In its recent 13F filing, Soros Fund Management, the New York-based investment firm set up by billionaire George Soros, revealed a major new position in Devon Energy (NYSE:DVN), an independent oil and gas producer. According to the filing, the position was initiated in the first quarter and accounted for about 0.50% of the fund's portfolio as of the end of the first quarter.
As I have argued before, I believe Devon Energy presents a compelling risk/reward scenario given its massive opportunity in south Texas' Eagle Ford shale, strong prospects for production, earnings and cash flow growth, and its attractive valuation. Let me explain why I believe Soros Fund Management's move is a good one and why Devon could also make a great addition to your portfolio.
Shift to liquids is paying off
Devon is one of the largest independent exploration & production companies in the country, with proved reserves totaling 18.8 Tcfe as of year-end 2013. Devon's asset portfolio is concentrated in the U.S. and Canada and includes premier positions in leading liquids-rich plays, such as south Texas' Eagle Ford shale, West Texas' Permian Basin, Oklahoma's Anadarko Basin, and Canada's oil sands, as well as sizable stakes in gas-rich plays, such as the Barnett, the Horn River Basin, and Texas' Carthage region, among others.
Over the past few years, the company has completely revamped its business model, opting to divest the vast majority of its international assets in order to focus on North America. It has also drastically curtailed dry gas drilling -- once its main focus -- in response to depressed gas prices over the past few years and is now focused overwhelmingly on oil and natural gas liquids (NGLs).
The shift in strategy is already paying off in spades. Devon's first-quarter oil production jumped 21% year over year to an average of 176,000 barrels per day, which helped fuel strong growth in earnings, margins, and cash flows. Adjusted earnings skyrocketed 103% year over year to $547 million, while operating margins surged by an impressive 54% year over year and operating cash flow increased by an equally impressive 41% over year-earlier levels, coming in at $1.4 billion.
Huge opportunity in the Eagle Ford
One of the key drivers of Devon's production growth will be the Eagle Ford shale, one of the most prolific and economical oil plays in North America, where the company recently acquired 82,000 net acres. As of early May, Devon's net production in the play was running at 64,000 boe/d, up from an average of 49,000 boe/d in March, and is expected to average 70,000 to 80,000 boe/d in 2014, as the company plans to spend roughly $1.3 billion of its 2014 capital budget on the Eagle Ford.
Peers EOG Resources (NYSE:EOG), Marathon Oil (NYSE:MRO), and ConocoPhillips (NYSE:COP) are all also investing heavily in the Eagle Ford and view the play as a key driver of oil production growth in the years ahead. EOG is allocating the largest portion of its 2014 capital budget of $8.1-$8.3 billion toward developing its position in the play, where it estimates it has some 6,000 remaining drilling locations.
Similarly, Marathon Oil plans to devote $2.3 billion of its total North America E&P capital spending budget of $3.6 billion toward the Eagle Ford, with plans to accelerate rig activity in the play by 20% this year. And ConocoPhillips plans to spend $3 billion in the play from 2014 to 2017, which is expected to boost the company's production to more than 250,000 barrels of oil equivalent per day by 2017, representing 20% compound annual growth from 2012 production levels.
Free cash flow on the way
As Devon's oil production from the Eagle grows rapidly over the next few years, margins and cash flow should continue to improve. Combined with a significant ramp up in production from its Delaware Basin and Canadian oil sands operations, this will allow the company to generate significant free cash flow in 2015 and beyond, which will allow it to not only fund its drilling program internally, but also to pursue additional acquisitions as it sees fit and increase its dividend.
With Devon poised for much stronger growth in oil production, margins, EBITDA, and cash flows over the next few years, its relatively low valuation appears all the more compelling. The company trades at just under 11x forward earnings, while its E&P business commands a severely depressed EV/EBITDA multiple of around 4x. As such, I think multiple expansion is quite likely and should push shares closer to their fair value of around $80-$90 a share.
Arjun Sreekumar owns shares of Devon Energy. The Motley Fool owns shares of Devon Energy and EOG Resources. 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.