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Devon Energy is an international, independent oil and gas company that operates primarily in the U.S. but has major production centers in Canada, China, Azerbaijan, and West Africa. The company is one of the five largest holders of deepwater properties in the Lower Tertiary section of the Gulf of Mexico^[1], though production in the area is not expected to start until 2010. Deepwater exploration is both costlier (and made more so by the increasing day-rates of oilfield services companies), and riskier than traditional off-shore drilling, as finding reserves becomes more difficult as one goes deeper. If Oil prices were to fall, extracting oil in this way could cease being profitable, but if they stay high, it's an enormous opportunity for the company. The company also controls 75% of the Barnett Shale's production volume, a natural gas deposit that is the second largest producing on-shore domestic natural gas field in the United States.

Overall profitability for the company is threatened by increases in royalties paid to the Alberta government over oil sands production, terrorism and political instability in West Africa, China, and Azerbaijan, and hurricanes in the Gulf of Mexico. Devon's closest competitors are Anadarko Petroleum, Apache, and Comstock Resources.

Business Financials

Devon operates by selling its hydrocarbons to range of customers: utilities, refiners, pipelines, industrial users, and others. The company's most significant customer is refiner and oil giant Exxon Mobil, who accounted for 10% of Devon's 2006 revenues^[2].

The vast majority of the company's operations take place in North America, with 51.6% taking place at onshore U.S. reserves in Texas, Wyoming, and New Mexico, 10.3% taking place in the Gulf of Mexico, and 26.9% taking place in Canada; the remaining 11.2% of production occurs internationally^[3]. Much of Devon's future growth depends on the success of its deepwater operations in the Gulf, as well as its expansion internationally.

Source: 2006 Annual Report^[4]

• MMBbl: Million Barrels
• Bcf: Billion Cubic Feet
• MMBoe: Million Barrels of Oil Equivalent

Devon experienced strong growth from 2002 to 2004, but saw revenues and profits decline from 2005 to 2006. This can be attributed to stagnating production growth and falling oil prices from 2005 to 2006.

Source: 2006 Annual Report^[5]

Trends and Forces

Possible Liabilities

Current liabilities @ $4B are understated by 25% due to additional ~$1B off-balance sheet contractual & lease obligations. Furthermore, Devon is weighted more towards unconventional resource plays: Texas gas shale, Canadian oil sands, GOM deepwater drilling – all of these carry major engineering challenges and are subject to costly capital expenditures above and beyond conventional oil/gas exploitation.^[6]

Oil Prices Are Rising, Benefiting Devon

Oil and gas prices have fluctuated heavily over the past few years, though the most recent trend is a rise in prices, with a barrel of oil trading in international market a day after the new year at just over $100. Because both are nonrenewable forms of energy (they will eventually run out), slowing discoveries of new sources combined with increasing pricing has led to speculation that production is approaching peak oil quantities. Whether this is true or not, oil and gas are commodities: one company's gas can only be differentiated from another company's gas based on price. While Devon currently benefits from high prices, the profitability of the current market will drive increased exploration and production, which could eventually cause prices to fall and margins to drop.

Devon's Bet on the Lower Tertiary Leaves the Company Unhedged Against Fluctuating Oil Prices

Devon is the second-largest leaseholder in the Lower Tertiary of the Gulf of Mexico^[7] (after Chevron^[8]); it was one of the first companies to strike black gold in the Lower Tertiary, back in 2006, though production in the area is not expected to start until 2010. Deepwater exploration is both costly, as increasing demand has pushed day-rates of oilfield services companies way up, and risky, as finding reserves becomes more difficult as one goes deeper. The rewards of deepwater exploration, however, could be tremendous: oil companies need to find new reserves to supplement the maturing ones, successful deepwater hits are often extremely rich in oil and gas, and deepwater Gulf properties are not subject to the political risks of reserves in developing nations. An example of deepwater rewards was seen in November 2007, when Brazilian oil company Petrobras discovered 5-8 billion barrels of oil equivalent in the deepwater Tupi field off the coast of Brazil^[9]. Successful deepwater exploration and extraction could combine with high oil prices to be a tremendous boon to Devon's business, though repeated failures in finding reserves would waste millions of dollars and drive margins down. Furthermore, if oil prices fell, the hit Devon would take to its margins would be greater than most competitors, since the company is so heavily invested in high-cost, high-risk areas.

Canadian Government Regulations and Forex Risk

In October of 2007, the government of Alberta announced that it would increase the total amount of royalties paid by companies developing Alberta's oilsands by 20% - about 1.4 billion Canadian dollars. Oil companies like Devon will see drops in net profitability come 2009, when the law takes effect, though it should be noted that industry efforts to lobby the tax away were mildly successful - most Albertans favored a much higher tax^[10].

Moreover, the strengthening Canadian Dollar (C$) has affected bottom-line results to the extent that Devon has shut down conventional resource production in light of escalating operating costs. The combination of rising costs and the exchange rate hit has hurt Canadian results.^[11]

Devon's Stake in the Barnett Shale Could Continue to Deliver...With Risks

Devon has about a 75% stake in the North Texas Barnett Shale by production volume^[12], an area that has delivered tremendously in the past. Though most of the easy-access wells are beginning to mature, there are purportedly rich reserves in the area that simply require more complicated technologies to access. In November 2007, Devon announced that because of the royalty increase in the Alberta Oil Sands, it would move some of its capital from Canada to the Barnett Shale. Without moving the equipment, Devon's 3Q07 Barnett production increased 32% from 3Q06 to 856 million cf/d; with the new equipment in place, Devon expects to reach 1 billion cfe/d in the area by early 2009^[13]. This could come at a price, however, as more complicated well access means more expensive equipment is needed. In the event of a fall in oil and gas prices, Devon would be left unhedged against a dramatic reduction in margins.

Political Risk and Terrorism Could Affect Devon's Profits

Outside of North America, most of Devon's operations are based in West Africa, China, and Azerbaijan, all highly unstable areas. Unstable governments pose threats to Devon because of their unpredictability when it comes to taxation, war, currency fluctuations, trade regulations, and nationalization. Furthermore, in areas that are politically unstable, there is a high risk of terrorist attack, especially on western establishments like Devon's facilities. Though these areas are rich in oil and gas, Devon's profitability in each of them is unpredictable because of the possibility of political and terror-based cost shocks. The overall effect of these areas on Devon's business is not very large, as they comprise only around 9.5% of Devon's reserves^[14], but as North American reserve production begins to slow in the future, development in these unstable zones could become more important.

Natural Disasters Are Seasonal Threats to Devon's Diverse Operations

Because of the geological position of many of Apache's sites, the company risks production failures and rising costs from natural disasters. Highest visibility growth prospects center around the deepwater Gulf of Mexico plays in the Lower Tertiary, which is subject to weather (hurricane) risk. After the 2005 hurricanes (Katrina, Rita, etc), catastrophe insurance has been hard to come by and as the company puts it, their coverage in this respect is “de minimis.”

Hurricanes in the Gulf of Mexico during the third quarter and storms in the North Sea during the fourth quarter can damage equipment, hurt employees, and make transportation of products very difficult. This leads to higher costs and lower profits all around.

Competition

Devon's main competitors lie in the independent oil and gas sector, since the major oil companies like Exxon Mobil and BP are too large and diverse to fairly be called "competition". Among Devon's independent competitors are Anadarko Petroleum, Cabot Oil & Gas, Comstock Resources, EnCana, and Apache. Anadarko Petroleum is the largest of these, and possibly the most similar, as it produces mostly in the Rockies and the Gulf of Mexico, with some drilling activity in Algeria. Comstock Resources is the smallest of Devon's competitors, and is also betting on deepwater exploration to deliver in the future. Apache's strategy is a unique one; the company buys up "mature" properties from oil majors and then extracts more from them, taking advantage of the high price level to keep margins up despite the use of expensive technology. Apache is expanding on the Gulf shelf, a zone that Devon is leaving alone.

Cabot Oil & Gas and EnCana are both heavily invested in natural gas (only 3% of Cabot's reserves contain liquids^[15]); if Devon's gas production from the Barnett Shale and its deepwater reserves continues to increase, it could be in closer competition with these two in the future.

Notes

1. ↑ JPT Online: "Lower Tertiary Trend: A Study in the Impact of Advancing Technology"
2. ↑ http://sec.gov/Archives/edgar/data/1090012/000095013407004377/d43782e10vk.htm#102
3. ↑ http://sec.gov/Archives/edgar/data/1090012/000095013407004377/d43782e10vk.htm#105
4. ↑ http://sec.gov/Archives/edgar/data/1090012/000095013407004377/d43782e10vk.htm#105
5. ↑ http://sec.gov/Archives/edgar/data/1090012/000095013407004377/d43782e10vk.htm#110
6. ↑ http://www.enlightened-american.com/wealth/research/dvn_report_risk.htm
7. ↑ JPT Online: "Lower Tertiary Trend: A Study in the Impact of Advancing Technology"
8. ↑ Petroleum News: "New horizon for industry"
9. ↑ http://www.plenglish.com.mx/article.asp?ID=%7BF7FB5E40-66BA-421F-9111-061341EA40CF%7D&language=EN
10. ↑ http://en.epochtimes.com/news/7-10-26/61223.html
11. ↑ http://www.enlightened-american.com/wealth/research/dvn_report_risk.htm
12. ↑ http://www.thebarnettshale.com/
13. ↑ Devon Might Boost Barnett Shale Activities, http://startelegram.typepad.com/barnett_shale/devon_energy/index.html
14. ↑ http://sec.gov/Archives/edgar/data/1090012/000095013407004377/d43782e10vk.htm#105
15. ↑ Reuters, Cabot Oil & Gas Corp, http://stocks.us.reuters.com/stocks/fullDescription.asp?rpc=66&symbol=COG