Wait to Buy Devon Until After 2nd Quarter Results

By Maxwell Fisher - August 2, 2012 | Tickers: CHK, DVN, ECA, RRC, SD | 0 Comments

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Based on calls from other analysts, Bloomberg is predicting that Devon Energy’s (NYSE: DVN) second quarter earnings will come in lower than expected due to a drop in gas liquids prices. The drop is also expected to hamper WPX Energy (WPX), which like Devon moved towards liquid gas to blunt the impact of falling dry gas prices over the past few quarters. Range Resources (NYSE: RRC) is also feeling the push, as it called propane prices “soft” and prepared to take a different approach to its hedges.

I think that Bloomberg is on the right track with Devon, although it is not predicting anything that Devon did not already outline for its shareholders. However, I suspect that the hit might be worse than anticipated.

Indications of a Less Than Impressive Quarter

The price of gas liquids such as ethane and propane dropped over the last three months due to warm weather in the U.S., strangling demand amid increased supplies as other producers made similar moves. Devon already attributed the differentials on natural gas liquids as well as the differential on Canadian oil with its lower than anticipated first quarter earnings, and it looks like this quarter will be a repeat: The median guidance Devon provided for the first quarter was $1.35 per share, but results came in at $1.05 per share. Devon’s first quarter realizations on natural gas liquids were 7% below the median in its guidance at 34% of WTI benchmark prices, due partly to reduced demand in the Gulf region and high propane inventories.

All of this was despite a 10% growth rate over the first quarter of 2011, centered mostly in oil and other liquids, and record production in the Permian Basin, Jackfish, Cana-Woodford, and Barnett shales. Devon has higher than average exposure to natural gas liquids in its portfolio, as these resources make up 16% of its production mix. A further 63% of its production is in dry natural gas, leaving just 21% in oil. While 21% oil is better than virtually none, as Encana (NYSE: ECA) and Chesapeake Energy (NYSE: CHK) well know, it is not enough weight to blunt natural gas prices that fall below the cost of production.

Devon also expects that planned downtime to allow for expansion of its Gulf Coast Fractionators facility will reduce its midstream operating profit  by nearly 40% in the second quarter, to between $70 and $90 million, $50 million below previous guidance. This, too, should have a small but measurable impact on earnings.

Growth in Joint Ventures

Devon is going after oil in the Utica shale, with several wells approved and in various stages of drilling in the western reaches of the play. This may be a move to help limit its increasing exposure to falling prices for natural gas liquids, since the eastern portion of the Utica is gas and wet gas rich.

Encana is following a similar strategy, planning five wells for the Collingwood/Utica play in its current forecast, a switch from its initial 2012 forecast that did not include any liquids action on the Utica. Range Resources is also crowding into the wet gas window on the Utica, with initial tests providing “encouraging results.” This, of course, is after Chesapeake became the first driller to reach commercial production from the Utica. This crowding will squeeze pressured gas liquids margins even further as these firms bring the initial wells to full production, but here Devon does have an edge since its diversification into oil is more complete than that of Chesapeake, Encana, and Range.

Devon recently agreed to a shipping commitment for Kinder Morgan Energy Partners LP’s (KMP) proposed Trans Mountain pipeline expansion, along with BP (BP), Tesoro (TSO), Husky Energy, Cenovus Energy (CVE), and others. The expansion would mirror an existing line between Edmonton, Alberta and Burnaby, British Columbia, doubling capacity of crude flowing to ocean tankers in port. While there is strong opposition to the pipelines, I think there is a reasonable chance that the project will ultimately be approved given the National Energy Board and provincial governments’ previous open stances towards responsible development.

In the news, Devon Executive Chairman Larry Nichols was recently named 2012’s “Most Powerful Oklahoman,” just one rung ahead of Chesapeake CEO Aubrey McClendon, who took the number two spot. The list, compiled by the Oklahoma City Friday and based on surveys completed by business, education, finance, government, political and media leaders, is in its fifteenth year. SandRidge Energy (NYSE: SD) CEO Tom Ward and Continental Resources (CLR) CEO Harold Hamm also made the list.

Outlook

In the first quarter, Devon gave guidance that production would be essentially flat. Due to flat production and low prices, Devon is expectedto earn $0.94 per share in the second quarter, a measured drop from its first quarter earnings at $1.05 per share. This is driven by Devon’s expectations for its natural gas liquids realization to come in between 32 and 38% of WTI benchmark prices, far lower than in previous quarters. Devon might do well to hedge itself more thoroughly, like SandRidge, which has 81% of its guidance oil production hedged through 2015.

Since not all of Devon’s growth prospects are in crude but are also dependent on natural gas liquids, I think that Devon will be showing lower earnings, in this and future quarters, against dry natural gas prices even as it decreases its production in this area.

Devon’s share price is essentially flat for the month, with current trades around $59. The stock did see a run up from a week ago low of $55, an increase of nearly 10% in just a few days. Looking back towards June Devon experienced a similar curve, and I think this is due in large part to the two edges of Devon.

On the one hand, Devon has industry leading financials, with a 0.3 debt to equity ratio, a 39.7% net margin, and considerable liquidity with nearly $8 billion in cash and short term investments. On the other hand, Devon is still primarily a dry and liquid natural gas producer, and liquid natural gas is about to join dry gas in a price depression as more producers take Devon’s route to diversification. For the long term, I expect that the pressures on Devon will ease as gas prices return to normal, but for the short term I think it’s likely Devon will see a dip after its earnings release, which will lead to a better buy opportunity.

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