Devon Will Repeat Front-Load Capital Program in 2024; Production Declines Expected in Interim

Analyst

Katherine Olexa

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Devon Energy is an oil and gas producer based in Oklahoma. It has assets in several shale basins across the United States, including the Delaware Basin, Eagle Ford Shale, STACK, and Powder River Basin. Management has reshuffled the portfolio in the last few years, divesting its Canadian oil sands business and exiting the Barnett Shale natural gas play. In January 2021, it combined with another Oklahoma-based shale firm, WPX Energy, in a “merger of equals” that significantly expanded Devon’s Delaware Basin exposure and added a small position in the core of the Bakken Shale fairway in North Dakota. The merger brought economies of scale and more efficient field operations, and enhanced the competitiveness of the combined firm.

The Delaware Basin offers the best development economics in Devon’s portfolio and will be the primary growth engine for the company. The combined firm has 400,000 net acres of leasehold in the play and derives more than half of its production from there. Management has allocated around 60% of the 2023 capital budget to developing the Delaware and is likely to prioritize the asset in future years as well. That translates to slow and steady volume increases in the basin over time.

How fast firmwide production grows will depend on the trajectory of commodity prices to an extent. But management has pledged to keep growth at 5% or less, even during upcycles (though 2023 guidance implies 7% expansion over 2022). And it intends to spend no more than 70%-80% of cash flows under any circumstances, which means any windfall during periods of higher commodity prices will be returned to shareholders rather than plowed back into new drilling. The firm was the first U.S. exploration and production company to implement a variable dividend to funnel excess cash to shareholders, and the strategy was warmly received by the market when it came into effect in 2021 (when Devon was the top performer in the S&P 500). After 50% of free cash has been distributed in cash the remainder will fund buybacks and strengthen the balance sheet. We prefer cash returns during upcycles, when firms are more flush with cash but also when stock prices are typically higher.

Business Strategy & Outlook

Devon has an inherent cost advantage baked into its asset portfolio (Rystad Energy ranks Devon first among U.S. E&Ps on breakeven costs associated with undeveloped reserves, ahead of several narrow-moat firms such as Diamondback Energy and EOG Resources). This enables the company to reliably deliver excess returns on invested capital, which are a hallmark of moaty companies in our framework. We assign a narrow moat rating as a result.

However, those excess ROICs are masked by substantial asset impairments that have been recognized over the years. If such impairments are included in invested capital, as we typically do, then Devon would be apparently failing to earn its cost of capital. These impairments date back to 2012-16, a period that saw a change in midcycle oil prices from over $100 to $55 for West Texas Intermediate. By itself, that’s not a good enough reason to exclude the impairments because downturns can happen in this volatile industry, and we would not rule out further write-offs during future commodity downturns.

However, Devon was a very different company in 2012-16. It had no Bakken exposure, and its Delaware Basin assets were a smaller portion of the portfolio (under 10% of total volumes compared with 70% today). The biggest areas of focus were the Barnett Shale and the Canadian oil sands, along with other assets it has since divested. None of these were favorably positioned on the cost curve, unlike the Permian and Bakken plays the company concentrates on today. When oil prices collapsed in 2015, Devon recognized $21 billion in write-downs. This alone would double the firm’s invested capital base and halve its ROICs if we include it. Had the firm been exclusively operating in low-cost areas like it does today, those 2015 impairments would probably have been much milder. We therefore argue that in this unique case, it is unfair to apply our typical methodology. Our ROIC calculation only adds back the very minor impairments the firm has recognized since 2017. On that basis, we expect the firm to earn its cost of capital under midcycle conditions with a margin of safety exceeding 5%, giving us confidence in a narrow moat rating. 

The cost advantage that underpins Devon’s moat is driven by the acreage it holds. A large portion of its production is derived from the Permian Basin, which is the cheapest source of crude oil in the U.S.—sitting below other shale plays, deep-water projects, and all other unconventional sources on the global cost curve. The firm is ideally located within the play as well, on the Texas-New Mexico border. By focusing on areas that typically yield very impressive initial flow rates, the firm’s fixed costs, such as drilling and completions, are spread more thinly, delivering more bang for the buck. Likewise, the firm’s Bakken footprint overlaps the core of the play, where well results are typically strongest (near the Fort Berthold Indian Reservation). The rest of the portfolio – in Oklahoma and Wyoming’s Powder River Basin– is more speculative in terms of position on the cost curve. However, management is unlikely to pour capital into those areas disproportionately unless the respective teams can make the economics competitive (we award an Exemplary capital allocation rating). Overall, Devon’s undeveloped reserves have the lowest breakeven costs of our entire E&P coverage.

Like all E&P firms, Devon is exposed to a range of potential environmental, social, and governance issues that could hurt its ability to generate strong returns. The most significant ESG exposures are greenhouse gas emissions (both from extraction operations and downstream consumption) and other emissions, effluents, and waste (primarily oil spills). Of these, greenhouse gas emissions are the biggest threat, and there’s no way for oil producers to avoid them.

Firms can clean up their operations in the field as much as possible by avoiding unnecessary flaring and using technologies like electric fracking and carbon capture to reduce carbon dioxide volumes being released into the atmosphere during the extraction process. Downstream emissions—at the refinery and beyond—are beyond producers' control, yet these account for the vast majority of total emissions. So, there's no such thing as a "green" oil producer. As consumers become more averse to fossil fuels, the reputational risk grows for producers and the probability of widespread substitution away from fossil fuels increases. This also makes value-destructive regulatory intervention more likely (think fracking restrictions or carbon taxes). These threats are not likely enough to be included in our base-case forecasts, but the impact is potentially material.

Spills are not a major concern for firms operating exclusively onshore, as Devon does. There is no chance of a devastating accident like the BP Macondo disaster in 2010. Nor would the firm be on the hook for adverse events during long-haul transit, like the Kalamazoo River spill in Michigan, which also occurred in 2010. This activity is typically outsourced to midstream firms that operate regional pipelines. Instead, Devon is more vulnerable to spills at or around the wellsite. These tend to be frequent but relatively minor. Costly legal challenges are unlikely for this kind of event, and we see little chance of significant value destruction.

Narrow

Economic Moat

Devon Energy

Devon Energy Corp. engages in the exploration, development, and production of oil and natural gas properties. It develops and operates Delaware Basin, Eagle Ford, Heavy Oil, Barnett Shale, STACK, and Rockies Oil. The company was founded by J. Larry Nichols and John W. Nichols in 1971 and is headquartered in Oklahoma City, OK.

Earnings data Q1 2024

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Devon Energy Corporation (NYSE:DVN ) Q3 2023 Earnings Conference Call November 8, 2023 11:00 AM ET Company Participants Scott Coody – Vice President-Investor Relations Rick Muncrief – President and Chief Executive Officer Clay Gaspar – Chief Operating Officer Jeff Ritenour – Chief Financial Officer Conference Call Participants Doug Leggate – Bank of America Merrill Lynch Nitin Kumar – Mizuho Neil Mehta – Goldman Sachs Scott Gruber – Citigroup Neal Dingmann – Truist Charles Meade – Johnson Rice Matthew Portillo – TPH Kevin MacCurdy – Pickering Energy Partners Paul Cheng – Scotiabank Scott Hanold – RBC Operator Hello, everyone, and welcome to Devon Energy Third Quarter Earnings Conference Call. At this time all participants are in a listen-only mode.

Devon Energy Corporation (DVN) Q3 2023 Earnings Call Transcript

Devon Energy's (DVN) third-quarter production volumes are better than the year-ago quarter's level due to solid contributions from the Delaware Basin.

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