Profit From Devon's Aggressive Growth Now

Jun.18.12 | About: Devon Energy (DVN)

Devon Energy (NYSE:DVN) is having a very good year. Its shareholders agree, passing all of the company-sponsored proposals at Devon's annual meeting in a sweeping show of support for Devon and its leadership. Analysts are also paying close attention to Devon, as EquityLeader introduced research coverage of Devon on June 11. Devon has a foothold in most of the big U.S. plays, including the Mississippian, the Utica, the Permian, and the Barnett, as well as oil sands and liquid natural gas developments in Canada. Right now, its U.S. focus appears to be on the Utica and the Cline, both of which have the potential to fuel Devon's stock to new highs.

Though there is some debate over whether the Cline Shale is actually its own play or merely an extension of the Wolfcamp, Devon is looking heavily at this level for production (and for the record, counts the Cline as part of the Permian). Devon estimates that each well drilled into the oil and liquid gas rich Cline formation could produce 570,000 boe, with flow rates up to 600 boe per day in the first month, at a cost of $6.5 million per well. Chairman and CEO Randy Foutch of competitor Laredo Petroleum Holdings (NYSE:LPI) calls the Cline "world class", and is preparing to drill the Cline after analysis of its most recent 3D survey. Devon is further ahead of Laredo, as it already has 500,000 net acres over the Cline, on which it plans to drill 15 wells this year.

Action in Ohio on the Utica Shale

After a period of boom, Ohio residents and regulators are beginning to push back against hydraulic fracturing through litigation and regulation. Ohio Governor John Kasich signed legislation enacting new drilling rules for Ohio operators on June 11. The new rules include mandatory disclosure of chemicals used in fracking operations and reporting of water usage and sources.

The new law is somewhat of a win for shale operators, since the proposal to raise severance taxes on high-producing wells was left out of the bill. I think in the short-term, this should help mitigate the higher costs energy companies will now face in complying with the new rules. However, Governor Kasich is not giving up on the tax hike increase, which remains on the table for future legislation. Tom Stewart, Executive Vice President of the Ohio Oil and Gas Association, recently pointed out that the proposed tax changes would introduce "problems regarding equal treatment under the law" by "singling out by formations, or certain sized businesses." This would be a particular burden on Devon, which owns leasehold on some of the highest producing areas and has several successful wells already producing.

Just before the new rules were signed into law, Chesapeake (NYSE:CHK) announced that it is looking for a buyer for 337,481 acres across nineteen Ohio counties. Even if it sells all of this acreage, Chesapeake will still be the largest leaseholder on the Utica, but this move to divest even more of its core assets than previously announced indicates that players could force Chesapeake into a bargain. This includes Devon, which has the capital and resources to turn Chesapeake's acreage to account. The deal is attractive, since the acreage is not scattered, but occurs in two largely contiguous bands. The northeastern band occurs close to where Devon is currently operating a joint venture with Sinopec.

According to Meagher Energy Advisors, the firm marketing the sale on behalf of Chesapeake, most of the acreage is in the wet gas or oil window, and ranges from thicknesses from 100 to 300 feet. The depths are between 2,000 and 7,000 feet, which is close to Devon's current target between 3,000 and 6,000 feet. These factors would make this an attractive deal for Devon, though the Prospectus for the offering admits that the acreage is "high prospective", and previous drilling on five non-operated wells revealed "minimal production volumes". With a bid date of July 11 and a closing date of August 17, Chesapeake is looking to push this deal through much more quickly than previous offerings, meaning that interested operators do not have much time to review a move here. This limits action to firms with cash on hand, but with $5.8 million in cash and cash equivalents as of the end of the first quarter, this does not exclude Devon.

BP (NYSE:BP) recently entered the Utica, purchasing 84,000 acres in northeast Ohio at the end of March. 84,000 acres is not much, especially for a company of BP's size, and to me it appears that this small deal is just an entry point for the supermajor. I think it is very likely that BP will also make a bid on Chesapeake's offer, and since BP needs to build its acreage in order to make an impact on the play and has a considerable amount of cash on hand despite its pending lawsuits, BP could well outbid Devon.

Outlook

Devon is currently trading near 52-week lows, around $57, with a price to book of 1.0 and a forward price to earnings of 8.4. These are very attractive ratios for Devon, especially compared to other energy independents. Anadarko (NYSE:APC) is currently trading around $64, with a price to book of 1.6 and a forward price to earnings of 12.1. Meanwhile, Apache (NYSE:APA) is trading around $84, with a price to book of 1.1 and a forward price to earnings of 6.2.

Devon is not done growing yet. At the company's annual meeting, CEO John Richels told shareholders that Devon is still in:

a period of reorganization…I think we're going to see very good results in the future that will bear all of our efforts out.

I think Richels is on target here, since even through its reorganization, Devon is maintaining attractive operating margins (36.6%, compared to an industry average of 24.9%) and leading net margins (39.7%, compared to an industry average of 13.1%), without accumulating more than a token amount of debt. At current levels, Devon is a very strong buy for this sector.

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