Description

At 4x EBITDA, Devon Energy Corporation is cheap on a current operating basis while offering significant oil and NGL production and reserves growth.  In addition, with natural gas constituting over half of its reserves and production, Devon provides an option on a recovery in North American natural gas prices.

Company Background.  Devon engages in the exploration, development, and production of oil, natural gas, and NGLs.  Devon also operates a substantial midstream business.

In November 2009, Devon announced plans to strategically reposition itself as a North American onshore exploration and production company.  In 2010, Devon sold its properties in the Gulf of Mexico, Azerbaijan, China, and other international regions, in 2011 Devon sold its assets in Brazil, and in 1Q 2012, Devon sold its final international asset in Angola.  The sales generated approximately $10 billion.

A portion of the proceeds ($3.5 billion) was used to repurchase approximately 11% of the company’s common stock.  As of the end of 1Q 2012, approximately $6.8 billion in cash remains overseas pending repatriation.

As a result of the repositioning, Devon’s exploration and production activities are located exclusively in North America.

Reserves.  At YE 2011, Devon’s proved reserves were as follows:

U.S. Oil (mmbls)            168

Canada Oil (mmbls)      537

Total Oil (mmbls)          705

NGLs (mmbls)               552

Natural Gas (bcf)     10,486

Total (mmboe)          3,005

Of the proved reserves, 58% are natural gas, 23% are oil, and 19% are NGLs.

Current Production.   For 2011, production and realized prices (before hedges) were as follows:

U.S.Oil (mmbls)            16.8       $91.19

Canada Oil (mmbls)     27.9         66.97

Total Oil (mmbls)         44.7         76.06

NGLs (mmbls)              36.6         41.10

Natural Gas (bcf)       952.5          3.58

Total (mmboe)          240.1       $34.64

Production for 2011 was 66% natural gas, 19% oil, and 15% NGLs.  For 2012, Devon is projecting mid 20’s % growth in oil production, low teens % growth in NGL productions, and flat natural gas production, for a total increase in production of 6%.

Properties.

Barnett Shale.  The Barnett is Devon’s largest property in terms of production and proved reserves.  The Barnett constituted 32% of Devon’s 2011 production, and holds 38% of Devon’s proved reserves.  78% of Devon’s Barnett reserves are natural gas.  Devon is still actively drilling in the Barnett, exclusively targeting liquids rich areas.  Liquids production in 1Q 2012 was 20% higher than liquids production in 1Q 2011.  Devon states that its operations in the Barnett generate free cash flow after cap-ex ($800 million in 2011; $600 million projected for 2012).

Cana-Woodford Shale.  Devon is the largest leaseholder and the largest producer in the Cana-Woodford.  During 2011, Devon increased its production by 85%, and is actively drilling, again exclusively targeting liquids rich areas.

Permian Basin.  Devon has over 1 million net acres in its legacy Permian properties (this excludes the Cline Shale acreage discussed below).  78% of Devon’s Permian reserves are liquids.  Devon is actively drilling in the Permian, targeting conventional and non-conventional liquids-rich targets within the Delaware, Bone Spring, Wolfcamp, Wolfberry, and Avalon Shale plays.

Jackfish (Canada).  Jackfish is a thermal heavy oil project in the non-conventional oil sands of east central Alberta.  Jackfish holds 65% of Devon’s oil reserves.  Devon employs steam-assisted gravity drainage at Jackfish.  The first phase of Jackfish is fully operational with a capacity of 35,000 barrels per day.  The second phase of Jackfish began production in the second quarter of 2011 and will continue to increase production throughout 2012.  Devon began construction of the third phase this year, and plant start up is targeted for late 2014.  Devon projects each phase to maintain a flat production profile for greater than 20 years at an average net production rate of approximately 25,000 to 30,000 barrels per day.

Pike (Canada).  Devon’s Pike oil sands acreage is situated directly to the south of its Jackfish acreage and has similar reservoir characteristics to Jackfish.  Pike is a joint venture with BP; Devon has a 50% working interest and is the operator.  Devon plans to file application for regulatory approvals to build three Pike plants (each with similar capacity to a single Jackfish plant) to be developed concurrently on a single plant pad.  If approved and built, the first plant would begin production in 2016.

Sinopec Joint Venture Properties.  During 2010 and 2011, Devon acquired approximately 1.37 million liquids rich acres in the following five plays:  Michigan Basin (340,000 acres); Mississippian (230,000 acres); Niobrara (300,000 acres); Utica Shale (235,000 acres); and Tuscaloosa Shale (265,000 acres).  In April 2012, Devon closed a joint venture with Sinopec, in which Sinopec acquired a 33.3% interest in these plays for approximately $2.5 billion, consisting of $900 million cash at closing and $1.6 billion in drilling carries.

Additional Acquired Acreage.  Devon has assembled 500,000 acres in the Cline Shale light oil play in the Permian.  Devon has also leased or contracted for 250,000 acres in an undisclosed oil play, and is targeting 500,000 acres in the play.

Other U.S. Properties.  Devon’s other U.S. properties include the Granite Wash, Carthage, Washakie (Wyoming), and the Arkoma-Woodford Shale.

Other Canadian Properties.  Devon’s other Canadian properties include Northwest (Alberta and British Columbia), Deep Basin (Alberta and British Columbia), and Lloydminster (Alberta and Saskatchewan).

Financial Position, Capital Spending, and Production Growth.  Devon’s projected capital spending is as follows:  2012, $6.3 billion; 2013, $6.6 billion; 2014, $7.4 billion; and 2015, $7.3 billion.  Annual cash flow before cap-ex should average $5 billion to $6 billion over this time frame, meaning Devon will be outspending its cash flow.  However, with $7.1 billion of cash on the balance sheet as against $10.8 billion in debt, $900 million in cash received from Sinopec, and $1.6 billion in drilling carries, Devon can comfortably meet its capital spending goals.

The company projects that the capital spending plan will result in average annual production growth through 2016 of 19% for oil, 13% for NGLs, and 1% for natural gas, for total production growth of 6% to 8% per year.

Hedges.  Devon has hedged approximately 70% of its remaining 2012 oil production at an average price of $95, and approximately 40% of its forecasted 2013 oil production at prices between $91 and $104.  In addition, Devon has hedged approximately 40% of its remaining 2012 natural gas production at an average price of $4.41.  Devon’s 2013 natural gas production is for practical purposes unhedged.

Valuation.  In 2011, Devon generated $6.8 billion in EBITDA, including a $542 million contribution from its midstream business.  EBITDA is likely to decline in 2012 because of lower natural gas prices and lower realized NGL prices.  However, based on current production trends and the current price curve, EBITDA should rebound in 2013.  At $60 per share,Devon sells at slightly over 4 times trailing and projected 2013 EBITDA.  This is an unreasonably low multiple for a company with a clear path to growing oil and liquids production and concomitant EBITDA growth for the foreseeable future.

Nor is Devon expensive on an NAV basis.  To equal the current stock price, Devon’s NAV would look like this ($ millions):

PV-10 at 12/31/2011                                                      24,900

Cash at 3/31/2012 (less taxes at 35% for repatriation)    4,700

Midstream business (5x 2011 income of $542m)              2,700

Risked unproved reserves                                                6,000

Less debt at 3/31/2012                                                -10,845

Less asset retirement obligations                                   -1,496

Less other liabilities                                                           -791

NAV                                                                                24,759

NAV per share                                                                 $59.78

At $60 per share, one pays approximately $6 billion for Devon’s 8.8 million undeveloped acres and 13,200 mmboe in risked unproved reserves.  This amounts to $680 per acre and $0.45 per boe. For reference, Sinopec paid over $5,000 per acre and approximately $1.00 per boe of unrisked reserves.  Because of the high liquids content, the Sinopec JV acreage is likely of higher value than Devon’s other undeveloped acreage.  However, the discrepancy is unlikely to be nearly that large.

Risks.

Unproductive or uneconomic capital spending yielding lower than expected production and reserve growth at higher than expected cost.

Lower Oil Prices.  This risk is magnified because the majority of Devon’s current oil production is in Canada, with lower realized prices and higher expenses.

Catalyst