Things haven’t exactly been going Devon Energy’s (DVN) way over the last few years.
First, the natural-gas-focused energy company has been struggling because of relatively low prices for its primary production fuel. As we’ve seen, the rapid adoption of hydraulic fracturing has continued to push supplies of natural gas, while dragging prices lower.
Then, several of Devon’s “hot plays” have turned out to be duds. After spending a tidy sum to gain acreage in Ohio’s Utica shale, DVN has decided to put its entire land position up for sale after it didn’t produce anything from its five wells last year.
These issues have weighed on shares, and several analysts now estimate that Devon could become the latest target of activist investors. In an effort to perhaps prevent this fate, management unveiled a series of share price-boosting moves — which the market promptly ignored.
However, you shouldn’t pass on the company’s master limited partnership plans. They could be the key to the company’s future success.
Striking While the Iron’s Hot
Unfortunately for Devon shareholders, the company has been the second-worst performer in the natural gas sector this year — even beleaguered Chesapeake Energy (CHK) is doing better — with DVN shares falling about 30% in the past two years. That has prompted management — perhaps in an effort to save their own skin — to propose spinning off the company’s midstream assets into a master limited partnership.
Many energy companies have been drawn to MLPs as a way to create tax efficiencies. By placing pipelines, gathering and storage assets into an MLP, the sponsoring firms help avoid taxes and receive back generous distribution payments. Individual investors benefit from the security type’s high tax-advantaged yields. This powerful combo has been a win-win for both issuing firms as well as retail investors. And given the benefits, new MLP spinoffs and issuances have surged.
The new publicly traded limited partnership will include the company’s natural gas gathering and processing assets in Oklahoma, Texas and Wyoming. Devon boasts some of the most extensive midstream operations of any U.S. independent producer and owns more than 6,500 miles of pipelines, 300 compressor units and eight gas-processing plants. The total intake capacity of these assets are around 1.2 billion cubic feet per day.
By and large, the partnership will control a minority position in these businesses, while DVN will own the general partner, retain distribution rights and hold a majority of the partnership units after the initial offering. All in all, Devon’s plans sound very similar to recent moves by Marathon Petroleum (MPC), QEP Resources (QEP), EQT Corporation (EQT) and many others.
And yet, Wall Street couldn’t care less. In fact, the day Devon announced its plans, shares of the energy producer actually went down about 1.5%.
The reasoning behind the selloff and lack of interest comes from a very vocal camp claiming that Devon should focus on raising its production of oil rather than natural gas.( Currently, about 60% of production is natural gas-related.) Additionally, analysts have stated that the company could pay a big special dividend or shed all assets that it does not consider essential to its base as better ways to increase shareholder value.
But if you ask me, the MLP spinoff seems like a sweet deal.
Plenty Of Bullish Catalysts
First, Devon will raise about $300 million to $500 million in initial proceeds from the MLP spinoff. Keep in mind that it will still have a controlling interest in these assets and generate some hefty tax-advantaged distribution rights. Those pipelines and processing plants will generate about $475 million in EBITA this year.
That $475 million is money Devon can use to plow back into oil-rich shale plays. Already, the firm has increased its spending in places like the Permian Basin — which yields the energy trifecta of oil, natural gas and natural gas liquids. Producing oil and NGLs are more profitable than natural gas, and so far this year DVN’s U.S. oil production has risen 23%.
Basically, the spinoff gives it the cash necessary to do what analysts exactly want it to do.
Secondly, the MLP can act as “Second Balance Sheet.” Given the size of Devon’s midstream portfolio, expanding that network is a costly proposition. With investor thirst for yield, MLPs have had an easy time raising capital for new projects. By shifting the responsibly of expansion to the new partnership, Devon will be able to create growth along its pipeline system easier, while using its own balance sheet for strictly E&P activities.
Finally, all of those incentive distributions could flow back to shareholders in the way of increased buybacks and dividend raises. Devon currently yields just 1.5%. However, as more tax-advantaged cash flows back into its coffers from the MLP, investors in DVN stock could finally see some bigger dividend checks every three months.
All in all, Devon’s plans to spinoff its midstream asset shouldn’t be ignored and could finally be the kick needed to move shares much higher.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.