The hydraulic fracturing boom hasn’t been so kind to Oklahoma-based E&P firm Devon Energy (DVN). While DVN has seen many of its rivals trade for lofty new 52-week highs, the company has pretty much drifted sideways since the market recovered from the credit crisis and Great Recession.
Much of that underperformance has to do with the firm’s continued focus on natural gas drilling.
You see, Devon placed its chips in some of the hottest and upcoming unconventional shale gas resources in North America … at just the wrong time. Back in 2009, DVN began selling its various Brazilian and offshore Gulf of Mexico assets to focus on natural gas. And with natural gas prices trading in the basement, the company’s production, profits and share price have been hurt.
However, two recent moves by Devon to “reinvent” itself could finally be the spark that sends shares higher. And DVN’s chronic underperformance makes it pretty darn cheap. Ultimately, shares of the E&P name could be the best blend of growth and value in the energy sector today.
A Major Shift At DVN
Devon investors’ biggest concern was that it simply wasn’t diversified enough as an energy producer. Virtually all of DVN’s assets focus on natural gas and natural gas liquids (NGLs), rather than crude oil. That’s been a huge issue for the E&P firm as natural gas has been below break-even levels for several of its holdings, while crude oil has surged in price.
Well, times are changing at Devon.
The company entered into a deal to purchase 82,000 acres of prime Eagle Ford acreage from privately held GeoSouthern Energy and Blackstone (BX) for $6 billion in cash. The acquisition will add 53,000 barrels per day of current shale oil production to Devon’s energy mix. However, that those acres have about 400 million barrels of proved reserves — meaning they can actually be tapped. DVN will be able to increase production to 140,000 barrels per day in just a few years by drilling more than 230 wells in the field.
Devon also plans on selling some of its non-core natural gas assets in the U.S. and Canada — totaling about 30% of its current natural gas output.
All in all, Devon estimates that its fourth-quarter production volumes would be about 31% oil if these new Eagle Ford assets are included and the assets being divested are excluded. Currently, only about 25% of its production is from oil. Additionally, Devon should realize a 20% earnings per share bump from the GeoSouthern purchase during 2014.
This newfound shift away from natural gas prompted Chief Executive John Richels to say that investors will “find that the new Devon is a significant North American oil producer capable of delivering high rates of growth in high-margin oil production while generating free cash flow.”
And while free cash flows and higher profit margins are attractive enough on their own, Devon is doing investors one step further.
Shelving its plans to spin off its own master limited partnership (MLP) for its extensive midstream network, Devon is merging those assets with Crosstex Energy LP (XTEX). DVN will control more than 70% of the general partner and hold 53% of the new MLP units. The combined MLP will own more than 7,300 miles worth of pipelines as well as 13 natural gas processing plants. This provides a much bigger asset base for DVN to work with.
DVN Is Ripe For Investment
Ultimately, these moves are great for Devon’s current and future shareholders.
Even though it paid a lot for it new oily acreage, DVN will now have a prime spot in one of the most important energy producing regions in the country — something it was severely lacking. After selling its non-core natural gas fields and adding the Eagle Ford assets, the E&P firm will hold acreage in five core areas — including the Permian basin, the Barnett Shale, and the Anadarko basin.
With oil prices continuing to be high and the potential for exports on the horizon, Devon will now be ready to take advantage.
At the same time, the pipeline deal with XTEX will allow Devon to buy up additional oil assets and “drop-down” the field’s gathering/pipeline assets into the new MLP subsidiary. That will help offset the purchase price of the fields while providing plenty of incentive distributions and dividends from its ownership of the general partner and the MLP shares it controls … all while avoiding taxes. That will help strengthen DVN’s cash flows, which will be already enhanced from high oil prices.
These factors should help move Devon back into a top spot into the energy sector.
Meanwhile, after years of underperformance, DVN shares are pretty darn cheap when compared to its “oily” peers. Devon is currently only trading at forward P/E of around 12. Eagle Ford rival EOG Resources (EOG) trades for a forward P/E of 19, while Bakken superstar Continental (CLR) is trading at 16x future earnings. Given similar multiples, analysts estimate that Devon should be trading in the $75 to $80 per share range.
What’s more striking is that those future earnings estimates for DVN aren’t taking into account the new shift towards shale oil and neither of its two shale oil peers have anywhere the size of Devon’s midstream assets.
Given its prospects, DVN could be one of the best blends of growth and value in the energy sector. Investors should snatch up shares before it’s too late.
As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.