There are three kinds of oil companies. Upstream finders and drillers of oil, downstream refiners and sellers of products, and integrated oil companies that handle all aspects of the system. Today, I am going to look at how the lower prices are impacting Devon Energy (DVN), an upstream producer, and one of the companies most vulnerable to oil and gas price declines. Of course, complicating the oil price declines for Devon is the fact that it is also exposed to natural gas prices, which, after falling to as low as about $1.90 per mmBTU, have risen to about $2.70 on the strength of increasing use, along with decreased domestic production.
Devon is among the largest American based oil and gas producing companies. Its big news so far this year was its January sale of a one third stake in five oil and gas projects to Sinopec (SNP). The structure of the deal was brilliant, requiring an upfront, $900 million cash payment, plus Sinopec will pay 70% of the capital costs on the five projects, up to an additional $1.6 billion. Sinopec overpaid for the deal, and we can think of that as "tuition." China has vast shale formations, and the Chinese want to learn from American experts how it is done. Devon can drill with very limited risk or leverage.
Devon presented at the Citi Global Energy Conference on June 7th. It was far from the best investor presentation I have read, but the overall impression is that Devon's management knows what it is doing. Its five year plan is to take a company that in the first quarter of 2012 had dry natural gas equal 63% of its overall production down to about 48% by 2017. In terms of numbers, Devon plans to obtain primarily from the Permian Basin and Canadian Tar Sands about 23% more oil, and 12% more liquefied gas in 2012 than in 2011. It expects a modest decline in dry gas results. But the price of that dry gas after rising some 40% from its low already this year, it might be that Devon is retreating from dry gas prematurely. The percentage of domestic electricity that comes from coal has been falling steadily for years, and this year, at about 40%, will be at its lowest level in over 60 years.
Coal is expected to supply about 30% of our electricity production by the end of this decade. Natural gas, which is not just cheaper, but also far cleaner burning than coal, along with wind, solar, and a new generation of nuclear, will form much of America's electrical needs going forward. Of course, the company expects Texas sweet crude to average $105 per barrel this year out through next year, and I doubt that part of the company's equation will come to fruition.
Devon's stock price has fallen nearly 30% since mid-April, and now trades at its lowest level since recessionary 2009. I think investors are undervaluing the stock primarily because of oil and natural gas price fluctuations. Analysts have earnings at about $4.70 per share this year. First quarter earnings of $1.05 per share missed by a wide margin the $1.43 that had been estimated. Analysts are now estimating $1.01 for the second quarter, but with the recent relative strength of gas prices, I see Devon beating that modest target.
Devon has over $7 billion cash on hand, and an investment grade bond rating. I see its stock being a solid investment choice, probably my favorite such choice among independent producing companies. Its stock won't really rise until either gas prices, oil prices, or both rise, but by then it would likely be far too late to cash in on today's bargain price for this company. No other independent producing company has Devon's financial strength. Apache (APA), otherwise a fine company battered by low commodity costs, has $245 million of cash on hand. EOG Resources (EOG) has $294 million, and Chesapeake (CHK), a disaster in most every way, has $438 million of cash. In addition to Apache's balance sheet issue, it also runs at a profit margin roughly half of Devon's 44%. Otherwise, the numbers for these two producing companies are very similar. Devon wins largely because of that cash hoard. Chesapeake, which I will write about separately, has substantial management and legal issues. I really cannot overstate the advantage of having $7 billion in cash in this environment. As oil and gas prices remain low, more and more properties are likely to become available. No company of similar size has the financial flexibility of Devon.
Integrated oils, such as Chevron (CVX) and Exxon Mobil (XOM) have an advantage in a low price environment, as they control all aspects of pricing. Their large chemical businesses have not been profitable these past few quarters, and the current low commodity cost environment will aid those operations immensely. I will be checking on those companies when they release second quarter earnings.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.