How Important Is Management When Buying an Energy Stock

How Devon Energy’s management has improved shareholder value through smart transactions and a focus on per-share results.

Jun 2, 2014 at 5:00PM

With some exceptions, the oil and gas business is generally viewed as a mature one. Returns tend to be driven largely by factors outside of management's control, such as commodity prices, which are, in turn, driven by global supply and demand.

Therefore, one might be tempted to assume that management doesn't play nearly as big of a role in driving energy companies' returns as, for instance, the management team of an Internet or biotechnology company does. While that's true, they still play a bigger role than most investors might assume, and poor management decisions can frequently destroy a great deal of shareholder value.

For instance, excessive spending by management that led to a rapid buildup of debt at Chesapeake Energy (NYSE:CHK) cratered that company's share price in 2012, causing shares to trade at a significant discount to the company's net asset value. But since the ouster of free-spending former CEO and founder Aubrey McClendon in late January 2013, the company's financial performance has improved dramatically, and its shares have surged nearly 60% since then.

Other examples that highlight the importance of a good management team to energy companies' performance include SandRidge Energy (NYSE:SD) and Hess Corp. (NYSE:HES). At SandRidge, the problem was wasteful spending, including an excessively high pay package for former CEO and founder Tom Ward, compounded by poor oversight by the board. But since the ousting of Ward in June 2013 amid pressure from the company's largest shareholders, SandRidge's financial performance has improved meaningfully, and its shares have risen by about 30%.

The story is similar at Hess, a company whose inability to keep costs contained led to dismal capital efficiency and poor financial performance that resulted in its share price collapsing by 50% from March 2011 to June 2012. But upon the insistence of activist hedge fund Elliott Management, the company reconstituted its board and embarked on a major restructuring that has resulted in a near doubling of its share price over the past two years.

With that in mind, I'd like to highlight a company that I believe has one of the best management teams in the upstream oil and gas industry: Oklahoma-City based independent E&P Devon Energy (NYSE:DVN). Over the years, Devon has consistently demonstrated its commitment to enhancing shareholder value through a persistent focus on per-share results and value-accretive transactions.

Devon Energy Permian Basin

Source: Devon Energy.

Why Devon's management stands out
Founded in 1971, Devon is led by John Richels, who was elected president and chief executive officer back in June 2010. Mr. Richels has been with Devon since 1998 and had previously served as president, a senior vice president, and president and chief executive officer of Devon's Canadian subsidiary.

During his tenure, Devon has pursued numerous initiatives that have significantly boosted shareholder value, including -- most recently -- its acquisition of oil-rich assets in the south Texas' Eagle Ford shale, the sale of gas-rich assets in Canada, and the completion of its EnLink Midstream combination.

Devon's acquisition of 82,000 net acres in the Eagle Ford shale, which it closed on February 28, 2014, provides the company with several years of high-margin drilling inventory in the sweet spot of one of America's most economical oil plays. The acreage, located in the sweet spot of the play, is immediately self-funding and will generate some $800 million of free cash flow per year starting in 2015, in addition to improving the company's margins and cash flow.

Similarly, Devon's merger of its midstream assets with Crosstex Energy to form EnLink Midstream, which it completed during the first quarter of this year, has also resulted in significant value creation. Devon's ownership interest in EnLink is currently valued at around $7.5 billion, up from $4.8 billion when the transaction was announced, representing an incremental benefit to shareholders of several dollars a share. 

Lastly, Devon's sale of the majority of its Canadian conventional assets to Canadian Natural Resources (NYSE:CNQ) for C$3.125 billion, or US$2.8 billion, which it closed during the first quarter, highlights its remarkable deal-making capabilities. Not only was Devon able to monetize these assets at nearly 7 times EBITDA, a significant premium to the company's current trading multiple, but the $2.7 billion net proceeds the transaction will generate will help the company repay debt incurred to finance its Eagle Ford acquisition, further bolstering its already robust balance sheet.

Investor takeaway
Devon possesses one of the key traits required for success in the oil and gas industry: an excellent management team that's focused on maximizing shareholder value through consistent financial discipline highlighted by some of the value-accretive transactions I just mentioned.

With the company expecting oil production to grow at a double-digit rate this year, margins, earnings, and cash flows should continue to improve, which should result in an expansion of its currently depressed forward P/E multiple of 10.5 times that could send its share price to as high as $90 a share.

Will this stock be your next multi-bagger?
While Devon looks meaningfully undervalued by many measures, there's a huge difference between a good stock and a stock that can make you rich. The Motley Fool's chief investment officer has selected his No. 1 stock for 2014, and it's one of those stocks that could make you rich. You can find out which stock it is in the special free report "The Motley Fool's Top Stock for 2014." Just click here to access the report and find out the name of this under-the-radar company.

Arjun Sreekumar owns shares of Chesapeake Energy, Devon Energy, and SandRidge Energy. The Motley Fool owns shares of Devon Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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