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Devon Energy Corp Stock: What Am I Missing?

Matthew DiLallo, Jason Hall, and Tyler Crowe, The Motley Fool

Even when we're not writing about stocks, we're probably discussing some investment theme or stock that perks our interest. Here's a sneak peek at some of the conversations that go on behind the scenes with some of our writers here at The Motley Fool.

One of the benefits of writing for the Fool is the ability to talk shop (or in our case, talk stocks) with some really smart people who don't always hold the same views. Those varying perspectives can be invaluable because someone with a different viewpoint can spot issues that one of us might have missed. That's why I (Matt here) recently asked a few of my colleagues to take a closer look at Devon Energy (NYSE: DVN), because I'm thinking about buying it for my portfolio. 

An oil pumping unit at sunset.

Image source: Getty Images.

Tempted by the turnaround at Devon Energy

Matt DiLalloI've had my eyes on Devon Energy for several years. I've watched the company transform from a go-for-broke shale driller to a highly disciplined oil company. That discipline came into focus last fall when the company unveiled its 2020 Vision, which will be its guiding light over the next three years. It will focus on drilling wells to earn a return on the capital invested instead of just growing production, while at the same time streamlining its portfolio and strengthening the balance sheet so it can return excess cash to shareholders.

That plan seems to be working better than I expected. The company's focus on drilling for returns has it on pace to grow cash flow at a 25% compound annual rate through 2020, which should generate $2.5 billion in free cash over that time frame, assuming $60 oil. Meanwhile, it sold several non-core assets, including its midstream business, which gave it the money to reduce debt and buy back stock. Devon currently expects to repurchase as much as $4 billion in stock by the end of next year, which is 20% of its outstanding shares at the current price. That seems like a good use of capital, in my opinion, given how cheap shares are versus peers.

From my viewpoint, Devon looks like one of the more attractive oil stock options out there. Shares appear undervalued, the company is on pace to grow cash flow at a healthy pace for the next few years without the help of higher oil prices, and it has a needle-moving buyback. I'm very tempted to pull the trigger and buy shares, but after getting burned on several oil stocks during the downturn, I'm a little gun-shy. Am I missing anything here?

On Pirate's Code and oil stocks: Producers rarely make the cut

Jason Hall: I have very few firm investing rules, rather treating them more like a "Pirate's Code." That is to say, to paraphrase the pirate Barbossa, "guidelines." But when it comes to investing in independent producers, I almost always avoid them because frankly, the upside prospects rarely outweigh the downside risks. 

I'll admit that it's partly my fault for buying the wrong producers at the wrong time, and Devon is certainly attractive. Management has done a good job paying down debt, and it also has a substantial amount of its production hedged, helping reduce the downside risks if oil prices fall sharply in the near term. 

However, it still has almost $10 billion in debt, and as we learned over the 2014-2016 oil downturn, prices can fall much further, and stay down much longer, than anyone expects. And that means its hedging strategy is only valuable in the near term. The irony is that the near term looks really good for higher oil prices, as supply drawdowns and production/midstream bottlenecks limit how much oil North American producers are able to bring to market, which actually means its hedging limits Devon's upside. 

Yes, it's possible -- maybe even likely -- that higher prices will be the norm for the next several years, particularly as we "pay the decline curve piper" after multiple years of underspending in the oil patch. But at the end of the day, Devon's future prospects for market-beating returns are tied to oil prices. Management's efforts to strengthen the balance sheet and improve operating efficiencies will help the company operate just fine even during a low price environment, but I don't think they'll lead to it being a market-beating stock. If that were the case, wouldn't it be trading at a premium valuation today? After all, oil prices are at multiyear highs.

A pipeline and an oil pump at sunset.

Image source: Getty Images.

I'll believe it when the rubber hits the road

Tyler CroweThere is a lot to like when you go up and down the investment presentations for Devon Energy. There seems to be a coherent plan here that grows the business significantly without outspending its cash generated from operations. That is a sight for sore eyes after years of shale drillers foolishly thinking they could "grow into their debt loads." If the company really can meet these goals, then Devon could absolutely be a great investment today with shares trading at what seems to be a reasonable price.

The thing that still makes me apprehensive is that I have read too many of these investor slide decks from exploration & production companies that promise the world, but then those companies fail to deliver on their promises. 

For all the talk about lowering costs and making cash flow and earnings projections at reasonable oil and gas prices, there are so many factors that could cause Devon to fall short of achieving these goals. One that immediately comes to mind is the rising costs for services, especially in the Permian Basin and STACK formation, where Devon is concentrating so much of its spending. Devon isn't the only company out there throwing lots of money into this region, and service costs are rising quickly as demands for water, sand, and labor are through the roof. These costs will get passed on to the producer, so assuming Devon will achieve its goal of reducing per well costs by 20% seems overly optimistic. Toss in the infrastructure bottlenecks in the region that could depress prices, and you get an incredibly challenging operating environment. 

I'm not in complete disagreement with the things Devon is saying, but there are some things that make me a little skeptical. I would like to see a couple quarters of earnings that show clear progress toward these goals before personally making an investment here. 

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Jason Hall has no position in any of the stocks mentioned. Matthew DiLallo has no position in any of the stocks mentioned. Tyler Crowe has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.