Update - Devon Energy: A Perfect Contrarian E&P Play

| About: Devon Energy (DVN)

On August 1, Devon Energy Corp. (NYSE:DVN) reported net income for the second quarter of $477MM, or $1.18 per common share. Adjusting for a net gain on derivatives of $253MM, Devon's non-GAAP earnings were $224MM, or $0.55 per share, missing analyst estimates of $0.81 per share.

Wider price differentials and production maintenance were the primary culprits in the disappointing earnings report. Devon is not likely to begin hitting on all cylinders until we see some improvements in pricing, particularly for natural gas and natural gas liquids. We profiled Devon on July 2, and wanted to provide an update after analyzing the quarter.

We view Devon as a cheap play on a potentially robust growth portfolio of energy assets, with a management that we trust to allocate shareholders' capital in a positive way. I don't want my CEO or my investment to be leveraged to excess, needing unattractive financing deals at inopportune times, or worst yet, using shareholder capital to pay ridiculous compensation plans to a CEO after losing his money gambling on stocks.

Our belief in Devon's strategy has been enhanced by today's announcement that the company has signed a $1.4 billion deal with Sumitomo Corporation in exchange for 30% of Devon's interest in approximately 650,000 net acres in the Cline Shale and the Midland-Wolfcamp Shale. The deal calls for $340MM in cash upon closing, and an additional $1.025 billion to be invested in the form of a drilling carry.

Devon expects that the drilling carry will fund 70% of its capital requirements, resulting in Sumitomo paying 79% of the overall drilling and completion costs during the period. The partnership allows Devon to drill around 40 wells in the full year 2012. This is the type of deal that Chesapeake Energy Corp (NYSE:CHK) developed an excellent reputation on, but the difference is that Devon does these deals from a position of financial strength, as opposed to relying on continuously increasing prices, eventually forcing poor economic deals in times of stress.

In the second quarter, Devon grew oil production 26% YoY and 5% sequentially to 149,000 barrels per day, largely due to growth from the company's Jackfish and Permian Basin projects. Total production of oil, natural gas, and natural gas liquids increased 3% YoY to 679,000 oil-equivalent barrels (NYSE:BOE) per day in the second quarter.

During the quarter, Devon was also hamstrung by production interruptions in the company's natural gas processing facilities, which reduced production by 16,000 BOE per day. Management logically used the second quarter to perform the maintenance, as natural gas prices were exceptionally low, meaning that the opportunity cost was not as great.

In the Permian Basin, oil production increased 24% over the 2nd quarter of 2011. The Permian Basin assets are some of Devon's most liquid-rich, as oil production accounted for nearly 60% of the 59,000 BOE per day produced in the Permian Basin in the quarter. Devon brought 19 Bone Spring wells online in the second quarter, and initial 30-day production was 680 BOE per day, on average. Much of Devon's growth is coming from the Jackfish 1 and Jackfish 2 oil sands projects in Canada, which averaged a record 51,000 barrels per day in the quarter. These projects have increased oil production 63% YoY, and Devon has a third Jackfish project on the way that is expected to begin in 2014.

Devon continues to focus on growing production through a prudent capital allocation strategy. The company filed a regulatory application in June for the first phase of a new oil sands project called Pike, which Devon believes will have gross production capacity of 105,000 barrels per day. This project is adjacent to the Jackfish projects.

To help fund Devon's drilling plan, the company entered into an agreement with Sinopec in April. The transaction price included a $900MM cash payment at closing, recovering significantly more than 100% of Devon's initial land and exploration costs. In addition, $1.6 billion in payments will be used to fund 80% of the joint venture's capital requirements over the next few years.

The company also continued to add acreage in the Mississippian oil play by adding 400,000 net acres in Oklahoma, bringing the total to 545,000. Six wells were brought online in the Granite Wash, and initial 30-day production from these wells averaged 1,270 BOE per day. Net production from the Cana-Woodford Shale averaged 280 million cubic feet of natural gas equivalent per day in the second quarter, with liquids production increasing 59% YoY, accounting for 30% of total Cana-Woodford production.

Devon continues to aggressively hedge its portfolio opportunistically, with 128,000 barrels of oil per day hedged at $97 per barrel, and 1.7 billion cubic feet per day protected at a weighted average floor price of $3.76. The company forecasts that these positions represent about 85% and 65% of 2012 oil and natural gas production, respectively.

Devon's profitable marketing and midstream operations suffered an operating profit decline from $148MM to $68MM YoY, due to downtime related to expansion of a facility which is now complete. The company continues to maintain its top-tier balance sheet strength with $7 billion in cash and short-term investments, and net debt to adjusted capitalization of 14% as of June 30, 2012.

This quarter did have its share of negative news beyond the earnings miss. Devon is really being hurt by the decline in natural gas liquids pricing, therefore, it is having to adjust its drilling programs to focus more on oil production. Despite this, the company still expects to deliver full year 2012 oil production growth in excess of 20%, shifting oil production to 40% of liquids production by year-end. The company remains on target for 253-257 million barrels of oil equivalent production for the year, but it is looking like the lower end of that range is more realistic. Additionally, Devon drilled two wells in the northwestern Ohio Utica region, which were disappointing. The company is drilling a new well to the south, and it is too early to tell too much about what this play will bring.

For the third quarter, Devon expects production to increase to between 680,000 to 690,000 barrels per day, despite maintenance at the Jackfish plant, which is expected to reduce oil volumes by 10,000 barrels per day in both the third and fourth quarters. Pretax cash costs were $14.39 per BOE in the second quarter, and if the company did not incur production disruptions, cash costs would have been $14 per BOE. It is Devon's low cost position that allows it the potential to succeed in an extremely difficult market for E&P's with a heavy slant towards natural gas, and natural gas liquids.

Devon is going to have a tough go of it the next couple of quarters, as lower prices and maintenance operations in the Jackfish projects will reduce profitability. Moving forward to next year, Devon is making really positive growth in production and the composition of production towards oil. With the stock trading well below the private market value of the company's assets minus liabilities, Devon is one of our three favorite ways to play the energy sector, along with BP plc (NYSE:BP) and Apache Corp. (NYSE:APA). Because so many companies are decreasing natural gas output, prices are likely to rise before too long, which would be extremely beneficial for Devon. We believe this stock should trade in the high $70s with upside well over $100 as Devon hits 2013-2014 production targets.

Disclosure: I am long DVN, APA, CHK, BP.