Devon: Ready To Jump 40% On Natural Gas Rebound

| About: Devon Energy (DVN)
This article is now exclusive for PRO subscribers.

Devon Energy (NYSE:DVN) recently announced the issuance of unsecured notes totaling $2.5 billion of long-term debt in three series, and plans to use $1.7 billion of this to pay off short-term debt rather than dip into its cash. Fitch Ratings gave all three series a BBB+ rating, which is investment grade, noting Devon's strong reserve base and increasing production as well as its financial stability. $6.5 billion of Devon's cash reserves are currently overseas, and Devon is hopeful the U.S. government will announce a repatriation holiday that would allow Devon to avoid $1 billion in taxes on these funds.

Given the substantial tax savings that Devon could realize by waiting to access its cash reserve, the bond issuance is a less expensive way for Devon to meet its short-term obligations. I think this shows how Devon's management team is continually assessing its cash management strategy for benefits to the company and its shareholders.

Enhanced Recovery Better for the Bottom Line

Devon continues to explore enhanced recovery methods and more efficient operation methods. Its production at Beaver Creek in Wyoming, is exceeding expectations, producing 1,000 boe per day more than anticipated, at 5,700 boe per day. This production is possible due to Devon's use of liquefied carbon dioxide in injection wells for fracking. This relatively new technology can result in a 15% to 20% improvement in oil recovery, and may pose less risk of aquifer contamination than traditional hydraulic fracking.

Devon is also set to begin water recycling for its operations on the Anadarko Woodford formation. According to the company, 36 well sites will be connected to the recycling facility, where solids will be separated out before being sent to a separator for oil and natural gas liquids removal. The water will then be stored until it can be shipped back to the wells for re-use. Devon anticipates that this move will reduce truck traffic and freshwater use, as well as reduce its water disposal costs.

First Quarter Rougher Than Expected, But Points to Growth

According to its first-quarter earnings report, Devon realized a gain of $145 million on its derivatives trading for the quarter net of losses. According to Devon's Executive Vice President and CFO Jeff Agosta, this effectively raised Devon's average realized price per barrel by $2.50 per barrel. Compare this with Kodiak Oil & Gas' (NYSE:KOG) $23.3 million loss (pdf) on its hedging activities in the first quarter and Chesapeake Energy's (NYSE:CHK) loss of $5 million, with its total hedges currently $1.7 billion on the negative side. Devon appears to be trading conservatively according to the realities of the current market, which should be reassuring to its shareholders.

As of March 31, 2012, Devon successfully divested all of its international offshore assets in accordance with its 2009 plan. Its operations in Angola were the last asset to be divested, and this deal was closed in March 2012, netting Devon $71 million.

Devon now has 21 rigs running in the Permian Basin, and its production there increased 32% in the first quarter of 2012 compared to the quarter a year ago. 76% of Devon s production in the Permian is in liquids, and Devon expects to drill 15 additional wells in this area in 2012, primarily seeking light oil in the Cline Shale, where it competes with Pioneer Natural Resources (NYSE:PXD) and Range Resources (NYSE:RRC) among others.

Liquid Natural Gas the Future?

Devon is producing roughly twice as much liquid natural gas from its U.S. plays as it is oil, at 102 mmbl per day and 55 mmbl per day, respectively. Devon attributes its 21% increase in liquid natural gas production primarily to activities in the Barnett Shale, Cana-Woodford Shale and Granite Wash. Devon appears to believe that natural gas prices will remain stable for the short term, as it is only maintaining a $1 million hedge against its natural gas production.

As there is comparatively little oil produced from Bakken, any calls for U.S. energy dependence from production in the lower 48 will depend on natural gas and liquid natural gas or LNG. Many companies are experimenting with using a special form of natural gas called compressed natural gas as an alternative fuel. The price of compressed natural gas would naturally fall if adoption were scaled to consumer use and could be competitive with imported gasoline and diesel, given time. Estimates are that natural gas as vehicle fuel on a production scale could come in at half the cost to consumers as diesel. Though prices are low now, this liquid natural gas production capability could accrue to Devon's benefit in the future.


Moving forward, Devon is expecting to produce between 685,000 and 695,000 boe per day in the second quarter of this year, compared with an average 694,000 boe in the quarter ended March 31. According to Devon President and CEO John Richels, the company expects its production to be driven by a 20% increase in oil production and "double-digit" growth in liquid natural gas. Some of this growth could be fueled by the closely held new play John Richels hinted at in the first-quarter earnings call, indicating that the company already acquired 250,000 acres in this new play with a goal of acquiring 500,000 acres total. I expect Devon will announce the name of its new play in the coming months, as acquisitions of this size can rarely be kept quiet for long.

Devon is currently trading around $62 per share, with a very attractive price to book of 1.1 and a forward price to earnings of 8.9. The stock is tracking down from $65 in the last seven days due to its less than excellent earnings report, but I think that the recent trades are unfair to Devon's true value and potential - though a boon to shareholders looking to build their holdings. Competitor Chesapeake is also tracking down, though in Chesapeake's case the trend is more of a downward spiral driven by controversy. Around $14 per share, Chesapeake is trading at a 0.7 price to book and a forward price to earnings of 7.1. Range Resources is trading overpriced, around $64 per share with a price to book of 4.4 and a forward price to earnings of 41.5. Finally, Pioneer is trading around $98, with a more reasonable price to book of 2.1 and a forward price to earnings of 12.9.

It is my opinion that the fall in Devon's stock represents a true opportunity. At $62, I am not expecting shares to trade much lower, and would recommend a buy and hold for Devon as the company has the potential to break $100 once natural gas prices return to normal in the next few years.

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