Seeking Alpha
Long only, deep value, registered investment advisor, portfolio strategy
Profile| Send Message| ()  

Few industries have faced greater upheaval over the last 5 years than the natural gas industry due to the development of "fracking," which elevated inventories 30% higher than the 5 year average. This additional supply has caused natural gas prices to drop well below $3 per MMBtu. Negative pricing pressure has created a situation where once viable projects must be shelved, and most exploration and production (E&P) companies are reducing their drilling plans to focus on "liquid rich" plays, to take advantage of the much better relative pricing of crude oil and other liquids that these wells produce. Devon Energy (DVN) is one of the largest independent E&P companies in North America. The company's strong balance sheet, prudent capital allocation, and exceptional growth profile should allow it to be a consolidator in the depressed energy sector. At around $57 a share, the stock offers a very compelling value.

Oklahoma City-based Devon made a radical decision several years ago to focus its drilling efforts on onshore U.S. and Canadian projects. To accomplish this, Devon divested nearly $10 billion in deepwater and international assets. This decision put the company in a position to reduce debt and buy back its own stock, which is in stark contrast to many other E&P companies, such as Chesapeake Energy (CHK). Chesapeake leveraged itself to the extreme, forcing unattractive financing deals at inopportune times. As of May 2, 2012, Devon was sitting on $7 billion of cash and short-term investments, and the company boasts a net debt to capital ratio of only 11%. Since 2003, Devon has reduced its net debt by greater than $4 billion, and since 2004, the company has reduced the share count by 20%, while increasing dividends by 26% per year on average. This shareholder-friendly capital allocation not only rewarded the owners, but it also kept the company from overpaying for resource plays simply for the sake of expansion. Devon should be able to fund its expanded drilling plans through operating cash flows, reducing the company's reliance on buoyant capital markets.

As of Q1 2012, Devon's production mix was 21% oil, 16% natural gas liquids, and 63% natural gas. The company believes that by 2016, the mix will be 32% oil, 20% natural gas liquids, and 48% natural gas. This heavy exposure to natural gas is worrisome, but the benefit of lower prices is that many operators are forced to cut production, which will eventually reduce supply and prices should slowly recover. Natural gas is a primary element to the United States' shift towards energy independence, and I'd expect to see increasing investments in developing the infrastructure for its use in vehicles, and as a source of fuel for utilities. Many of the highly leveraged E&P companies that have a focus in natural gas are likely to be consolidated by the stronger players like Devon.

Devon's MMBOE production growth has been and should continue to be explosive. From 2006-2011, the company has grown production by a compound annual growth rate of 7%. For the next five years, Devon expects a production CAGR of 19% in oil, 13% in liquids, and 1% in natural gas. Production is projected to increase from 240 million barrels of oil equivalent in 2011, to 340 million by 2016. The firm has large positions in the Barnett and Cana-Woodford Shales, Permian Basin, Rocky Mountains, and both conventional and oil sands projects in Canada. Additionally, 100% of the company's capital allocation for 2012 is dedicated to developing oil and liquids rich projects primarily in the Cana-Woodford, Permian, and oil sands properties. Due to lower natural gas prices, Devon is reducing its drilling plans in its natural gas heavy positions in the Barnett Shale, the Carthage region of eastern Texas, and the Horn River Basin. Devon's portfolio is low-cost relative to more aggressive deepwater operations, and it isn't as susceptible to regulatory risks that have dramatically slowed down production in areas such as the Gulf of Mexico. The company owns 13 million net acres and still has about two thirds to develop in the future, so it is very likely that its best days are ahead.

Devon has proven reserves of 3 billion BOE and 16.2 billion BOE of risked resources, consisting of 4.7 BBOE of oil, 3.1 BBOE of natural gas liquids, and 8.4bboe of natural gas. In Q1 2012, production rose to 694 MBOED, which is the highest daily production rate in the company's history from its onshore properties, and it represents a 10% increase from last year's first quarter. The company earned $416 million, or $0.97 a share in the quarter. In 2011, Devon's cash margin per BOE was $22.73 and earnings over the last twelve months have been $5.87 per share.

At $57.12, Devon has a market cap of $22.9 billion and an enterprise value of $26.8 billion. With an EV/EBITDA of 4.36, Devon is not getting any credit for its outstanding growth prospects and rock solid balance sheet. While earnings in 2012 are likely to be depressed at $4.50 per share due to extremely low natural gas prices, the company boasts a P/E on trough earnings of only 12.69. Within three years, I believe that Devon has in excess $10 of earnings power as growth projects accelerate and natural gas prices stabilize. Even if prices remain depressed, Devon's downside is limited by the fact that, at current prices investors can buy the company for $9.30 per BOE. To put this in perspective, when Devon exited its Gulf of Mexico and international projects in 2009 and 2010, the company realized about $45 per BOE of proved reserves. I believe Devon should trade at about 7 times EBITDA, which would value the company around $91.70 per share. For investors worried about prices over the short term, it may make sense to look at selling the January 13 $65 calls for about $1.90, which would provide a cash flow yield of 3.3% in addition to the 1.38% dividend, while allowing ample room for upside.

Source: Devon Energy: A Perfect Contrarian E&P Play