Devon's 2 Major Plays Will Shoot Stock Higher In 2013

| About: Devon Energy (DVN)

In early May, Devon Energy (NYSE:DVN) became one of few energy companies to miss analyst expectations this earnings season, reporting $1.05 earnings per share in the first quarter. Analysts expected to see earnings per share of $1.44. Devon attributed much of the impact on "unusually wide Canadian oil price differentials"-- presumably against the WTI Cushing, Oklahoma cash price-- and pointed out that prices were normalizing as of the end of the quarter.

Based on the lower than expected first quarter results, Devon CFO Jeff Agosta indicated that shareholders could expect profits in the next quarter to arrive $50 million below previous guidance, though he also pointed out that the company expects to meet its goal of raising liquid hydrocarbon output to 40% of the company's total output. This is inline with moves by other companies, including Anadarko (NYSE:APC) and Cabot Oil & Gas (NYSE:COG), moving to diversify into liquids based on weak gas prices stateside. Though Devon's output is not currently 40% in liquid hydrocarbons, its total proved reserves are-- with 1.26 bboe of its reserves in liquids-- so I expect it to be able to meet its target.

Strong Margins on Strong Unconventional Plays

Devon's unexpected earnings results are more a product of the current pricing environment than a reflection of Devon's operations. At last report, Devon had a unit cash margin of 177% per barrel, excluding hedges. Shortly after its earnings report, Devon CEO John Richels indicated that Devon is open to developing joint partnerships to share the risks of development. Given its strong history of successful joint ventures and healthy balance sheet, I don't believe that Devon will have a problem acquiring partners where needed.

Devon's recent joint venture with Sinopec Shanghai Petrochemical (NYSE:SHI) netted it significant acreage in five different plays, including the Mississippian in Texas, the Rockies Oil shale in Colorado and Wyoming, the Utica in Ohio and Michigan, and the Tuscaloosa marine shale on the border of Louisiana and Mississippi. Devon expects to drill or participate in 125 wells through 2012 as a result of the joint venture. In addition to this, Devon is beginning exploration activities on the Cline shale in the Permian basin, with 500,000 acres closed and committed and plans to drill 15 wells in 2012.

Out of these plays, I think the Utica and the Permian represent the best opportunities for Devon. Competitor Chesapeake Energy (NYSE:CHK) recently announced that its 1.25 million net acres on the Utica could represent $15 to $20 billion of reserves to the company at today's prices based on previously unsuspected liquids-rich formations in the areas of the shale underlying Ohio. Though Devon's leases here have a considerably smaller net acreage, at 157,000 acres (235,000 including Sinopec's interest), there is still the potential for Devon to expand the play. Even if it does not, Devon has a good position with these acres, located as they are above the Utica-Point Pleasant play.

The Ohio Department of National Resources Division of Geological Survey is not hesitating to encourage energy companies to invest in Ohio's natural resources. The ODNR indicates that fracking could be very effective in areas near the Point Pleasant play, and that the area of the play extending to the northwest shows signs of being oil rich. This western part of the play is where Devon is setting up, in an area that roughly overlaps explorations by Royal Dutch Shell (NYSE:RDS.A), Chesapeake, and Anadarko. Occidental Petroleum (NYSE:OXY) is also exploring the Utica, though further east, with 229,000 acres in West Virginia above the Marcellus and Utica shales.

The ODNR's most recent data map indicates that Devon already has three permitted wells and one drilling well in its Ohioan acreage. The heavy presence of mid- and large-cap energy players in this area speaks to the promise of these plays, and the companies' belief that the ODNR is not exaggerating the potential, and point to the likelihood of Devon further increasing its activities in this area.

The second area of focus for Devon, the Cline shale in the Permian basin, could produce 3.6 mboe for Devon according to its estimates. Devon is seeking a partner for this play to share in development costs and provide cash up front. In this play Devon is competing against Laredo Petroleum Holdings (NYSE:LPI), which focuses primarily on this area, as well as Range Resources (NYSE:RRC), and Pioneer Natural Resources (NYSE:PXD). In its first quarter earnings report Devon announced a 32% increase in oil production from the Permian over the first quarter of 2011.


According to the U.S. Energy Information Administration, inventories of natural gas have increased 56% over the past twelve months, indicating a severe oversupply. Devon is moving to protect itself from these low prices, which look to be headed even lower, but it might not be moving fast enough. In order to prevent a complete glut, energy companies are actively shutting down wells but production remains near record highs. This is a boon to consumers but could be a disaster in the making for energy stocks.

After its disappointing earnings, Devon is trading 3% lower around $68 per share, with a forward price to earnings of 9.4 and a price to book of 1.3. Anadarko is also trading down at $73 per share, albeit keeping a high forward price to earnings of 14.2 and a price to book of 1.8. Occidental is trading around $93 with a forward price to earnings of 9.8 and a price to book of 2.0. Chesapeake is currently trading around $17 with a forward price to earnings of 6.2 and a price to book of 0.8. Range Resources is trading around $65 with an astronomical forward price to earnings of 42.5 and a price to book of 4.4 on above average volumes, indicating Range Resources is currently oversold.

Devon's strong dividend may help offset shareholder disappointment over the latest earnings report, as it currently stands at 1.1%, an 800% increase since 2004, though still tracking below the industry average of 1.5%. I think that Devon is conservatively risking its unconventional plays, and these could contribute revenues far above expectations when the plays are brought into production and U.S. gas prices stabilize closer to normal levels.

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