Energy stocks like Devon Energy (DVN +1.85%) have been brutalized by the sell-off in oil prices over the past few months. As the following chart shows Devon Energy's stock is now over 23% off its highs thanks to the 36% sell off in oil prices.
This correlated sell-off isn't all that surprising considering that 34% of Devon Energy's production is oil. That said, oil prices aren't the only thing that move this stock. As I recently pointed out there are reasons to be bullish that the stock can regain its former highs, even if oil prices don't move higher. Likewise, there are several risks that still remain, outside of oil prices, that investors need to monitor as these risks could drag the stock even lower.
Leverage to natural gas
Currently, Devon Energy is expected to grow its oil production by 20-25% in 2015 even as capital spending remains level with 2014 spending. However, that was before oil prices fell off a cliff, so it's quite possible Devon Energy will decide to cut back spending in 2015. While that would be a prudent move for the company, it would signal to the market that it needs to slow down its transition to oil.
That said, despite the push to grow oil production, Devon Energy is still predominantly a natural gas company. At the moment 45% of the company's production is natural gas, while 21% of production is natural gas liquids. Because of this the company still has a lot of leverage to the price of natural gas. So, if the price of natural gas starts to plunge it could cause another sell-off in Devon Energy's stock.
Exploration upside is put on hold
One of the big drivers for Devon Energy over the past few years has been its ability to uncover new oil plays. These new plays offered high return drilling opportunities that the company is now turning into production growth. However, the company might have to limit its exploration activities due in the future to weaker oil prices. The reason for this is because when oil prices fall energy companies tend to cut riskier exploration drilling because there is a much higher risk of drilling a dry hole. Devon knows this risk quite well as its exploration activities in the Utica Shale came up dry. So, during a period of uncertainty in the oil market the company might only invest its money in its surest bets.
That being said, cutting exploration spending could cause the company to miss out on opportunities that could have created value for shareholders. For example, one area that has encouraging upside is the Upper Eagle Ford Shale, which as the following slide notes has five wells being tested.
Source: Devon Energy Corp Investor Presentation
The Upper Eagle Ford represents an opportunity for the company to drive greater value out of its recently acquired Eagle Ford shale acreage. What the company could do, if its test wells are a success, is develop both layers of shale simultaneously, which would reduce drilling costs thanks to efficiency gains. However, if the company chose to hold off on riskier exploration drilling it would delay Devon's ability to turn this opportunity, or others like it, into value for shareholders. Just announcing that its holding off further tests in the Upper Eagle Ford could worry investors that the play lacks potential, when really all the company might be doing is reducing its risk for the time being.
Too aggressive in consolidation
One of the opportunities of lower oil prices is that it's making acquisition valuations more compelling. Because of this Devon Energy could go on the offensive and buy up a weaker rival. However, the company also runs the risk of being too aggressive and biting off more than it can chew.
If the company seeks to take over a similarly sized rival, or the U.S. shale assets of a multi-national, and uses debt to fund a large portion of the deal it could end up in a weakened financial state. So far the company has a solid track record when it comes to acquisitions. However, its $6 billion acquisition of acreage in the Eagle Ford Shale earlier this year was made at what now looks like the top of the market for oil assets. So, an even larger deal in a now very uncertain oil market would be tough for investors to swallow, meaning Devon Energy's stock price could be pummeled if it decided to go on the offensive and make another oil deal.
Investor takeaway
If falling oil prices weren't enough, there are several other risks that could take Devon Energy's stock lower in the future. The company has some tough choices to make on how to spend its money as it could cut back and slow down or go on the offensive. However, if it's too aggressive in either its spending cuts or its acquisition dreams, these moves could take the stock lower.
