As expected, Devon Energy (NYSE:DVN) was hammered by the market on the release of earnings, which missed analysts' EPS estimates by $0.09 and modestly exceeded revenue by $6.6 mm. They then committed two unpardonable sins. First, raising the 2023 capex forecast range modestly for the year, which analysts view dimly these days. Second, the company raised the standard dividend to $0.20, but reduced the variable to $0.69, a 34% drop from the prior quarter. On a forward basis, this is a 6.2% YOC, which is not too shabby, but tell that to the analysts and the fund managers who follow them. All they saw was a QoQ cut, and cut their ratings on the stock.
Shares of Devon tanked on these two pieces of news. When combined with the rest of the macro downer news of the week-a massive crude inventory build (due in large part to refinery maintenance), and downward pressure on the futures curve from economic and interest rate worries, these moves spelled doom for the stock. Shares dropped from $64 to $53 60 during the trading session on the 15th and finished the week near there.
Trading volume was nearly 10X normal, with 52 mm shares hitting the market and indicating the large funds were washing their hands of DVN. I think this is overdone and will discuss why in this article. Investors who understand the continued importance of oil and gas to the world’s economy have been handed a gift.
The thesis for DVN
I've discussed my core concepts in past OilPrice articles. The key attributes-rock quality, scale, logistics, management/technology, and low cost, which a shale driller needs to have for a long-term future. 20 years from now, thanks to some shrewd acquisitions in key basins, DVN will be one of those companies. Beginning with WPX in 2021 and continuing with Validus in ‘22, with occasional "bolt-on" acreage adds in the Williston and another-Rimrock, also in the Williston, DVN has built a multi-basin platform that will enable organic growth for many years into the future.
With these acquisitions came Tier I inventory that provides “risked” drilling locations for a dozen years (4,500/400 per year), at $65 WTI, and $2.75 HH gas. Add to this figure, another 20 years of inventory with unrisked locations included, totaling 10,000.
Recent acquisitions discussed above will work to increase DVN's oil fraction for production and promote more income stability. Note how DVN takes care to point out the increase in oil fraction attributable to each acquisition. With 15K BOPD of production, the $885 mm upfront cost was recaptured in about 2-years, leaving decades of commercial life afterward. Noteworthy as well is the "fill-in-the-gap" aspect of the Rimrock acreage. This helps to connect other DVN acreage and enable the long laterals to increase production.
This speaks to strategy and is a compliment to management's vision to maximize the revenue potential for the product. In a similar but increased fashion the Validus pick up doubled production of an oily asset with a cost recapture in less than 2 years. Notable as well is the existing inventory of 500 derisked drill sites to maintain production.
CEO Rick Muncrief commented in the Devon, Q-4 2022 analyst call on the value gained in these transactions-
“We also supplemented per share growth in 2022 by deploying a portion of our excess cash toward taking advantage of unique M&A opportunities. These acquisitions in the Williston and Eagle Ford were highly complementary to our existing acreage, and we secured and met an attractive and accretive valuation and capture top-tier oil resource in the best part of these prolific fields.”
The WPX merger in 2020
Only three years ago Devon and WPX Energy, (NYSE: WPX) combined in a stock swap merger that essentially created the present Devon. The first slide below highlights the “bolt-on” aspect of the WPX acreage to existing Devon leaseholds.
Noteworthy here was the location of the WPX acreage in some key areas now under development. Stateline, highlighted in the slide below with a red dot, is the subject of intense focus and capital deployment in 2023. They will keep 11 rigs busy this year drilling up to 140 new wells. The targets will be Bone Spring and Upper Wolfcamp-typically Tier-I, favoring a slight edge to oil over gas. CEO Muncrief comments-
’Importantly, we expect overall well productivity from this program to be very consistent with the high-quality wells we have brought online over the past few years.”
Energy analyst firm, RBN has noted in past articles the Delaware basin is gassy and getting gassier. Currently producing over 22 BCF/D, a roughly 30% increase over a couple of years ago.
Devon has developed a plan to ensure access to markets for their gas through investments in the Pin Oak export terminal in Corpus Christie and the buy-in for the proposed FLNG tanker with Delphin. Something we discussed in an OilPrice article last year. In the Q-4 analyst call, CEO Muncrief commented on how Devon's strategy has evolved to ensure their gas has access to multiple markets and liquids are priced against Brent.
“Looking specifically at the gas volumes, approximately 95% of our gas in the Delaware is protected by either firm takeaway constraints -- excuse me, contracts, or Gulf Coast by regional basis swaps. With oil production, we expect our revenue to benefit from access to premium Brent pricing through Pin Oak's export terminal in Corpus Christi. This advanced pricing, combined with low LOE plus GP&T cost structure of around $7 per BOE will drive another year of strong margins and excellent free cash flow from this franchise asset.”
To summarize this section we think the management of Devon has done a superlative job of preparing the company to thrive in a number oil price scenarios. The diversified footprint it has builds the company into a multi-regional powerhouse with the ability to leverage the five characteristics of a long term survivor.
Key outtakes from the Q-4, 2022 CC
Devon announced a very modest capex raise of ~$200 mm for the full year 2023. I took some pains in the section above to highlight the M&A activity the company has engaged in the last couple of years-ex WPX. Roughly $3.0 bn of additional investment, with new drilling opportunities that didn't exist prior to these acreage pickups. In that light, I think the analyst's reaction to the increase in capex, was overdone.
These acreage pick-ups also provide the ability for refracs and adjustments in well spacing. In the refrac scenario-at a very high level, a reservoir that has been previously stimulated-technical term for fracking, is cleaned out of sand and hardware, and a modified frac is pumped to stimulate less permeable sections. Fracs generally follow the easiest, most permeable path on the initial application, and due to the nature of shale-no horizontal permeability, may leave considerable hydrocarbons behind. There is also the opportunity to apply modern well spacing theories to the new drill opportunities in the acreage pickups.
CEO Muncrief discusses the refrac potential and well-spacing improvements in the Williston, and the Eagle Ford -
“Overall, this development-oriented activity is designed to maintain steady production in 2023. Looking beyond the production trajectory, a key catalyst for this asset in the upcoming year will be the continued appraisal of resource upside from tighter redevelopment spacing and refracs.”
Key financial points from the Q-4, 2022 call-
For the full year 2022, free cash flow reached $6 billion, which is the highest amount Devon has ever delivered in a year. Devon's dividend payout more than doubled in 2022 to a record high of $5.17 per share. Share buybacks reduced float by 5% with $2 bn total authorization and $1.3 bn spent at an average price of $51. Recent acquisitions have been funded with cash. Ready cash balances increased by $144 million in Q-4, 2022 to total $1.5 billion. Devon maintains a healthy net debt-to-EBITDA ratio of only 0.5 turn. Return on Capital Employed- ROCE, for 2022 came to 39%, with the same metric projected at 25% for 2023.
Devon plans to up average output for 2023 to range between 643-663K BOEPD, with most of growth occurring after Q-1. The first quarter is projected at 635K BOEPD, with about one half the total being oil. The slow start is due to some downtime relating to a compressor fire at Stateline that will keep 10K BOEPD offline in Q-1. Post Q-1, there will be a 15% activity ramp that is intended to drive average volumes to the upper end of the forecast range, ~660K BOEPD. The company notes that its capex and base dividend is funded internally down to $40 WTI.
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A catalyst for future growth
The company is aggressively developing assets in the Powder River basin, acquired in the $1.9 bn purchase of Felix Energy (private) in 2016.
Adding to the gradual increases in lateral length shown in this 2020 slide, the company announced in Q-3 of 2022, the completion of a 15K foot lateral in the Powder River with impressive results. A three-well pad delivered IP-30's of 1,400 BOEPD (86% oil) per well with EUR's estimated at 1.2 mm bbl per well. This is 2-3X a typical recovery from a Delaware Wolfcamp A well. CEO Muncrief comments on the Powder River play-
“The key takeaway here is that Powder is one of the few emerging oil plays in North America, and we have a 300,000-acre net position in the core of the oil fairway providing Devon an important oil growth catalyst for the future.”
This substantial acreage footprint gives DVN considerable flexibility in capital allocation. With wells coming in like this, the capital efficiency for these wells is going to be well above average.
Your takeaway
It's been a rough ride the past few months for Devon. I think the share price has been punished out of proportion to the value the company delivers. I consider that DVN in the $50.00 zone is a compelling opportunity, and it is likely that if the current weakness in oil prices persists, we will get close to that level in the next few trading sessions.
As I noted above, trading volume Wednesday was 10X normal. It looks to me like a lot of funds cut their position. DVN is well below its 200 day moving average, and just below previous long term support at $55. At $50 per share DVN would trade at -5X OCF and $58K per flowing barrel. This is at a considerable margin of safety to current oil and gas prices. Devon should be attractive to investors looking for growth and income in this range.
In summary, Devon Energy has positioned itself through strategic acquisitions over the past several years. Each of these have served a purpose-increase oil percentage, gain access to European markets for gas, increase scale, and enable longer laterals on legacy acreage in key shale plays. The company is developing resources at a high level of capital efficiency and is able to fund maintenance capex internally. The dividend policy the company favors assures investors that 50% of free cash will go toward the special dividends that augment the regular dividend.
In my view WTI is passing through its worst levels of the year now, and the Q-1 bottoming in the relative QoQ performance of shale drillers like DVN, will present a strong buying opportunity at that level. Investors looking for growth and income may find the company attractive near current levels.
By David Messler for Oilprice.com
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