Devon Energy's Strong Management And Growth Prospects Make It A Strong Buy

| About: Devon Energy (DVN)

As a long-term investor, I tend to look for shareholder friendly management teams that truly treat shareholders as partners. In the energy sector, these types of management teams are in the minority, but one prime example of strong management is found at Devon Energy (NYSE:DVN). Devon has a history of keeping CAPEX spending within the realm of operating cash flow, increasing the dividend consistently and buying back stock when it trades at a discount to intrinsic value. In addition, Devon has shown a willingness to divest and acquire assets when the circumstances have been favorable, and the core capital allocation principal is based on maximizing shareholder value on a per-share basis. Devon's robust growth portfolio, leverage to increasing long-term natural gas prices, and cheap valuation makes the stock one of the most compelling opportunities in the energy space.

As a result of the drastic disparity between oil and natural gas prices, Devon has shifted the vast majority of its CAPEX towards high-margin oil plays. Devon has built huge low-risk, North American acreage positions that provide ample opportunity for the company to increase its drilling production over the next several years. Oil and liquids production now account for 41% of Devon's total production when just a few years ago oil represented 30% of production, led by growth in the oil-rich Permian Basin, where 60% of the company's 68,000 BOE per day produced were oil.

Natural gas prices have improved substantially since last year, assisted by increases in heating demand, and a decreased rig account, which is impacting supplies. Devon has a low-cost natural gas portfolio, which will be highly levered to future increases in prices. The recent gains in natural gas prices aren't likely to be enough to dramatically alter the supply landscape, but the future looks brighter than the recent past for gas pricing, and this is a huge benefit to companies like Devon. Devon has also been negatively impacted by decreased realizations on Canadian oil, but recently Western Canadian Select blended pricing has improved from approximately 50% of WTI in mid-January, to as high as 85% of WTI in recent weeks. Many of these Canadian oil properties have been written down with non-cash charges, but the potential for cash flow improvements should materially improve Devon's financial results moving forward.

On May 1st, Devon Energy reported a net loss of $1.3 billion or $3.34 per common share for the 1st quarter of 2013, highlighted by a $1.9 billion non-cash asset impairment charge primarily related to lower oil and natural gas liquids pricing. Adjusting for this charge, Devon would have earned $270MM or $0.66 per diluted share in the quarter. It is important to note that current accounting rules mandate that assets must be written down in accordance with a significant drop in prices, which can impact future cash flow calculations, but the write-downs cannot be reversed when prices rise. I believe that the cash flow Devon's Canadian and natural gas prices will produce in the future, greatly exceeds the current book value of these assets.

Devon's companywide oil production averaged 162,000 barrels per day, which was a 14% increase compared to the first quarter of 2012, and an 8% increase sequentially. Devon experienced robust growth in its Permian Basin production, which increased by a whopping 24% YoY. Total production of oil, natural gas and natural gas liquids increased to an average of 687,000 oil-equivalent barrels (BOE) per day in the 1st quarter. The company ran 28 operating rigs focused on Permian oil development opportunities. In the Bone Spring oil play, Devon added 20 new wells to production in the quarter, and initial 30-day production from these wells averaged 590 BOE per day. Devon believes that oil production growth will continue in the 2nd quarter by an estimated 15% sequentially, and will continue to grow throughout the year. Overall, Devon expects to grow basin-wide oil production by nearly 40% in 2013.

Devon saw better than expected growth in many of its core growth properties, including Jackfish and Cana-Woodford. Jackfish 1 and Jackfish 2 in the Canadian oil sands continue to improve, averaging a record 54,000 barrels of oil per day in the 1st quarter, which was up 18% YoY. Jackfish 1 contributed 33,000 barrels of oil per day net of royalties, and both properties will benefit from improved price differentials in Canada. The company is now about 60% finished with its construction of its 3rd Jackfish oil sands project, which will obviously be an important source of future production growth. In the Mississippian play, Devon brought on 24 operated wells in the quarter with results in-line with management's projections. Management believes that the Mississippian will be one of the real large-scale growth leaders for Devon, and the company is increasing its utilization of 3-D seismic surveys to help capture that growth potential.

Devon continues to get good production in the Rocky Mountains and Granite Wash plays. Specifically, in the Granite Wash, Devon initiated production on two operated Hogshooter wells in the quarter with average 30-day production of 1,250 BOE per day, including 1,100 barrels per day of oil and liquids. 1st quarter production from the Cana-Woodford Shale averaged a record 340 MM cubic feet of natural gas equivalent per day, and liquids production now accounts for 41% of total Cana-Woodford production, which was 78% higher YoY. In the Barnett Shale, net production averaged 1.4 billion cubic feet of natural gas equivalent per day during the quarter, with liquids production increasing 5% YoY to 55,000 boe per day. The Barnett is expected to generate nearly $600MM of free cash flow, and any long-term improvement in natural gas prices will clearly bolster this number substantially.

Like other drillers, Devon has been working aggressively to cut drilling costs. In the 1st quarter, Devon's pre-tax cash costs of $898MM, or $14.54 per BOE were 5% higher YoY, but were down 4% sequentially. It is important to note that the costs of drilling oil are significantly greater than drilling for natural gas, and oil drilling has become a much larger percentage of Devon's production over the last year. Devon's marketing and midstream operating profit reached $125MM in the quarter, which was up 12% YoY, bolstered by higher natural gas prices and cost management. Devon has taken advantage of higher natural gas prices to hedge 75% of its expected natural gas production, or $1.7 billion cubic feet per day. $1.0 billion cubic feet per day is swapped at a weighted average price of $4.09 per thousand cubic feet, and the remaining $.7 billion cubic feet per day is hedged through costless collars with a weighted average ceiling of $4.19 per thousand cubic feet and a floor of $4.66 per thousand cubic feet. Devon has even looked out to 2014 where it has 900MM cubic feet per day of production locked in at a weighted average floor price of $4.34. The company has also hedged 70,000 barrels per day of oil at a weighted average price of $100 per barrel, while the remaining 65,000 barrels per day utilizes costless collars with a weighted average ceiling of $112 per barrel and a floor of $90.

In the 2nd quarter, Devon expects growth in the Permian and Mississippian to increase oil production by about 4%, to a range of 163,000 to 173,000 barrels per day. NGL production is expected to be flat, while natural gas production is expected to decline. Devon expects company-wide production to range between 670,000 to 690,000 BOE per day. The company also expects Canadian oil price realizations to improve to a range of 55-65% of WTI, which is much better than the 43% of WTI that was averaged in the first quarter.

Devon continues to possess one of the strongest balance sheets in the industry with $6.5 billion in cash and short-term investments, and a debt to adjusted capitalization of 22%. $6.1 billion of Devon's cash resides in foreign subsidiaries, but the company is going to be able to repatriate $2 billion of its foreign cash with minimal additional taxes. This could potentially set the stage for a large stock buyback, or Devon might look to increase its capital investment on some of its high-margin oil production plays. Devon generated $1.2 billion of cash flow before balance sheet changes in the 1st quarter of 2013. The company is one of most shareholder-friendly capital allocators in the industry. In March, Devon increased its dividend by 10%, which is the 8th time the company has increased its dividend since 2004. Devon's management has cited the deep discount the company trades at relative to its North American onshore peers, and I believe that stock buybacks at current prices are the best way for the company to increase the intrinsic value of the stock.

Another way that Devon's management is looking to create additional shareholder value is through potentially spinning off its midstream assets into an MLP. This is attractive due to the stratospheric valuations that are being assigned to MLPs based on their tax-advantaged dividend payouts, in this low interest rate world. While there are certainly advantages to retaining the midstream operations, the reality is that the valuation arbitrage makes the decision a no-brainer, and I'd expect management to announce that it is moving forward with a spin-off in the near future. Devon's midstream business generated $125MM of operating profit in the 1st quarter and is on pace to achieve a full-year operating profit of $425MM to $475MM.

As of March 31st, 2013, Devon Energy had 406MM diluted shares outstanding. At a recent price of $56.64, Devon has a market capitalization of roughly $23 billion. Devon has long-term debt of $7.955 billion, which is mostly offset by $6.501 billion in cash and short-term investments. Earnings should grow materially over the next several years as growth in oil production will lead to higher margins. Many intelligent market participants such as Jeremy Grantham believe that natural gas prices have tremendous room for upside. If this occurs, Devon can boost production, which would have a huge impact on boosting cash flow and earnings. I believe that Devon has between $4.00-$7.00 of normalized earnings power depending on price realizations. The spin-off of the midstream assets should be the catalyst that propels the stock into the $60s by uncovering several billion dollars in hidden value. Devon's valuation gives it no credit for one of the better production growth outlooks in the industry, and I believe this combined with a management that can be trusted with shareholder capital, makes Devon a strong-buy in the energy sector.

Disclosure: I am long DVN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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