Devon Energy: Entering 2020 On A Firm Footing
Summary
- Devon Energy has reported $171 million of free cash flows for Q4-2019.
- DVN has reshaped its portfolio by focusing only on high-margin US oil properties, which has helped bring its cash flow break-even level down to $46.50/bbl.
- The company can achieve double-digit growth in oil production in 2020 with lower CapEx while generating free cash flows.
- Devon Energy has a favorable debt maturity profile, robust liquidity, and has covered more than 40% of this year's estimated oil production with hedges.
Devon Energy (NYSE:DVN), the diversified shale oil driller, ended last year on a strong note by reporting free cash flows for the fourth quarter and it seems well prepared to withstand the current tough oil price environment. After high-grading its portfolio, Devon Energy can now generate free cash flows even as oil prices trade below $50 a barrel. The company has also covered a significant part of its future oil production with hedges, which minimizes its exposure to oil price weakness. The company also has a decent balance sheet, which bolsters its ability to withstand weak oil prices for an extended period.
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Earnings Recap
Devon Energy recently released its fourth-quarter results. The company produced 340,000 boe per day from retained assets in Q4-2019, including oil production of 160,000 bpd, depicting gains of 15.3% and 28% respectively on a year-over-year basis. The growth was led in large part by the 84% increase in oil and NGL production from the Delaware Basin to 116,000 bpd (72% oil, 28% NGL). Due to strong well productivity and a favorable completion schedule in the Delaware Basin, the company exceeded the midpoint of its oil production guidance by 3,000 bpd.
Devon Energy's realized oil prices fell by 1.1% to $55.46 per barrel and the realized price for the total production on an oil-equivalent basis fell by 6.1% to $32.72 per boe. The company earned an adjusted profit of $128 million, or $0.33 per share, and operating cash flows of $579 million. The cash flows funded the capital expenditures of $408 million and the company ended the period on a strong note with free cash flows of $171 million.
Looking Ahead
The oil price environment is looking tough, with the price of the US benchmark WTI crude falling from more than $60 a barrel at the start of the year to $47 a barrel at the time of this writing as the spread of the novel coronavirus from China to dozens of other countries stokes fears of slowing global demand. The prices could bounce back if we witness a drop in the number of coronavirus cases, the global economy recovers, production growth slows down in the US, and OPEC+ announces additional production cuts. But the commodity is widely expected to average below last year's $57.02 per barrel. The weak and volatile oil price environment is going to hurt the profits and cash flows of Devon Energy as well as other oil producers. However, I think Devon Energy is better prepared than ever to face this tough market.
The previous year was a transformative one for Devon Energy as the company reshaped its portfolio by selling high-cost assets and increasing focus on the high-margin, oil-rich properties located in the US. It exited from Canada by selling its heavy oil assets for C$3.8 billion and closing the transaction in Q2-2019. Then in December, the company announced the sale of its gas-weighted Barnett Shale asset for $770 million. Now, the company is concentrating on producing oil from four low-cost and high-return regions in the onshore US - the Delaware Basin, STACK play, Eagle Ford, and Powder River Basin.
By high-grading its portfolio and allocating capital solely to its highest-return properties, Devon Energy has brought its cash flow break-even level lower to just $46.50 per barrel. At this price, Devon Energy can generate enough cash flows to fully fund its capital expenditures. At higher prices, the company can deliver free cash flows.
If oil prices plunge to less than $45 a barrel and stay at that level for an extended period, then I expect Devon Energy to make a downward revision to its spending plans. The company may even scrap any production growth plans, but by taking such an extreme step, the oil producer might be able to balance cash flows. In this worst-case scenario, I believe the management's priorities in terms of the use of cash flows will be to keep the production flat and pay quarterly dividends. If, however, oil prices improve to $50 or higher, then Devon Energy will continue growing production and generate free cash flows. In a $50 a barrel oil price scenario, the company has forecast cumulative free cash flows of $400 million for 2020-21, growing to $1.6 billion at $60 oil.
I expect Devon Energy to keep a tight lid on spending this year, which should help the company in generating free cash flows. Last year, Devon Energy substantially cut CapEx. Its upstream capital clocked in at $1.83 billion in 2019, down from $2.42 billion in 2018. For the current year, the company has forecast upstream CapEx of between $1.7 billion and $1.85 billion, which depicts a drop of 2.9% from 2019 at the midpoint.
Despite lower CapEx, the company will keep high levels of drilling activity. At the Delaware Basin, in particular, which is Devon Energy's highest return prospect, the company will increase spending by 20% to around $1.05 billion. The region, which is located within the prolific Permian Basin, will get around 60% of the company's upstream capital and will likely drive the production growth. The company expects to bring around 120 new wells online in the Delaware Basin in 2020 which, I think, will likely lead to strong double-digit growth in oil volumes. Here, the company has witnessed substantial improvements in capital efficiencies, with an increase in well productivity and a decrease in well costs. The productivity gains can able attributed to better well design and reduction in cycle times. In Q4-2019, Devon Energy reported drilling and completion costs of $880/ft, which depicts a drop of 28% from FY-2018. That's made Delaware Basin a low-cost and high-margin play. I think by concentrating on drilling in this region in 2020, Devon Energy can expand its profit margins and free cash flows.
For 2020, Devon Energy has forecast total production of between 328,000 and 339,000 boe per day, including oil production of between 161,000 and 163,000 bpd. The midpoint of the guidance shows that the company expects to increase its total production by 3.25% this year led by a 10.2% increase in oil production. What I like about Devon Energy is that the company can potentially achieve this production growth target with lower CapEx and strong levels of free cash flows.
That being said, the weakness in oil prices does pose a threat to the company's future earnings and cash flows. Devon Energy, like all independent oil producers, is directly exposed to the weakness and volatility in commodity prices. But thanks to its crude oil hedges and a decent balance sheet, I think it is well positioned to face this challenge.
Devon Energy ended the fourth quarter with a total debt of $4.29 billion, down 3.6% from a year earlier. This translates into a debt-to-equity ratio of 74%, which is higher than the large-cap peer median of 57%, as per my calculation. But the debt seems manageable. That's because the company is now generating free cash flows which can be used for debt reduction purposes. It is also selling assets that will help shore up its balance sheet. Moreover, the company isn't facing any near-term debt maturities. Its earliest maturity relates to $485 million of notes due in 2025 and nearly all of the company's remaining debt matures after 2030 (between 2031 and 2045). The company, therefore, has a highly favorable debt maturity profile. Moreover, it also has robust liquidity which includes $1.8 billion of cash reserves and $3 billion available under the revolving credit facility. This liquidity will help the company in meeting any short-term funding needs if it were to face a cash flow shortfall.
Devon Energy has hedged a large chunk of its future oil and gas production which minimizes the exposure of its cash flows to the weakness in commodity prices. For 2020, the company has covered more than 40% of its estimated oil production at an average floor of $53 a barrel. As a result, the company will continue to receive a good price for these barrels which is considerably higher than the break-even level, even as the spot price hovers below $50 a barrel. This should give a boost to the company's cash flows and help it in delivering free cash flows.
For these reasons, I believe Devon Energy can withstand the current slump in prices and generate strong levels of free cash flows if oil recovers to $50 or higher. The company's shares have tumbled by 37% this year, largely in line with other oil producers whose shares (XOP) have also fallen by 35% due to the drop in crude oil prices. The company's shares are trading almost 18x forward earnings estimates, higher than the sector median of 10.2x, and 4x in terms of EV/EBITDA (fwd) multiple, below sector median of 5.6x, as per data from Seeking Alpha Essential. The stock isn't currently trading at a big discount against peers, particularly in terms of the P/E ratio, but Devon Energy is a great oil producer which investors should closely follow and consider buying on weakness.
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