Devon Energy Can Make a Profitable Transition from Gas to Oil

(This is a highly-abbreviated version of a full SumZero report republished with the author's consent)

Contributor: Jay Siegel.
Firm: CGL Advisors. Hedge Fund.
Location: New York, NY

Recommendation: Long Shares of Devon Energy (NYSE: DVN)
Timeframe: 1 to 2 Years
Recent Price: $56.95
Target Price: $80.00

Strategy: Growth at Reasonable Price (GARP)

Quick Thesis:
Devon Energy is a large, integrated E&P company selling at a discount given its track record of opportunistic capital allocation, strong balance sheet and portfolio of low risk development opportunities. The company is currently in the process of building up significant onshore conventional and unconventional properties in the US and Canada following the 2009-2011 sale of $10.1B offshore and international properties.

Devon also owns a collection of steadily earning midstream assets and recently closed on a large JV(with another in the pipeline) and completed a debt refinancing on very favorable terms. A bit under 2/3 of current production is dry gas and the company has yet to receive credit for its ongoing transformation into an oil & NGL producer.

Devon is currently transitioning from nat gas to oil focus and has shored up its balance sheet for the task. The company is investment grade(BBB+) and recently raised $2.5B of LT debt on extremely favorable terms. As of May, 2012 the co. has $7.7B of cash and has a track record of prudent capital allocation and maintaining focus on shareholder returns(repurchased $3.5B or 11% of outstanding shares last 2 yrs and increased div.)

Currently, the company has ~3.0 bboe (42% liquid) spread across several legacy US shale plays and oil sands
locations in Canada. (Devon is the only US E&P independent to develop and operate a Canadian oil sands project.) Apart from its proven reserves, the company has partnered with Sinopec (by selling 1/3 interest across 5 US oil/NGL properties for $2.5B -- $0.9 upfront + $1.6 carry) to develop 5 recently acquired properties containing 1.6 boe (risked) aimed at increasing oil/NGL production. A second JV, est $1.3B, is contemplated for 2013.

For a commodity producer, opportunistic hedging is evidence of good capital allocation skills . Without explicitly turning their hedging activities into a profit center, Devon has garnered very favorable terms (Their ability to achieve better than expected natural production hedges frequently raised during earnings call Q&A.) They target hedging 50% of production but only if achievable on economically sensible basis. As of Q1 '12, ~2/3 of expected '12 oil prod. was hedged, with 25% swapped at $106 and 41% collared between $89-124. Even more impressive, 40% of expected '12 dry gas prod. is hedged at avg $4.42

Devon owns significant midstream assets in proximity to its TX/OK acreage to carry NGL's and dry gas to processing plants and the Access Pipeline linking its Alberta themal oil field to Edmonton. Midstream operations generated ~ $500MM operating profit in 2011.

Based on estimated $6.0B '12 CF, with ~$5.5B generated from E&P activity, the company is trading at about 10% discount to comparable peers.

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