A Change of Strategy for Devon Energy

Linn has acquired some of Devon's natural gas assets. The deal has advantages for both parties, and here's why.

Jul 9, 2014 at 8:43AM

At the end of June, Linn Energy (NASDAQ:LINE) announced that it had entered into an agreement with Devon Energy (NYSE:DVN) to acquire $2.3 billion of natural gas producing land. This agreement has benefits for both parties.

On one hand, Devon was able to offload the land for a good price, which will help the company transition from a natural gas producer into an independent oil company. On the other hand, Linn's acquisition of these natural gas assets will allow the partnership to reduce its decline rate and lower its capital intensity.

Indeed, the assets Linn acquired from Devon are mature and already producing, which reduces execution risk and other issues usually associated with gas project start-up.

A change of strategy
Devon Energy, like almost all of the independent domestic oil and gas companies, is moving into the oil market and away from low-margin natural gas. The company is focusing its exploration and production in the Eagle Ford region.

This switch in strategy has catapulted Devon's earnings higher. With the price of natural gas remaining below $5 per MMBTU for much of the past five years, Devon's earnings had hit a wall, but the switch to oil changed that.

The company's oil production jumped 21% during the first quarter of this year to average 176,000 barrels of oil equivalent per day. Off the bank of this surge in oil production, its adjusted earnings jumped 103% year on year and cash flow jumped 41%.

Devon is planning to spend $1.5 billion to develop its Permian acreage this year. The company's leasehold has net risked resource estimated at 2.8 billion boe with around 8,000-plus drilling locations.

The cash raised by this disposal to Linn should help fund this development. The assets in question only contributed 7% of Devon's total output during the first quarter. In addition, including the sale to Linn, Devon has raised $5 billion through asset disposals over the past few quarters and paid down $4 billion in debt in the process.

The other side of the trade
Devon will benefit from the sale as it fits the company's business plan perfectly. The asset deal also has advantages for Linn.

As already covered above, these assets acquired from Devon are mature, gas-weighted properties. What's more, the company is planning to fund the acquisition of these properties through the sale of its high-decline Granite Wash assets.

According to some analysts, Linn's Granite Wash properties are declining at a rate of around 40%, while the Devon properties have a decline rate of closer to 14%. A lower decline rate generally means that assets produce more hydrocarbons for a longer period.

Indeed, with these new assets from Devon, Linn will be able to reduce its capital expenditures and operation maintenance budget significantly. Some estimates predict that Linn could cut its capex cost by around 50% per annum thanks to this deal. Wall Street believes that Linn could save around $400 million per annum on lower capex.

Foolish summary
So all in all, the deal between Linn and Devon has advantages for both parties. Devon has been able to cut its exposure to low-margin natural gas, and it can use the proceeds to boost its oil production.

Linn, on the other hand, will profit because it has acquired mature assets with a low decline rate. The partnership should be able to cut capital spending as part of the deal, which will boost its margins and profits.

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Rupert Hargreaves has no position in any stocks mentioned. 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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