Devon Energy Stock: You Might Think (NYSE:DVN)

Introduction

There is no justice in the oil patch these days. Good companies, supplying badly needed products to a “thirsty” market are getting pounded out by the financial markets. There really has been no safe haven for holders of shale related equities over the past year. In spite of occasional fits and starts that drew in the unsuspecting, the general glide path has been lower since October of last year. One of my personal favorites, about which I’ve written many times

On this platform, Devon Energy Corporation (NYSE:DVN) has been taken out to the woodshed relentlessly over this period. DVN is one of the cornerstones of our portfolio, and as of today, it’s down 30% YoY, and about 40% from its peak in late October of last year. Honestly you might think that the world was going to quit using oil and gas abruptly, leaving DVN’s petroleum assets stranded in the ground. Intellectually we know that’s not the case, but it’s frustrating to see your capital wither away.

Now, DVN isn’t alone in this slow-rolling freight train of capital annihilation, but it’s fared worse than rival Pioneer Natural Resources (PXD), down from $252 a year ago, to $215 at the close today-say 12%. (Note-Holders of PXD might be interested in reviewing an older article of mine in which I discuss the now apparent rationale for Exxon Mobil (XOM) acquiring the company.)

ExxonMobil: Feeding The Beast

Ok, getting back on track here as regards Devon. In another case, EOG Resources (EOG) is down 12-13% to $119 from 145 a year ago. So it makes me wonder, what about DVN singles it out for such a pounding by the market?

In this article, we will review some pertinent aspects of this beleaguered energy giant, and see if we can justify our continuing to hold the stock, and perhaps buy more at these distressed levels.

You might think they were making lousy wells

You would be wrong, although there is a caveat to that statement we will discuss. As a nominal oil producer, the first thing you might think is that their wells are running dry and they are running out of good drilling locations. Nothing could be further from the truth. Devon is turning in some great wells with IP-30 rates three and four times the official new well average quoted in the EIA-DPR. With a key acquisition of WPX Energy in 2021, DVN picked up some of the best rock in the Permian basin, which it has been developing since.

In past articles, I’ve extolled the wonders of the Permian Basin, and in particular the multi-tiered, Upper and Lower Bonespring, and Wolfcamp A, B, C, and D in the Delaware sub-basin that is powering national shale production ever so incrementally higher. Here is a link to my earlier articles on Devon, which you can access for a deeper treatment of the Permian than I will do at this point.

Here is commentary from Clay Gaspar, President of DVN pointing out recent successes on Delaware projects:

A key project I would like to highlight from the quarter was our Mule development in Eddy County, New Mexico. We’ve talked in the past about the important appraisal work that we do each year with 10% to 20% of our capital budget. The Mule pad is an example to provide you some visibility into the fruits of this labor. This 11-well project successfully codeveloped multiple landing zones within the Wolfcamp with particularly exciting results from the appraisal of deeper Wolfcamp B benches.

The initial results from these 6 wells targeting the Wolfcamp B landing zones average greater than 3,100 BOE per day with 44% oil cut. Per well recoveries are on trend to exceed 2 million barrels of oil equivalent. Importantly, these highly commercial appraisal results de-risk and enhance the economic expectations on approximately 100 Wolfcamp B locations in the Cotton Draw area. Furthermore, these deeper Wolfcamp locations are expected to be highly competitive within our capital allocation framework going forward. The Delaware team also continued to make progress advancing drilling and completions efficiencies across our operations in the basin. In the Wolfcamp, we improved drilling productivity by about 10% on a per foot basis over the past year, while some of our best spud-release times for 2-mile laterals pushing below 15 days.

In a recent internal article on Occidental Petroleum (OXY), we discussed how shrewd operators are extracting Tier I results out of what would nominally be Tier II intervals-Wolfcamp B as an example. What Gaspar is describing with the Wolfcamp B is just that-Tier I performance. Deeper, with higher pressures, perhaps lower Total Organic Carbon-TOC’s, and tending to be gassier than the upper “A” zone, without the elixir of technology, these new “100 Wolfcamp B locations in the Cotton Draw area,” might not exist. Gaspar goes on-

Completion efficiencies have also steadily improved, with our cycle times decreasing by 9% year-to-date and compared to 2022. Averaging a record completion pace of more than 2,200 feet per day in the quarter, this operational progress has been accomplished in conjunction with an even higher safety and environmental focus and expectation. The great work our team has done to drive improvements across the entire planning and execution of our resources coupled with a broader service cost deflation trends are positioning our business to be even more efficient as we head into 2024.

If a company drills four hundred wells a year, a 9% increase in efficiency delivers 40 additional wells. For free. Ok DVN is making great wells. Let’s move on.

You might think they were producing less

Certainly not. Across all of their shale portfolio, production is up 7% YoY. The Delaware decline YoY is probably explained by increasing gas production from the Wolfcamp B. That was the caveat, by the way, and a likely source for some of the pain the market has inflicted on the company. For those who are new to my work, here’s a point I haven’t covered in a while. Thermally, the “oil window” begins to convert to gas and gas liquids as wells become deeper and as a consequence-hotter. Deep and hot gets you dry gas.

So, declining production is not the answer. One final point in regard to the Eagle Ford, the Validus acquisition is paying dividends in raising the oil content of DVN’s daily output. In past articles, I’ve shown the EIA map of the Eagle Ford, I’ll just link it here. Give it a look and you can see DVN’s showcase development on the Butler pad is right on the southern flank of the oil and gas condensate rich section of Karnes county. As of now, of the 502 rigs looking for oil, 44 of them are in the Eagle Ford.

Clay Gaspar details the results of their exploration work in the Eagle Ford-

In the Eagle Ford, our 3-rig program resulted in 29 gross wells placed online during the quarter. This activity which was concentrated in the recently acquired acreage in Torrance County drove a 9% increase in productivity versus the previous quarter. This margin – this high margin growth was driven by strong well productivity achieved from a balanced mix of development and appraisal activity designed to refine the next stage of development for this prolific resource play. Our top development project in the quarter was headlined by LP Butler pad. This 4-well pad developed a highly charged theme of pay in the volatile oil window of the play that exceeded pre-drill expectations, reaching an impressive average 30-day rate of 3,600 BOE per day, with a 56% oil cuts.

The Butler unit was part of the package that came with Validus. Something I’ve harped on-consistently, is rock quality matters above all. Sure, DVN spent a couple of billion to get this bolt-on to their existing acreage, but it is yielding impressive results.

On the appraisal front, a key success in the quarter was the Knudwig unit. This development project in Torrance County tested infill spacing, ranging from 140 to 180 foot intervals, and yielding roughly 30 wells per section. The initial 30-Day rates from this package of wells averaged 2,000 BOE per day, resulting in highly commercial returns, that adds the depth and quality of our inventory in the play.

Also, adding to the commerciality of this tighter spacing was our drilling performance where we broke a company record averaging over 2000 feet per day, which included the fastest bud rig release time in company history of only 5.7 days. As we look to allocate capital for 2024 and beyond, the positive operating results we have achieved year-to-date served as valuable data points to optimize future development activity in the Eagle Ford and other and further deepens our convictions of the resource upside that a trend exists across this entire field.

So they are increasing production and increasing the oil-cut of the same. What’s next?

You might think they weren’t making any money

Yes they are. Great gobs of it… but revenues and margins are down. And now we begin to understand at least part of the reason why DVN has gotten whacked by the market. In Q2, DVN logged gross revenues of $3,365 bn, down sequentially from $3,584 in Q-1, and a big step down from $5,794 the year prior. Oil prices down by nearly half and gas dropping to ~$2.00 MCF explains the drop. DVN still managed to generate $1,575 bn of EBITDA, $1,405 bn OCF, and Free Cash of $690 mm for the quarter. This covered the fixed and variable to the tune of $0.49 per share, or a dividend expense of $313 mm for the quarter.

Their operating margin-OM, for the quarter fell to 43.95%, an 18% drop QoQ, and a big step down from the 63.33% OM recorded in Q3 of 2022. I chose Q3 for comparison as it shows what the decline in gas has meant to DVN. For reference, though, PXD OM for Q-2,2023 is also 43%, so DVN is not necessarily underperforming competitors as oil and gas prices have slumped through Q-2.

Let’s look at another metric, Return on Capital Employed, or ROCE.

On ROCE DVN outperforms PXD. The company claims more than 20% in the slide deck for the quarter. My calculation shows 31.16% on TTM basis, so we will run with that.

The main reason the market has thumped DVN

What has been perceived as dividend cuts since Q2, 2022 have absolutely helped to crush the stock. I’ve made the point before that the company has stuck to their capital returns model, where 50% of free cash goes to dividends and share repurchases, but it hasn’t mattered. Nor has it mattered that other shale high dividend payers have also moderated their payouts as cash flow has declined over the past year. In each case, in conjunction with or slightly in advance of the announcement, fickle investors have voted with their feet.

A catalyst for Q3

The company expects to place online around 90 gross wells in the third quarter, with capital spending expected to approximate $900 million. The decline in capital spending is driven by the drop of a temporary frac crew in the Delaware Basin and efficiency gains that accelerated completion activity into the first half of the year. This level of activity is expected to drive oil production to a range of 322,000 to 330,000 barrels per day in the third quarter.

Increased production at a time when oil prices are surging and gas has recovered from off the bottom should add meaningful cash flow and bump up the margins.

Your takeaway

It’s been tough sledding for DVN the past year as we have discussed. My expectation is they will turn the corner with their Q3 earnings announcement that will come o/a the First of November. EPS is expected to come at $1.46 per share, a 20% bump from Q2. If they hit that target, free cash should be back in the ~1.0 bn range. Half that, minus the fixed at $0.20 or $127 mm leaves $322 mm for the variable or about $0.51, making the total payout $0.71 per share. With forecast EPS of $1.61 for Q4, the pot should continue to get fatter.

We should also mention DVN’s aggressive stock buybacks, bringing value to shareholders. Rick Muncrief, CEO and Jeff Ritenour, CFO comment on the timeliness of these buybacks-

We also have an active buyback program that resulted in the repurchase of nearly 4 million shares over the past 3 months. We see great value in our equity and continue to be active buyers of our stock. During the quarter, we repurchased an additional $200 million of stock, bringing our year-to-date total to approximately $750 million. With the authorization we have in place, we remain on pace to repurchase approximately 9% of our outstanding shares by the end of next year. These opportunistic buybacks are a critically important tool for us to compound per share growth for investors over time.

It should go without saying…almost, that as the float declines more cash is available for future distributions.

Right now Devon Energy Corporation is trading at a paltry 2.1X NTM estimated EV/EBITDA. That puts it squarely in a buy zone. Investors looking for growth and income should definitely consider DVN at current levels. If I am half right, these prices aren’t going to stick around long. I will probably add to my position tomorrow.