What happened
Shares of U.S. shale driller Devon Energy (DVN 0.19%) fell hard this week, down 12.3% through Thursday trading, according to data from S&P Global Market Intelligence.
The oil-and-gas fracker reported earnings this week that underwhelmed some analysts and investors. In addition, Devon guided to some elevated costs for the current year relative to its projected production.
While some of the curtailed production in the fourth quarter was due to inclement weather, Devon's higher spending forecasts still spooked analysts, as oil and gas prices have retreated mightily from their highs.
So what
For the fourth quarter, Devon's revenue came in at $4.3 billion, up 0.7% year over year, slightly above expectations, but adjusted (non-GAAP, or generally accepted accounting principles) earnings per share of $1.66 missed expectations by $0.09. U.S. oil and gas companies had to contend with some inclement weather during the fourth quarter, which management said trimmed Devon's production by about 2% in the quarter relative to expectations.
But what really irked investors was likely Devon's forward guidance for production and capital expenditures for the year ahead. For the first quarter, Devon expects to produce 635,000 barrels of oil equivalent per day, which was about 5% lower than expected.
The blame, according to Devon, is due to an outage at a compressor station, as well as third-party midstream infrastructure downtime in the Delaware Basin in Texas. That will affect output in Devon's Delaware Basin assets by about 10,000 BOE/D in the quarter.
However, management expects the outages to be fixed and maintenance completed by the end of the first quarter. For the full year, management expects production to average a higher 643,000 to 663,000 BOE/D.
Yet another element also caused some concern among investors: the increasing costs of production. For 2023, Devon forecast between $3.6 billion and $3.8 billion in capital expenditures, including between $3.44 billion and $3.56 billion in upstream spending, to produce those 643,000 to 663,000 BOE/D. By comparison, Devon only spent $2.53 billion in upstream capital in 2022 and still produced an average of 610,000 BOE/D.
On the conference call with analysts, management noted it is continuing to see service costs inflation, as older service contracts expire and are renewed at higher rates than came through during the past year's inflationary period.
Now what
If investors fear increasing costs even as the price of oil and natural gas fall, lower oil and gas prices could also eventually lead to lower inflation or even deflation in service costs. Still, the forecast was no doubt mildly disappointing for Devon investors.
Devon also declared its fixed-plus-variable dividend for March of $0.89 based on last quarter's free cash flow, which may have disappointed some hoping for more. After all, Devon's fixed-plus-variable dividend totaled $5.17 in 2022, which is a higher rate than the March payout.
However, shareholders shouldn't be surprised, as oil and gas prices are down significantly from their highs seen in the middle of 2022. Although Devon raised the fixed portion of its dividend by 11%, the bulk of the payout still comes from the variable dividend, which can go up to 50% of excess free cash flow. With free cash flow coming down from its highs, it should be no surprise to see the dividend follow suit.
A bet on Devon is ultimately a bet on the strength or stability of oil and gas prices. Keep in mind that even if oil and gas prices stay at levels seen in the fourth quarter, Devon made $1.2 billion in earnings. Extrapolating that to a full year, and Devon only trades around 8.75 times those annualized figures. For what it's worth, analysts expect $7.94 per share on average for 2023, giving Devon a forward P/E ratio of around 7.
That's fairly cheap, and would give investors a good return even at these lower oil and gas price levels. However, given the low multiples across the oil and gas industry due to long-term concerns over oil demand, investors probably shouldn't expect much in the way of multiple expansion. Rather, stocks like Devon should continue to pay out dividends and share repurchases, and those payouts will fluctuate with oil and gas prices. At this low a valuation, that still might not be such a bad investment.
