Devon: A Hidden Gem In A Bad Sector

| About: Devon Energy (DVN)

Last week's capital markets were unkind to energy stocks. The per barrel price of oil decreased by more than 17% to below $83.23 per barrel for West Texas Intermediate crude, a 15% decrease to and natural gas dropped 3.4% to $2.34 per 1,000 cubic feet. Last week there were price decreases across the board in major oil producers, Exxon Mobil (NYSE:XOM), Anadarko Petroleum (NYSE:APC), Chesapeake Energy (NYSE:CHK), Encana (NYSE:ECA), Chevron (NYSE:CVX) and Conoco Phillips (NYSE:COP). Energy producers are now in a state of flux, either waiting for oil prices to stabilize at higher levels, or waiting for natural gas prices to pick up.

Meanwhile, Devon Energy's (NYSE:DVN) first quarter 2012 results showed net earnings of $393 million or $0.97 per share compared with $416 million or $0.97 per share from the same period in the previous year. Earnings were as a result of the wide Canadian oil differentials from U.S. West Texas Intermediate and Brent crude. The differential between WTI and Edmonton Par or Western Canada Select crude is in the range of $18. The differential between Edmonton Par and Brent crude is $16. The Canadian Oil Sands crude has been trading at this discount because of the increased production in the Oil Sands and the continued state of flux over pipeline constraints.

Production of oil, natural gas and natural gas liquids showed the highest daily production rates in Devon's onshore North American properties in the first quarter 2012. The 694,000 barrels of oil equivalent (NYSE:BOE) per day was increase was a 10% increase from the same period last year. There was a 3% increase in the sale of oil, natural gas and natural gas liquids from the same quarter last year. Marketing and midstream operating profit was down 7% from the same period in 2011 which is attributed to lower natural gas and natural gas liquids prices.

Two thirds of Devon's recent output is natural gas, prices of which are at a decade low. The company increased operating and property activity in its Permian basin properties and now has a 500,000 net acre position and 21 rigs operating in the Basin. Rising oil fields services and supply costs were partially mitigated through cost containment measures.

Devon had concentrated its drilling activities on shore after liquidating it offshore assets. It has sold its offshore assets in the Gulf of Mexico to Apache (NYSE:APA). Devon received over $7 billion in proceeds from this sale. Part of the proceeds from the sale of those assets was used to re-purchase over 10% of its outstanding shares and to pay down debt. It has approximately $7 billion to make acquisitions. Proceeds from the sale of its offshore assets have not been repatriated to the U.S. to avoid taxation. The company is likely waiting for a repatriation holiday to see what it will do with that cash.

Devon has cashed up in the U.S. by selling a partial interest in 1.4 million acres new exploration areas in Tuscaloosa Marine Shale, Niobrara Mississippian, Ohio Utica Shale and the Michigan Basin to China Petroleum and Chemical/Sinopec (NYSE:SNP). This sale will allow China Petroleum/Sinopec to have access to more North American oil without upsetting U.S. regulators. Devon received $900 million up front and expects an additional $1.6 billion which will cover as much as 70% of its exploration expenditures in these areas. Devon remains as an operator on these properties selling only a 33% share.

Devon is concentrating its efforts on drilling for oil and natural gas liquids in North America mainly the Canadian Oil Sands and the Permian Basin in the U.S. Companies in the same area as Devon in the Permian are Energen (NYSE:EGN), Pioneer Natural Resources (NYSE:PXD), Berry Petroleum (BRY) and Gulfport Energy (GPDR). All of these operators are buy rated companies. The implied value to the acreage could increase the value of Devon's shares. This activity will improve Devon's output of oil by 19% and natural gas liquids by 13%. Devon gets an excess of 35% of its cash flow from the Canadian oil sands and from pipeline assets used to transport oil and gas. Devon's concentration on North America and its joint venture activity is allowing it to expand and expedite it activities while keeping a lid on expenses.

Friday, June 1st saw disappointing job growth in the U.S. and heightened the sense that there is a lot of worry about the pace of global economic growth. The unemployment figures added one tenth of one percent gain to 8.2% which is the first increase in almost a year. Oil prices have dropped to the lowest since October 2011 in the last week.

The decline is due to slower than expected economic recovery and the recent strength in the U.S. dollar relative to the Euro. It is believed by some that the current price levels will serve as the low point for prices during the second half of the year into 2013. The U.S. Energy Association is predicting average of $104 per barrel for the duration of the year with refinery costs being $110. The projected cost of refining is up $8 per barrel from 2011, the projected price per barrel is down $2 from 2011.

U.S. crude inventories are above the five year average range with the slowdown in world demand, indicating that crude oil supply still outpaces demand. In the alternative, gasoline inventories have fallen below the five year average levels, sending upward pressure to prices at the pump. Production issued related to up-graders and unforeseen repairs at plants in the Oil Sands were partially responsible for the price Canadian Oil Sands differentials in February and March. The price discount returned to normal in April 2012.

Increased production of natural gas and higher crude oil stocks and fewer imports will keep prices the same or a bit better going forward. There is still some hope that demand for personal use vehicles, the need to enhance methods of public transportation and the need for heavy equipment needed to fuel growth in emerging markets will be responsible for keeping oil prices out of the basement. The stagnant economy is keeping price hikes in check.

Devon has some valuable natural gas assets onshore and is managing its oil, natural gas and natural gas liquids business well. The company is achieving the same per share earnings on lower revenues than in the previous year. Despite Devon's cost cutting measures, asset sales, share buyback program and its distribution of dividends, it is evident that even well managed energy companies that do everything right to add value to shareholders face a lot of difficulty in today's markets.

The market is demonstrating that energy stocks are extremely vulnerable to any bad economic news either domestically and abroad. Devon is trading near its year low. It is possible that if oil and natural gas prices do not recover soon, Devon's book value will be impacted and a break through the bottom end of the 52 week price is likely. Devon is a great company, it is just in a bad market sector for investors who don't have any tolerance for volatility.

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