Devon Looks Good,
But Could Stumble
If Gas Prices Drop, Analysts Wonder
What Will Fuel Producer's Shares
By RUSSELL GOLD
Staff Reporter of THE WALL STREET JOURNAL
By most appearances, Devon Energy Corp. is sitting pretty. The largest independent producer of natural gas in the U.S. is enjoying unusually high natural-gas prices. Its profit in the first quarter rocketed to $436 million, roughly seven times as large as the year before. Its shares are up nearly 50% over its 52-week low.
But as prices have climbed, so have Devon's costs, prompting some investors and analysts to question what will fuel the shares should natural-gas prices drop in the highly volatile sector.
Devon's "break-even gas price is a lot higher than people think," says Andrew Lees, an analyst at RBC Capital Markets, the investment-banking and research unit of Royal Bank of Canada. The company provides commercial loans to Devon, but no investment-banking services. Mr. Lees has an "underperform" rating on Devon shares.
Acquisition-hungry Devon has taken on lots of debt to acquire many fields that are more expensive to produce than other gas plays. As a result, Mr. Lees expects the company to spend as much as $3.97 per million British thermal units of natural gas, up from an estimated $3.50 per million BTUs last year and $1.97 per million BTUs in 1998. That means if prices slip back to more traditional levels of $3 per million BTUs or less, Devon's profit could disappear.
Costs for most exploration and production companies are rising because the best prospects in the U.S. were long ago depleted. Companies are working harder -- and spending more on new technologies to find underground deposits and coax the gas out of the ground -- only to hit smaller pockets of gas. So natural-gas producers have become more vulnerable to the frequent price swings of the cyclical energy business.
Still, some of the independent oil and natural-gas producers are doing a better job of managing exploration and administrative costs than Devon, some analysts say. By Mr. Lees's count, Devon is spending 46% more to produce its gas than Apache Corp., which he estimates will spend $2.71 per million BTUs for its natural gas this year. Burlington Resources Inc. is expected to spend $2.97 per million BTUs, according to Mr. Lees.
Devon agrees that its costs have risen rapidly, but says Mr. Lees's estimates are too high. While analysts estimate costs to produce gas by looking at spending over a three-year period, Devon and other gas producers spread initial drilling costs over the life of a project. By depreciating costs out over a longer horizon, Devon says its costs are comparable with other producers.
"We are not a high-cost producer," says Brian Jennings, Devon's senior vice president of finance and development.
Devon estimates its costs are $3.15 per million BTUs in 2003, up 19% from a year earlier. Mr. Jennings adds that competitors may appear to have lower costs because they have more international production, where costs tend to be lower, he says, but so are returns. "Devon is uniquely North America focused," he says.
If natural-gas prices drop from $5.16 per million BTUs level to an even $3.50, a level well above the 10-year average, "you have to take a look at who you want to own," says Jim O'Brien, an energy analyst with Citizens Advisers Inc., a mutual-fund company in Portsmouth, N.H., which cut its holdings of Devon earlier this year. For now, he says, high natural-gas prices are hiding the creeping costs. But he warns, "this is something you have to be concerned about."
The odds of a price drop? The futures markets are pricing in a slight drop over the next couple years, though not to the $3.50 level. But those bearish on Devon note that natural gas is the most volatile of all major commodities. Over the past six years, natural-gas prices in the Northeast have been four times as volatile as crude-oil prices, says Craig Pirrong, a finance professor at the University of Houston who studies energy markets. "You are much more likely to see swings in natural gas than other commodities," he says.
With their recent rise, Devon shares fetch about 20 times the company's trailing 12-month earnings, slightly pricier than the industry average, according to data firm Multex. And while they do trade more cheaply than numerous peers based on estimated earnings for this year, the stock's dividend yield is sharply lower than the industry average, at 0.40% versus 2.16%. Meanwhile, the company's ratio of long-term debt to equity, at 1.4, is well above the average.
The debt came as Devon doubled in size over the past few years. In 2001, it bought Canadian producer Anderson Exploration Ltd. for $3.4 billion and Mitchell Energy & Development Corp., which had large reserves of natural gas in Texas, for $3.1 billion in stock and cash. It assumed a combined $6.2 billion in debt for both deals. Devon felt that "natural gas was becoming increasingly scarce in North America and our shareholders would benefit if we owned a lot of it," Chairman and Chief Executive Officer J. Larry Nichols said earlier this year.
To reduce debt and shed unwanted assets, Devon sold about $1.5 billion in assets acquired in the Anderson and Mitchell deals. Analysts expect the company to end 2003 with a little less than $8 billion in long-term debt, meaning interest payments in 2003 will total $550 million, which raises costs by 40 cents per million BTUs.
But Devon hasn't stopped buying. In February it issued $3.5 billion of stock to buy Ocean Energy Inc., adding a number of international operations.
A number of large Ocean stockholders haven't stuck around. Jerry Castellini, president and chief investment officer of Chicago-based mutual-fund firm CastleArk Management, sold most of his new Devon holdings. "They need to do the pruning and harvesting of the higher-cost assets to bring that cost structure back in line," he says. Otherwise, he adds, "they will be penalized in the marketplace in terms of valuation."
Although Mr. Castellini says it is hard to get a handle on its cost structure because of the acquisitions, Mr. Castellini says the company needs sustained high natural-gas prices to avoid stumbling.
The good news for Devon is that many industry observers, including Federal Reserve Chairman Alan Greenspan, believe natural gas will settle at a new equilibrium price significantly higher than the 1990s norm of $2.50 per million BTUs.
And fans like Deutsche Bank Securities analyst John Bailey praise Devon for acquiring "prolific exploration" opportunities in the Ocean deal. If these new prospects turn out to be world-class finds with large amounts of low-cost oil and natural gas, Devon's costs would drop substantially, he says. Deutsche Bank Securities was a financial adviser to Ocean in the merger.
Also, analysts like its industry-leading position and regional focus, and some say the market is actually undervaluing Devon because of skepticism it can deliver strong growth after the Ocean acquisition. Bottom line: Devon has a lot of gas, no matter what it costs to get it out of the ground. "The stock is leveraged to a commodity we like: North American natural gas," says Frank Bracken, managing director with investment bank Jefferies & Co. Inc., which doesn't have banking ties with Devon. He rates Devon shares a "buy." |
