With the Federal Reserve's recent announcement of QE3, fears of inflation over the longer term have risen noticeably. The decision to carry out open-ended purchases of mortgage debt was followed by a weaker dollar and higher prices for commodities like gold and oil. This is just one of many reasons investors should pay close attention to high quality oil exploration and production companies.
One in particular looks especially promising. It's a major oil and gas producer with a balanced production mix and one of the strongest balance sheets around. And with a couple of recent joint ventures under its belt, the company's prospects for future growth look brighter than ever.
A natural gas company? Yes, but no
I'm talking about Devon Energy (NYSE: DVN), one of the largest oil and gas producers in the country, with a market cap of around $25 billion and an enterprise value around $30 billion. The company boasts proved reserves of roughly 3 billion barrels of oil equivalent, of which 42% are liquids.
With the bulk of its risked resource base consisting of natural gas, Devon is generally perceived as a predominantly natural-gas-focused company. But this view can be misleading and doesn't give sufficient credit to the company's liquids businesses, which have grown tremendously over the years.
Devon was quick to recognize the poor economics of dry natural gas production and made it a point to reduce its exposure to the commodity and instead focus on higher margin oil and natural gas liquids. For the year, Devon has allocated 100% of its $6 billion plus capital budget toward oil and liquids-rich projects.
It's also got a solid track record of growing oil production in recent years. Oil output has seen a consistent upward trend over the past six years, going from 65.7 million barrels of oil per day in 2006, to 100.9 million barrels in 2009, and finally to 148.6 million barrels in the second quarter of this year. That amounts to a roughly 23% annual growth rate in oil production. Natural gas liquids have posted a similarly impressive 11%-13% annual growth rate.
Party in the Mississippi Lime
As part of its transition toward liquids, the company recently increased its position in the Mississippi Lime play, an up-and-coming oil-rich formation underlying parts of Oklahoma, Nebraska, and Kansas. The big advantage here is that the Mississippian has significantly lower completion and drilling costs, especially when compared to North Dakota's Bakken play, while still offering high rates of oil production.
After adding 400,000 net acres in the Mississippian, Devon now controls 545,000 acres in the play, which so far has posted some very impressive production numbers. This position makes Devon one of the largest players in the Mississippi Lime, just behind SandRidge Energy (NYSE: SD), which commands roughly 1.75 million net acres, and Chesapeake Energy (NYSE: CHK), which continues to seek a joint venture partner for its roughly 2 million acreage position.
By year's end, around 40% of Devon's total production will consist of liquids, and the rest will be dry natural gas. And even though the company has drastically increased its liquids exposure, it still maintains the flexibility to shift back to drilling for dry gas should prices rebound sufficiently.
Financial position
Financially, Devon is as healthy as ever. It continues to have one of the strongest balance sheets and liquidity positions among its peer group, having ended the second quarter with around $7 billion in cash and short-term investments. The company's net debt-to-market-cap ratio was equally impressive, at just around 14%.
Since 2003, Devon has reduced its net debt by more than $3 billion, while still raising its dividend by an annual average of 26% since 2004. Speaking of dividends, Devon's payout stacks up nicely among its peer group. It currently yields 1.3% and, judging by a 12% payout ratio, looks sustainable.
By comparison, EOG Resources has a dividend yield of 0.6%, with a payout ratio of 13%. Apache (NYSE: APA) has a yield of 0.8%, with a payout ratio of 7%, while Chesapeake yields 1.7%, with a payout ratio of 9%. The lowest yielding company in Devon's peer group is Anadarko, whose dividend is 0.5%, while the highest yielding of the bunch, Encana (NYSE: ECA), yields 3.5%.
Final thoughts
Overall, there are numerous reasons to like Devon Energy. It has a vast and diversified portfolio of high quality assets all over North America. While traditionally regarded as a natural gas company, Devon's liquids production has grown at an impressive pace and is set to grow faster than dry gas production for the next few years. Between the company's Cline Shale position and its recently increased acreage in the Mississippian, Devon has roughly a million net acres in two major oil plays that are posting very impressive production results.
Another reason I like Devon is its shareholder friendly management that has consistently demonstrated a disciplined focus on maximizing debt-adjusted cash flow per share. It's nice to have management concentrating on per-share results, especially in an industry replete with firms that have a "bigger is better" mentality. The company's strong balance sheet and flexibility in shifting its resource base to the most profitable commodities also shouldn't be overlooked.
While I think Devon is a rock-solid company that you can buy today, its upside is still limited by its massive size. Smaller E&Ps can provide much greater returns for investors willing to take on greater risk. One such company is SandRidge Energy. Investors were startled after SandRidge plummeted when natural gas prices reached 10-year lows, but with the company halfway through its ambitious three-year plan to profitability, the future looks bright. If you are unsure about the future of this emerging oil and gas junior, and are looking to find out more about its strengths and weaknesses, you should view this brand-new premium report detailing SandRidge's game plan and what to expect from the company going forward. To get started--click here!
