we reach different payout tranches, as we reach different return tranches, we could have a -- we will have a drop in our nets, so it’s affected by oil price both on the net that we take and the cost oil that we recover as prices go higher.

Vince White

If I remember correctly, this is just kind of a broad brush recap, we’ll go through two tranche reductions in the next nine months or so that will reduce our net take to about half of the current level, and then we really expect flat production for a long time thereafter.

David Heikkinen - Tudor, Pickering & Co.

That’s perfect, Vince. Thank you.

Vince White

Okay, just a quick recap of the quarter; it was an excellent quarter again. Operationally we delivered growth from our core development projects, we continue to see very promising results from our long-term exploration program. Our organic production growth of 10% over last year’s third quarter positions us to raise our 2007 production forecast, which of course will in turn lead to higher growth over 2007 over 2006. All of this leads to increases in revenues and earnings and cash flow. Divestiture program moving forward, and we expect to be positioned to fully fund our capital needs, repay debt, and repurchase stock in the year ahead.

In summary, we are very happy with our continued high level performance and think we are very well-positioned for the future. Thanks and we’ll talk to you again in February. Take care.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Devon Energy Q3 2007 Earnings Call Transcript
This Transcript
All Transcripts