3 Threats to Devon Energy's Success

If you are looking for what independent oil and gas companies will do next, look at what Devon Energy (NYSE: DVN  ) has already done. Between selling off its overseas and offshore assets to focus on North American unconventional plays and shifting more toward a more stable liquids/gas production mix, the company has been ahead of the curve in some of the most common tactics used by producers today. While the company has been pulling the right levers recently, there are still some issues that it needs to overcome if it hopes to keep up this success. Let's look at three issues that could keep Devon down.

Source: Devon energy Media Relations

1) Bad economics in Barnett Shale
The Barnett Shale formation has been Devon's bread and butter for several years. This past quarter, one third of the company's production came from this region, which is three times greater than its second largest production region -- the Permian Basin. Recently, though, drilling activity for Devon has waned in this region, and for good reason. The economics for this region are not very attractive based on today's prices. 

Devon estimates that the production costs in the Barnett are $3.91 per thousand feet equivalent -- also known as mcfe -- for both its liquids and gas production in the region. Prior to 2012, these kinds of production costs were fantastic, but the slump in natural gas prices makes for a challenging environment. This past quarter, it realized about $3.49 for its natural gas production, well below its production costs. But Devon gets gets about 22% of its Barnett production from liquids, right? Not so fast, liquids production from the region comes in the form of natural gas liquids --also called NGLs -- not oil. This past quarter, Devon realized an NGL price of $4.42 per mcfe, which means that the company realized a weighted average price of $3.69 per mcfe, still under the company's production costs.

Today, all drilling activity for Devon is coming in the liquids-rich part of the Barnett shale, and much of the natural gas produced there is from old wells that are generating cash with minimal investment. This should help improve the economics of the region, but not too much because of low NGL prices. 

2) Continued bottlenecks in Canadian infrastructure
In order to balance out the company's gas-heavy assets in the US, the company is developing sizable oil sands projects in Canada. The company is building the third phase of its Jackfish steam-assisted oil project, which will bring production there to 88,000 barrels per day, and its 50/50 joint venture with ConocoPhillips (NYSE: COP  ) for the Pike project is slated to produce 109,000 barrels per day. 

The major benefit that Devon has on these two projects is that a condensate pipeline, as well as a blended bitumen pipeline from Access Pipeline running right through the middle of it, is providing ample takeaway capacity to Edmonton, Alberta. After that, though, is where Devon's operations, and just about every oil sands producer for that matter, start to see issues. The bottlenecks for takeaway capacity from the major oil hubs in Alberta have resulted in deep discounts on Canadian oil sands prices. Devon estimates that the company realized prices of $61.84 on its bitumen and oil from Canada. This is a major improvement on the prices it was receiving in the previous quarters, but it is still nowhere near the prices for the US benchmark West Texas Intermediate.

There are still lots of political hurdles before pipelines come online to move oil in any direction, so for now companies like Devon and ConocoPhillips will need to rely on rail to get their product to the primary markets; the US Gulf coast and Asia. Rail may be able to fill the gap until pipes come online, but the higher costs will result in weaker prices for producers. 

3) Missing in the Mississippian
The Mississippian formation in the Anadarko Basin has been a rather mysterious play, but Devon is taking a stab at it. The company has a 650,000 acre holding in the Northern Oklahoma/Kansas part of the Mississippian, with over 1,000 risked drilling sites up for bids. While it is an ambitious plan, not every company has had great success in the region. SandRidge Energy (NYSE: SD  ) has found internal rates of return as high as 50% in its wells there, which proves that the Mississippian can be a very profitable venture. On the other hand, Chesapeake Energy (NYSE: CHK  ) has struck out there trying to develop the more northern parts of the play. 

Devon is trying a new tactic that both SandRidge and Chesapeake have not; it is going deeper. Rather than trying to tap the Mississippian Lime formation, it is going for what is called the Mississippian-Woodford trend. This formation lies below the Miss. Lime and is expected to be a more oil-concentrated formation. The downside to exploring this part is that it is more costly to drill, and cheap wells has been a reason that SandRidge has been so successful there. 

Devon has had some promising results at its first few wells, but the company still has a lot of drilling left to do. If the Mississippian gives Devon fits like it did Chesapeake, then the company may have a large position in a region that isn't worth holding onto. 

What a Fool believes
There are lots of reasons for investors to like Devon. It just came off a quarter of record-breaking production, and the big shift toward drilling in the Permian could help push those production numbers even higher. At the same time, investors should be aware of the threats that could sidetrack Devon. If the company can mitigate these issues, then it should be able to continue its impressive streak.

Who Will Join Devon in Dominating the American Energy Boom?
Devon is carving out a position as a top American energy company, but they aren't alone. The transformation of the American energy space is creating investment opportunities everywhere, but picking the right ones will mean the difference between a flash in the pan and a long term jewel. For this reason, we have put together comprehensive look at three energy companies set to soar during this transformation in the energy industry. Find out which two companies have joined Devon on our list of companies that are spreading their wings by checking out our special report, "3 Stocks for the American Energy Bonanza." Simply click here and we'll give you free access to this valuable investing resource. 


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