Devon Energy Emerges Triumphant From Downturn

| About: Devon Energy (DVN)

Summary

Devon Energy Corporation does it again, another solid earnings report.

Free cash flow generation on tap.

Devon Energy is trimming its asset base to reduce debt over the long haul.

$55+ WTI is huge for Devon.

Devon Energy Corporation (NYSE:DVN) posted a solid third-quarter earnings report. With West Texas Intermediate marching towards $60 a barrel, Devon Energy Corporation's fourth-quarter trajectory (and more broadly, its momentum heading into 2018) is very bullish. Let's dig in to some key Q3 highlights.

Financials are secure

Devon Energy consolidates its financial statements with EnLink Midstream LLC (NYSE:ENLC) and EnLink Midstream Partners LP (NYSE:ENLK) due to its strategic stake in both entities (115 million ENLC units and 95 million ENLK units). Management provides tables that separate the data out, but keep in mind there may be some adjustments to those figures that aren't apparent.

During its latest quarterly update (looking at just Devon and not the consolidated side of things), Devon Energy Corporation generated $577 million in operating cash flow, received $66 million from EnLink via distributions, spent $30 million on its own dividend payments, and spent $545 million on capital expenditures. $637 million in organic cash inflows and $575 million in organic cash outflows mean Devon Energy was free cash flow positive last quarter. Solid, especially as WTI averaged ~$48/barrel in Q3.

Rising oil volumes due to Devon spending more on capex to increase its drilling and completion activity, with that growth weighted towards the second half of 2017 and early 2018, will materially enhance its cash flow generation. As will the recent rally in WTI and to a lesser extent Henry Hub. The fourth quarter will provide a snapshot of how well Devon performs in a mid-$50s WTI world, with an eye on free cash flow growth.

Keep in mind that we have seen crude prices rally before, only to crater a while later. A common theme is that this time it's different but it is important for investors to note that an agreement between major oil exporters, not some physical or logistical obstacle, is primarily what is holding enough supply back to create oil draws. Get rid of the OPEC+ agreement and WTI/Brent would come crashing down. Always taper your enthusiasm in this market.

With that in mind, Devon would do stellar in a $55-60 WTI world. During the downturn the company rebuilt its asset base around two key plays, the STACK in Oklahoma and the Permian Basin in West Texas and Southeast New Mexico. Those are the two most economical unconventional upstream regions in the world, making Devon a Tier 1 player. Sure, the company would still do fine in a $50 WTI world, but it requires a $55-60 WTI environment for upstream firms to truly differentiate themselves (when Devon in theory should really outperform).

Last quarter, Devon posted $228 million in net income (attributable to DVN shareholders) when WTI averaged just over $48 in Q3. As of this writing, WTI is now over $57/barrel. Double-digit increases in its realized prices, combined with oil-weighted production growth from Tier 1 plays, should result in material net income and free cash flow growth this quarter.

On a side note, Devon is close to turning its retained earnings, current at an accumulated deficit of $428 million at the end of Q3, positive once again. That should be achievable by the end of Q1 2018.

Managing debt and possible asset monetizations

One of Devon's drawbacks is that it does have a fair amount of debt. Not looking at EnLink's debt that is non-recourse to Devon, the upstream firm has $6.862 billion in total debt (versus $2.639 billion in cash and cash equivalents). Devon doesn't have any significant maturities until 2021, but it is paying a fair amount in interest ($127 million in net financing costs in Q3) on that burden. The company brought up how future asset monetizations may be used for debt reduction, keeping in mind Devon expanded its Tier 1 asset base during the downturn through strategic acquisitions when oil prices were low.

Management has sold off $420 million in very non-core assets (such as Lavaca County acreage prospective for the Eagle Ford shale, which wasn't prolific) so far this year. Devon is actively marketing its Johnson County acreage in Texas that is prospective for the Barnett shale, which is home to 20% of its Barnett output (30,000 BOE/d, primarily dry gas). The Barnett shale is a Tier 2-3 play, and needs much higher natural gas prices to be economical. Even if Henry Hub were at $3.50 or $4, there are better places for Devon to put its capital. A sale should materialize relatively soon.

The size of the current divestment program is pegged at $1 billion, which is a rough target and primarily dependent on how much Devon can get for portions of its Barnett position. In regards to future Barnett development, Devon has been using the play as a testbed for restimulating activities, where old wells are fracked again to boost recovery rates (creating a production uplift in the process).

This was the excerpt from Devon's conference call that piqued the market's interest:

"Given the massive opportunity we have in the STACK and Delaware plays, we see the potential to monetize several billion dollars of less competitive assets within our portfolio in a very thoughtful and measured fashion over the next few years. Potential proceeds from these portfolio rationalization efforts would be balanced between further debt reduction, reinvesting in the core business and returning cash to our shareholders... [W]e also plan to have a fortress balance sheet with a net debt to EBITDA target of 1.0 to 1.5 times by the end of the decade [net debt to EBITDA ratio target doesn't factor in EnLink's debt, only debt recourse to Devon Energy]."

Debt reduction is not a bad use of divestment proceeds, particularly when the assets divested aren't competitive for capital and generate little cash flow. Free cash flow generation is one way to make that happen, but that is dependent on WTI cooperating and needs to be balanced with capital expenditures (Devon's dividend is very small, making it a tiny drain on cash flow). The Barnett shale isn't a bad place to start the deleveraging process.

Lavaca County in Texas wasn't able to reproduce the prolific Eagle Ford wells seen in DeWitt County (core part of EF), which is home to Devon's remaining position. Making a sale a smart if not inevitable move. It is possible that within the next few years, Devon may divest its DeWitt County acreage and exit the Eagle Ford.

The position is valuable and produces prolific wells, but it hasn't been a core focus for Devon for a long time. Devon has been allowing its Eagle Ford production to steadily move lower over the past couple of years as it halted drilling activity in the play last year. At the end of 2015, Devon was pumping out 113,000 BOE/d net from the EF. By the end of Q3 2017, that had fallen to 57,000 BOE/d net.

Without a plan to significantly grow its Eagle Ford growth runway, particularly through bolt-on acreage acquisitions, Devon Energy has little reason to classify this as a core asset. Another thing to keep in mind is that the amount of space allocated to the Eagle Ford on its quarterly operations report has been downsized to just a portion of a Power Point slide. Indicating management doesn't want to highlight the play anymore, which usually means a divestment is or could be in the works (a lot of M&A activity in the upstream space to pay down debt burdens).

As Devon Energy has time to wait for a strong oil pricing environment, maybe one where WTI is in the $60s, a sale should raise a ton of capital. Enough to really put a dent in its debt load. However, while the impact on Devon's Q4 production from the Lavaca County sale will be minimal (at 3,000 BOE/d, tiny portion of cash flow), selling off its DeWitt position would have a much bigger impact on both its cash flow generation and production base.

That's why the firm will most likely build up its output elsewhere before divesting its Eagle Ford operations. Austin Chalk exploration, appraisal, and delineation efforts, combined with Upper Eagle Ford development schemes (Lower Eagle Ford horizon is the core of the play; those are other opportunities), can be used to grow Devon's drilling inventory in the meantime.

Final thoughts

The upstream industry is currently in the best position it has been in since the downturn really took hold in 2015, with Devon Energy Corporation emerging from the worst of the bust in a prime spot to capitalize on the rebound. Devon Energy Corporation has a large position in two of America's best shale/unconventional plays with room for upside from its Powder River Basin position in Wyoming (a Tier 1.5-2.0 exploration, appraisal, optimization opportunity) and vastly improved cash flow generation from its three Jackfish SAGD (steam assisted gravity drainage) oil sands projects (all three are currently operational and collectively are exceeding nameplate production rates) up in Alberta.

Expect Devon Energy Corporation to showcase significant financial improvements in Q4, but make sure that exuberance doesn't translate into an unnecessarily large 2018 capex budget.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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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