This Independent Driller is Dirt Cheap

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Shares of Devon Energy (NYSE: DVN) are exceptionally cheap. Low natural gas prices and plunging natural gas liquid (NGL) prices have shares in the dumpster. That provides an interesting opportunity for those willing to hold their nose and buy other peoples’ garbage. Say the name “Devon Energy” and the first thought that likely comes to mind is shale gas. As a result of their pioneering role in the Barnett Shale, Devon’s virtually synonymous with shale. Half of its proved reserves are gas locked up in the Barnett and Cana-Woodward Shales.

At current nat gas prices, things just don’t look quite as rosy for the unconventional drillers. Ask shareholders of Chesapeake (NYSE: CHK), Encana or Talisman Energy (NYSE: TLM) how fun the last few years have been. There’s plenty of commiseration to go around. Despite that unpleasant truth, I think a case can be made that Devon shares have been unduly punished, providing an opportunity for investors long-term bullish on nat gas.

A survey of a few of Devon’s Independent Oil and Gas peers shows just how low shares have gone. One of the most fundamental price metrics for Oil and Gas E&Ps is your cost per barrel of reserves. The table below provides a look at 10 peers’ 2011 year-end reserve levels and enterprise values (their net debt plus their market caps).

 

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Devon’s reserves are the largest of the peer group, and have the lowest valuation, pricing below $9 per barrel of oil equivalent (BOE). Only Chesapeake sports a valuation as low, and that’s with all its excessive debt, infamous corporate governance record, and reserves far more concentrated in gas. 

In fact, all four of its peers with lower percentages of more valuable liquid reserves actually sport higher valuations.  EOG Resources (NYSE: EOG) is twice as high on a per-barrel basis. How about production? At $40,000 per flowing barrel, Devon sits at the back of the valuation pack again. Only Chesapeake and Talisman look as cheap. For the contrarian, Devon looks like a screaming buy. So what’s wrong? Not as much as you might think.

Reinventing Devon
In response to the global recession and collapse in natural gas pricing, Devon divested its offshore and international assets, and ran home to North America to focus on its core onshore business. That move raised cash at a critical time, strengthening its balance sheet and allowing Devon to refocus its North American operations. 

The sales gave Devon the strongest cash position of its peer group, a significant advantage in this economic environment, in addition to the chance to expand its already strong acreage position. Devon now holds over 13 million acres in North America. Two-thirds of that is undeveloped, leaving plenty of raw material for long term growth.

Getting Oilier
Part of that realignment was a concerted move toward liquid-rich basins. In 2010, Devon expanded their Permian acreage to a million acres and purchased a 50% stake in Pike, an oil sand prospect in Alberta. It also accelerated its drilling of conventional Permian prospects in the Bone Spring and Delaware sandstones. The success has been good so far: Permian oil production in Q2 was up 24% year-over-year. 

Due to divestitures, Devon's oil production bottomed in the third quarter of 2010. Overall, liquids production (oil and natural gas liquids) is up 31% off that bottom, with a 45% boost in oil production. Liquids as a percentage of production are now 37% of production, up from a low of 31% in 2010. Its next step in the Permian will be more exploratory. 

Devon is taking its considerable shale experience into Oil Shales, testing the unconventional, oil-rich Cline Shale of western Texas. Devon will also extend their noose to include unconventional targets in the Mississippian Limestone of northern Oklahoma.

Getting a little help from their friends

To ease the transition to unconventional Oil Shales, Devon’s enlisted a little cooperation. Finding a way to produce from a previously unexplored shale bed, or ‘derisking a play’ as the industry terms it, is a tricky and expensive business. Drillers play with locations, horizontal drilling length, water conditions, sand content, and the number of fracturing steps used. It’s an expensive process. To defray the cost, Devon’s embarked on two joint ventures. To the benefit of shareholders, Devon brings the brains and the partners bring the dollars.

The first, with the Chinese oil company Sinopec, is a JV aimed at derisking five different unconventional shale plays in North America: the aforementioned Mississippian Lime of Oklahoma, the Niobrara of Wyoming, the Tuscaloosa Marine Shale in Louisiana, the Utica Shale in Ohio, and the A1 Carbonate in Michigan. Sinopec will pay $900MM in cash up front with an additional $1.6B of future funding, for a third of the JV’s working interest. The deferred funding (or ‘drilling carry’ as the industry terms it), will be spent to fund drilling by the JV. Initial emphasis will be in the Mississippian Lime, where Devon will add rigs this year. 

The potential for growth in these plays is obvious. Two million of Devon’s acres are contained in these new plays, with the largest being Devon’s 545,000 acres of Oklahoma Mississippian acreage.

The second deal is more recent and more focused. Japanese Sumitomo will invest $410 million in cash and another $980 million in drilling carry for 30% interest in Devon’s unconventional Cline Shale and conventional Wolfcamp Permian acreage. Devon’s already at work here, but the new money allows them to shift even more emphasis toward this promising acreage. 

Drilling rigs will be moved from its gas-rich properties as needed to supplement development, further improving Devon’s liquids mix in production. Better yet, both JVs allow Devon the opportunity to play in its new sandboxes using other peoples’ money. That’s a beautiful thing in any financial circle.

Expanding their Oil Sands development
Investors also get exposure to Canadian Oil Sands with Devon. Its Jackfish plant produces synthetic oil from bitumen in Alberta. Significant expansion of Jackfish is planned and another 50% joint venture is planned at an adjacent facility. Pike, in its regulatory review stage, will have a 105 MBOEd capacity.

All in all, Devon expects to have over 150 MBOEd of capacity (net to Devon) in operation by 2020. With those extensions, Devon’s synthetic oil production alone will match the company’s current total oil production.

Is Devon a buy?
Devon’s doing a lot of things right by refocusing their drilling towards liquids and expanding its exploration in new basins through partnerships. Drilling with its partners’ money means reduced risk and more of Devon's own cash to further accelerate drilling, expand acreage, or just stash in the couch cushions if these rainy days continue. 

Devon's monetized non-core assets, expanded its leaseholds in North America to further enhance its competitive stance, and increased its oil sands development to help work toward the goal of becoming a more balanced domestic liquids producer. You get all that and more when you buy Devon. 

Its reserves give you a huge amount of proven gas cheaper than anyone in its beaten down peer group. For anyone long-term bullish on domestic natural gas and looking for value, Devon looks like a safe bet.


JustMee01 has no positions in the stocks mentioned above. The Motley Fool owns shares of Devon Energy and has the following options: long JAN 2013 $16.00 calls on Chesapeake Energy, short JAN 2014 $15.00 puts on Chesapeake Energy, long JAN 2014 $20.00 calls on Chesapeake Energy, and long JAN 2014 $30.00 calls on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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