Why We Missed the Mark With Devon Energy

It's "We Said What?" week on Industry Focus, and we're going over some of the biggest mistakes we've made on air.

In this segment, Taylor Muckerman looks back on his recommendation of Devon Energy (DVN 0.29%) -- which has gone down 23% since his recommendation and significantly underperformed the market and the oil industry average -- and shares what this taught him about investing in general and investing in the energy sector and commodities in particular.

A full transcript follows the video.

This video was recorded on Aug. 24, 2017.

Taylor Muckerman: Let's listen to the clip first, and then I'll talk about why it was wrong.

(Muckerman): I'm going with Devon Energy. I'm going my first producer. I'm looking at this company, a pro in terms of enhanced oil recovery. It has a good basin coverage with Eagle Ford, the Permian, among others. Those are two of the most popular that you might know of. It's getting into reusing a lot of its own energy to lower its cost. It's still producing pretty well. They have increased the production year over year in the latest quarter. Pretty low cost in terms of what you're seeing out there, maybe not as low cost as EOG in terms of per-barrel cost, but they're still competitive, and they've been beaten up just as much of some of worst producers in the business, so I think this company could fill some nice holes.

So you heard me talk about Devon Energy, also a producer. That was also my wild-card pick, the third pick that I've made. And for a time there, it treated me pretty well. 2016 was a decent time frame for oil producers after completely bottoming out in the beginning of 2016. But 2017 just shows you that this is a very tough market to predict. My mistake there was not technically owning, but owning in a competition, an oil or gas producer. I've said several, several times on the show that I don't believe in owning oil or gas producers or miners simply because, like we talked about, they're typically debt-heavy companies, and the cyclical nature of these businesses is so hard to overcome. If you look at Devon Energy from the day that we recommended it, down 22.8%.

Sean O'Reilly: And you picked it after a dip.

Muckerman: Yeah. We picked it toward the end of 2015, which, it had already suffered a huge drop at the end of 2014, and 2015 was still a little trickle. 2016 totally smoked it at the beginning, January and February. And then you saw the rebound. But, that rebound included, to date since we talked about it, Devon Energy down 23%. 

O'Reilly: The dividend was cut.

Muckerman: Yes, the dividend was cut. Oil- and gas-producing ETF, ticker XOP, down 20%. Then, the Energy Select SPDR from iShares, only down 5%. So that includes the whole energy industry -- services, companies, pipelines. So you see how much difference in performance there these producers had, and then you compare it to the S&P 500 and you hang your head in disgust because the S&P 500 is up 27% since we had this draft. Then you think, "That's only a couple years." But then you go back a decade, and the same oil and gas producer ETF down 32%, versus the Energy Select SPDR only down 10%, and Devon down 60%. Over 10 years. Versus 65% for the S&P 500. So there's certainly times you could have bought a producer over the last decade and made a killing. But it's tough to know when to sell, and these sell-offs for these producers generally drop much further than the previous bottom, or right around there.

So that was my big mistake, was investing in what I don't know. I mean, I know about these producers. I guess, it's not what I don't know, but investing in something I already said I would not invest in, for these specific reasons. And I took a flyer, and this shows what happens when you take a flyer sometimes.

O'Reilly: Don't break your rules!

Muckerman: Yeah. That's one thing. You have to have an investing process. Sure, you can adapt over time, but this was a hard and fast rule for me.

O'Reilly: So holding this up in the light of my lesson that I learned, which is, if you're going to do this, it needs to be a low-cost producer, was that why you picked Devon? Where do they fall in this? Because EOG, there I remember first seeing EOG three years ago, they're --

Muckerman: Yeah, we could compare EOG's ticker. Since our draft, EOG is actually up 9.7%.

O'Reilly: And that was my bedrock pick. Any report you look at is like, they're an incredibly low-cost producer.

Muckerman: Yeah, and they're someone integrated because they source some of their own sand, they have some takeaway capacity from some of their more remote well sites in terms of pipelines. So yeah, they're best in breed, and they're still underperforming the index by 18% since we drafted, the S&P 500 Index. Yeah, Devon Energy, I thought, was one of the more skilled companies in terms of unconventional drilling, and going back in with CO2 and water to really maximize well production. And they still kind of are, but having to cut the dividend really hurt their shares, and it goes to show, LINN cut their dividend a couple of times, and you've seen a lot of even the big energy producers, the integrated, cutting their dividend. Not all of them, but a handful. And that to me proves that no one is safe as an energy producer or a miner, because, I would say over 50%, I feel like, had to cut their dividend.

O'Reilly: I mean, in econ class in school, you learn that in the long run, any commodity producer, at best, you will get average returns on invested capital. It'll be about 10%.

Muckerman: Yeah. If they can't cover their capex from cash flow, how the heck are they going to continue to cut a dividend check to you?

O'Reilly: The bondholders, obviously! [laughs] 

Muckerman: Well, I guess. So, cash flow, cash flow, cash flow!

O'Reilly: Very good. Well, I think we both learned something here today.

Muckerman: Yeah. Both centered around energy producers. Kind of interesting there.

O'Reilly: Tough business.

Muckerman: Yeah, it's been especially tough the last few years. But like I said, going back 10 years, oil and gas producers as a unit have had a very rough time of it. Ten years, that's a couple cycles, and you're still in the red.