Devon Energy (DVN) recently announced plans to close its Houston offices and re-consolidate its energy and production operations groups into one single unit based at its headquarters in Oklahoma City. This shift is expected to be complete by the end of the first quarter of 2013, and result in some $80 million in savings to the company per year, mostly through reduced administrative and personnel costs. Although Devon will take a cash charge of $100 million across the fourth quarter of 2012 and first quarter of 2013 for the costs of the move, with its $80 million savings estimate this should result in realized savings by the first quarter of 2014.
The anticipated annual savings amount to nearly half of the general and administrative expenses Devon reported for the second quarter of 2012, which may seem minor but could actually go a long way towards helping Devon reposition itself as a liquids producer. Earlier in 2012 Devon shifted new drilling on the Barnett shale to liquids to supplement its activity on the Permian, and is now moving eastwards to a new but highly prospective target.
High Hopes for the Tuscaloosa Marine Shale
Devon is betting heavily on the Tuscaloosa Marine Shale through its joint venture with Sinopec. The Basin Research Institute at Louisiana State University estimates that the Tuscaloosa could hold as much as 7 bboe, which is one reason why players are taking an interest in this prospect. Encana (ECA) is one of the largest leaseholders, claiming 400,000 net acres on the play. Its two most recent wells reported 30 day IP rates of 930 and 1,080 barrels of oil per day, respectively, a better performance than Devon's most recently reported well in St. Helena Parish, with IP rates of 384 barrels of oil per day. Encouraged by these results, Encana intends to drill a total of 12 wells on the Tuscaloosa for 2012.
EOG Resources (EOG) is also making moves on the Tuscaloosa, recently signing on to a joint venture with Mitsubishi to explore the play, though unlike Devon it is reserving its star plays from any joint venture consideration. While it considers putting further resources into the Tuscaloosa, EOG is scaling back its drilling on the Eagle Ford, attributing the decision to its reduced drilling time per well. However, I think there are other compelling reasons for EOG to reduce its focus on the Eagle Ford, which have a direct bearing on the hopes of Devon and others for the Tuscaloosa.
Tuscaloosa Could Be a Disappointment
The Tuscaloosa Marine Shale is frequently compared to the Eagle Ford, though the similarity is primarily in the uppermost layer of the Tuscaloosa, which is comprised of close in age and geologically similar materials to the Eagle Ford. The big red flag on the Eagle Ford that I think producers are starting to notice is its precipitous rates of decline. Gary Swindell of the Society of Petroleum Engineers recently undertook a study of over 1,000 horizontal wells in the southern reaches of the Eagle Ford and found normalized rates of decline of 76% for oil and 60% for gas, noting that even as technology improves the performance of these wells is failing to improve commensurately.
Furthermore, the study found that generally, lateral lengths exceeding 5,000 feet actually decreased EUR. Certainly the study has limitations, not least of which is the fact that it relied solely on publicly available data that does not tell the whole story. Still, all of this tends to suggest that although certain counties of the Eagle Ford hold early promise, unless dramatic improvements to drilling technology are introduced profits from the Eagle Ford are a limited time offer. Due to the similarities between the Eagle Ford and the Tuscaloosa, as Tuscaloosa drilling ramps up producers may find that the same story holds true across the plays. Moreover, the Tuscaloosa has several disadvantages compared to the Eagle Ford which could make heavy bets on the play a disaster.
Data compiled by Goodrich Petroleum (GDP), another active Tuscaloosa operator, shows why this play is still highly prospective. First of all, the Eagle Ford is much larger, underlying 19 million acres as compared to Tuscaloosa's 2.5 million. The Eagle Ford is shallower, as much as 5,000 feet closer to the surface, while at the same time producing from greater thicknesses, between 100 and 300 feet compared to the Tuscaloosa's 70 to 200 feet of pay. Finally, well costs on the Eagle Ford are as much as half the well costs on the Tuscaloosa, at least until activity on the Tuscaloosa scales up.
This begs the question: Why is it that primarily the operators previously focused on natural gas are now so excited about shale oil in the Tuscaloosa? Virtually the only measurable area where the Tuscaloosa comes out ahead is in leasehold costs, and here the Tuscaloosa has an advantage that makes its weaknesses pale in comparison. Even with the interest in this play heating up, Tuscaloosa leases can still be had for below $400 an acre. On the Eagle Ford, Royal Dutch Shell (RDS.A) paid about $10,000 an acre for 106,000 acres on the Harrison Ranch in Dimmit County, which is actually below the average implied value per acre according to IHS of $14,000 in 2011. Top acreage commands as much as $25,000 an acre.
Now the focus on the prospective Tuscaloosa starts to make sense. Natural gas dependent players like Encana, Devon, and to a lesser extent EOG have a hard time making the economics of $10,000 and up per acre work at a meaningful scale. If the bet on the Tuscaloosa pays off for Devon, it will pay off handsomely, but if it does not, Devon at least has coverage with its drilling carry from Sinopec. Encana, on the other hand, is entirely exposed here.
Devon is trading around $59 per share, with a price to book of 1.1 and a forward price to earnings of 10.9. Shell is trading around $69 per share at a similar value to Devon, with a price to book of 1.2 and a forward price to earnings of 10.9. Encana is trading around $22 per share, with a price to book of 2.4 and a forward price to earnings of 29.6. EOG is still riding high, trading around $116 per share with a price to book of 2.3 and a forward price to earnings of 18.0.0 Finally, Goodrich is trading around $12 per share, with a price to book of 3.7 and a negative forward price to earnings, indicating that this E&P is currently overpriced.
There is no question that Devon's shift towards liquids is the right move, but there is room to question whether the Tuscaloosa represents a good resource allocation for the firm. However, exploration inherently involves risk, and Devon is playing its data on this field close to the vest for now; it is possible that Devon sees indicators of success where others see reason for caution. At the very least, it is strengthened by its activities on the mid-Continent and Canada, and given this resource base it is still a strong stock at $59.