The folks at Devon Energy in Oklahoma City have a favorite saying: The best place to find gas is in places where it's already been found. That philosophy sums up the company's conservative approach to wringing more gas out of existing deposits, but it might just as well refer to Devon's penchant for acquiring other oil and gas producers.
Indeed, in the past 12 months Devon hit a gusher on Wall Street, snapping up Anderson Exploration of Calgary in October for $3.4 billion in cash, followed by Houston's Mitchell Energy & Development in January for $3.2 billion in cash and stock. Together, these deals boosted proved reserves by 23%, to two billion barrels of oil equivalent, and secured Devon's status as one of the nation's largest independent exploration and production concerns.
The one-two punch drew a barrage of criticism from analysts, however, who wondered loudly whether Devon had bitten off more than it could chew. The prevailing view, says Jay Gibbons, an analyst for TCW Galileo Opportunities fund, was that Devon had taken on too much debt -- more than $6 billion in all -- at precisely the wrong time, when natural-gas prices were sliding to new lows in the vicinity of $2 per thousand cubic feet. Devon Energy boasts about 7.1 trillion cubic feet of gas equivalents, equal to roughly two-thirds of its energy reserves.
Last winter Gibbons was a rarity: He began buying Devon shares in the low- to mid-30s, near their two-year low, in the belief that a looming imbalance between supply and demand in North American natural gas eventually would vindicate the company's strategic moves. Almost as if on cue, gas prices rallied to a May high of $3.80, lifting the stock to 52.
These days prices for both have receded -- gas to $2.65-$2.70 per mcf, the shares to 40. But many more analysts, impressed by management's recent moves, are coming around to Gibbons's upbeat view. If gas prices head higher, as Devon expects, some Street seers think the stock could rally to 70, which would represent a gain of 75% from current levels.
The Energy Information Administration, a government agency, is forecasting an average price of $3.20-$3.30 per mcf in 2003. "Everything adds up to higher gas prices in the next six months," J. Larry Nichols, Devon's chairman, president and CEO, said in a recent interview. "We're not likely to have two record mild winters back-to-back. The economy is expected to improve from last winter's recession. And with production down, it seems likely we'll see upward pressure on prices."
Each 10-cent increase in the average annual price of gas translates into an additional 21 cents a share in Devon's annual earnings and a corresponding 25-cent gain in free cash flow, the company notes.
"If commodity prices continue to favor us, we will generate more cash flow than our capital budget, which we will use to pay down debt," Nichols says. This year Devon has earmarked $1.5 billion in capital spending.
Irrespective of the near-term direction of gas, Nichols defends the purchases of Mitchell and Anderson as one-time opportunities well worth the risk. "We believed then and now that acquisition opportunities have become scarce and that we wouldn't be able to do major purchases again," he says. "There just aren't that many big independent producers left."
Meanwhile, Nichols has wasted no time attempting to disprove his critics. By the end of March, Devon had refinanced its debt, pushing off major repayments until 2004. In addition, the company made good ahead of schedule on a promise to raise funds by selling more than $1 billion in assets. As a result, some believe, the company's debt-to-capitalization ratio could fall to 55% by yearend, from a current 60%.
Analysts expect Devon to earn about $500 million, or $3.02 a share, in 2002, according to Thomson/First Call, followed by $630 million, or $3.94 a share, in 2003. Last year the company earned $647 million, or $5.03 per diluted share, before special items, on $3.075 billion in revenue. Net earnings came to $103 million, or 97 cents, after an accounting change and a reduction in the carrying value of the company's oil and gas properties.
Table: Oil Patch Economics
Devon is trading for 10.3 times next year's earnings estimate, or about a 17% discount to peers such as Anadarko Petroleum and Apache Energy. Measured by enterprise value to cash flow (earnings before interest, taxes, depreciation and amortization), a standard industry benchmark, the company also lags behind most of the competitors listed in the table nearby. According to a recent report by Robert L. Christensen, an analyst at First Albany, Devon has "the most [price] appreciation potential of any of the four 'super' independents."
Devon dates back to a private partnership founded by Nichols's father, John W. Nichols, 87, who became chairman emeritus in 1999. The company came public through a stock conversion in 1988, but has always been tarred, in investors' minds, by a reputation for opportunistic buying and selling of assets. The rap is that Devon has yet to demonstrate it can survive by the drillbit, something with which with management understandably disagrees.
True, the company has made an acquisition a year for more than 30 years, practicing a kind of gray-suited geology more than old-fashioned wildcatting. But successful deals have masked a good record of discovering more gas in places where others have drilled the initial wells. Devon's supporters point to the company's development in the late 1980s and early 'Nineties of Northeastern Blanco, a 3,700-square-mile field in northwest New Mexico and southern Colorado, which, with more than 20,000 producing wells, turned into one of the two biggest gas-producing basins in the U.S. Devon wound up with a major stake in one trillion cubic feet of gas, developed at a cost of 30 cents per mcf.
"At the core these guys are very conservative," says Deborah Sufrin, senior analyst for MFS Financial. "We have known management for years, and they have done a good job of delivering on what they said they would. Still, we beat them up pretty badly on the issue of additional debt, and they gave us a lot of good answers."
MFS is Devon's largest institutional holder, with 10.4% of the company's 156 million shares. George Mitchell, the former chairman of Mitchell Energy, is the largest individual holder, with 8.9% of the shares.
Heeding the Call
Larry Nichols, 60, who holds a geology degree from Princeton, brings an unusual professional background to the oil patch. Nichols clerked in Washington for Chief Justice Earl Warren after graduating from law school at the University of Michigan, and might have been content to remain in D.C. until his father called him home to help run Devon. John still comes into the office to handle family affairs, and he retains a seat on the board.
Nichols fils has taken leading roles in numerous industry organizations and serves on the board of governors of the American Stock Exchange, where Devon trades. He and his wife, Polly, have taken a leading role in fund raising for a museum commemorating the Oklahoma City bombing of 1995. Mrs. Nichols was injured in the blast, but has fully recovered.
Devon's assets today are concentrated in four major North American gas fields, including the Barnett Shale, near Fort Worth, Texas, and the coal plays in the Permian Basin in west Texas. Through its latest deals, the company has acquired stakes in several significant exploration plays in both the Gulf of Mexico and the Mackenzie Delta in northeastern British Columbia.
To protect its cash flow -- some $1.9 billion in 2001 -- Devon has hedged more than 40% of its 2002 and 2003 production, enough to ensure the funding of capital programs even if gas falls as low as $2 per mcf and oil as low as $15 a barrel. The company has employed a variety of hedging strategies, including forward sales, price swaps and costless price collars. For example, in the second half of 2003 Devon has agreed to sell 100,000 mcf of gas a day at $3.42 per mcf, and 44.016 per day at $2.33 per mcf. The company also has established floor and ceiling prices for a portion of its oil production.
Key to the company's success, however, is a pickup in energy prices and a continued ability to integrate both Anderson's and Mitchell's operations. On the first score, at least, there is mounting evidence of gas-supply constraints. Gas producers have been folding in greater numbers than in the past, while the industry's all-important rig count, which peaked at 1,068 in July 2001, now has dropped to about 720. According to Phil Dodge, a Houston-based analyst for Ryan Beck, about 750 U.S. rigs are needed to maintain stable production.
Simmons & Co., a Houston brokerage firm specializing in energy, estimates that 13,780 gas wells will be drilled this year, down from 19,881 in 2001. The shortfall could result in a 4.2% decline in U.S. gas production, the largest decline in more than a decade, the firm notes. The EIA expects a 4.5% drop in the nation's overall gas supply.
On the demand side the outlook is sketchier, particularly after the recent rash of government and industry reports suggesting the U.S. economy is slowing again. But the long-term prospects for gas are anything but grim. Rebecca Watson, assistant secretary for land and minerals management at the U.S. Department of the Interior, in a July 16 speech called natural gas "an important cornerstone" in President Bush's national energy policy. "Because of the Clean Air Act standards and the availability of clean-burning natural gas...an overwhelming majority of new electric-generation projects will be fueled by natural gas," she said.
The caveat, of course, is that gas demand might rise more slowly than expected if the economy comes under additional pressure. But Nichols seems content to wait. Some analysts have even posited that Devon itself might make a tempting target for an integrated oil major, given its prime production assets. Royal Dutch Shell, for one, has said it is searching for North American gas holdings, and Bear Stearns analyst Fred Leuffer highlighted Devon, in a report last December, as having potentially the best fit with the Dutch petroleum giant.
Nichols simply shrugs at the mention of a takeover. For now, he has another