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Devon Energy (DVN) was recently downgraded by Barclays Capital from overweight to equal weight, placing it on the same footing (at least in Barclays' view) as smaller competitor SandRidge Energy (SD). This follows a downgrade from Wells Fargo analysts, who lowered Devon from outperform to market perform in late May.

One reason for Devon's lowered outlook is continuing bad news about natural gas prices. Although many producers are cutting back on production, inventory levels are still rising, although overall demand remains weak. Currently, storage capacity is about 75% utilized, a level usually not seen until late August. This indicates another hard winter for Devon, since the company still counts natural gas and liquid natural gas (LNG) as two thirds of its production. Fortunately, its diversification into oil will help offset these lowered revenues.

Boosted By Oil

While it has positions in many leading plays, Devon is also taking a contrarian approach to shale energy extraction, diversifying its focus into plays that are more difficult to reach, unproved, or previously extracted. One example is its work on the Tuscaloosa Marine Shale, where a test well in Louisiana is producing 384 barrels of oil per day, the best results for Devon so far. However, its competitors are doing better. Goodrich Petroleum (GDP) announced completion on a Tuscaloosa Marine target in Mississippi, where the shale is not as thick, in May that produced 1,082 boepd. According to research done by Louisiana State University, the Tuscaloosa Marine could hold potential reserves of 7 billion barrels of oil, so I think if anything is surprising about these wells it's that more producers are not pursuing similar tests.

This is also a different approach for Devon because the Tuscaloosa Marine is primarily oil producing. Devon began making moves towards liquids earlier than many in the industry; in point of fact, its big moves occurred in tandem with competitor EOG Resources (EOG).

What EOG CEO Mark Papa focusing "reading the tea leaves" others call visionary, since EOG was one of the first oil and gas independents to foresee the oversupply of natural gas due to the shale rush and take steps to diversify into oil. Papa is estimating that oil shales could add another 1.5 million barrels of oil a day to U.S. production within the next three years, from which EOG and Devon will both benefit. That number might even edge higher, since now that it can claim success in navigating the change, EOG is focusing on new technologies and drilling methods to assist it in producing more oil from its plays than is possible with current methods. Devon is showing interest in doing the same, and although EOG can claim more success in making the switch to liquids, Devon is well positioned to remain diversified while still enjoying a revenue boost from shale oil.

Devon is also setting its sights on the Mississippian Lime, where most of the activity is centered on the border between Kansas and Oklahoma. Competitor SandRidge is extending its focus area much further north, as far as Sherman and Thomas Counties in Kansas, where virtually no wells are completed; though most of Devon's 153,000 net acres are in the state line area, I would not rule out the possibility of Devon following SandRidge north.

One challenge in this underexplored area is a lack of infrastructure, similar to the infrastructure issues producers are facing further north in the Williston Basin. However, Devon claims more experience in dealing with such challenges than many of its competitors, and if its plans continue to go well I would expect it to be on the forefront of extending the Mississippian Lime's activity range. Already the company plans to drill or participate in 50 wells by the end of this year, at relatively shallow depths (6,500 feet or less). Apache (APA) is joining it here, and though the two companies are longtime competitors Devon might welcome the spur to infrastructure development that other large companies can bring.

Bad Publicity in Texas

Since Devon is typically not in the media spotlight for publicity mistakes, it's surprising to find that the company chalked up two blunders in the last month. First, a rare spill for the safety oriented Devon has some Texans scratching their heads. The spill, of production water which apparently leaked from a newly laid pipe, was discovered in late June by an activist group during a flyover of a non-production area on Devon's acreage in Odessa, Texas. According to Media Relations Manager Chip Minty, Devon is taking it "very seriously…we have to work hard to mitigate it and address the clean up and remediation of the area." About 200 barrels of spilled production water were removed from the site, and Devon is working with Texas regulators to identify the spill's cause.

Texans were further annoyed with Devon when a change in its accounting system allegedly delayed royalty payments in the Fort Worth area, which played like a comedy of errors. Usually such payments are done through direct deposit, but the accounting change resulted in checks being printed; some who were owed royalties were then told that the printing was delayed, all without notice to the landowners. Hopefully these two news items are a blip and not the start of a trend that could erode Devon's exceptional public image, which I think helps support the stock.

Outlook

Devon is currently trading around $56 per share, with a price to book of 1.0 and a forward price to earnings of 7.6. While these are attractive value metrics, taken together with Devon's other statistics Devon begins to look cheap indeed. To begin with, Devon is a dividend payer, with a yield currently standing at 1.4%.

Its dividend is affordable because Devon spends comparatively little servicing its debt, with a debt to equity ratio of 0.3 compared to an industry average of 1.1. Though its revenue growth is negative, at -6.2%, the entire industry is seeing the impact of a depressed pricing environment; with a net margin of 39.7%, more than twice the industry average margin of 14.9%, Devon's growth will return once prices return to stable levels.

Third Avenue Value Fund, founded by Marty Whitman and now led by Ian Lapey, believes in Devon's future. The fund recently initiated a position in Devon for 518,149 shares. Looking at its solid balance sheet, asset base, and future plans, I also think Devon is an excellent deal for value investors.

Source: Why Devon Is A Value Buy Now