Wednesday, December 18, 2013

What's the Deal With Devon Energy?

Recently, I wrote an article for titled Devon Bails but the Cline Shale Heat Up (APA, DVN, LPI, PXD).  The article was meant to be a summary of the last four months of news from the area, and I thought the title aptly summarize it, but I got a question from a reader asking whether or not I thought Devon had "truly bailed" or if they were merely scaling down to study completion techniques before ramping up again.  So with this post I want to clarify what I meant by "bailed", and  point out the evidence and economics I base my opinion on.  In short, I'd say Devon looks ambivalent on the Cline Shale, more interested in waiting for other operators to explore and delineate that investing the capital it takes to do that for itself.  Here is some discussion of the things I consider in making my assessment of Devon's presence in the Cline.

Devon's perspective on the Cline is different from other operators.
There's an anecdote I've heard repeated a few times by people I trust.  The gist of this anecdote is the Cline Shale is somewhat akin to swiss cheese in that there are holes in the formation that are not prospective.  I heard this first from a personal friend who is a Permian mineral interest owner, and again by the key note speaker at West Texas Energy Consortium's conference earlier this month.  My friend, who told me this weeks before that conference, attributed the quote to a geologist that works for Devon.  I'm not sure where the conference speaker heard that information from.  So, while other operators are having a lot of success targeting the Cline, like: Pioneer, Laredo, Apache, et al.; Devon doesn't really see its acreage with the same rose-tinted glasses.

Devon's other prospects are more attractive.
This was the main thesis of another article I wrote for, called Devon’s focus is not the Cline Shale, yet.  There I point out that the role of an executive in a big E&P company is to allocate capital in such a way as to maximize the return to shareholders.  For the most part, that means investing the company's budget in operatons in formations where the company can earn the best profit margin on the sale of its product.  And note, it's not just how much fossil fuels are coming out of the ground that makes a for a high profit margin, you also have to weigh the costs associated with production.  Right now, because of the newness of the Cline, its depth and need for long-lateral horizontal drilling with dozens of frac-stages, the cost of drilling Cline wells is quite high relative to other locations.  The risk-reward ratio for new formations is never as good as older established formations.  I point out in the article above that Devon likes its SAGD projects in Canada, the Cana-Woodford and Mississippi Lime plays in Oklahoma, and the Delaware basin formations much more than the Cline, right now.  

11/20/2013 - Devon buys Eagle Ford acreage.
In late November, Devon announced that for $6 billion it had purchased GeoSouthern's acreage on the Eagle Ford, an asset with risked recoverable resources of about 400 million barrels of oil equivalent.  This transaction represents the highest price paid on a per acre basis for undeveloped Eagle Ford acreage. I had to smile when I saw this because this purchase seems to confirm my position in the article above which I had written just three weeks previous.  Why would you pay an obscene amount for acreage in another formation when you have your own shale oil acreage to develop in the Permian?  What really makes this purchase a head-scratcher is that Permian acreage reportedly has a greater potential.  Some operators report up to 16 different pay zones totaling over 3000 feet of subsurface layers.  The Eagle Ford is just one formation and is only 300 feet thick.

Theory: Devon may just be good at the development stage of producing shale oil.
In business school they teach us that a firm should identify its core competencies and take steps to position itself in the value chain so that it can capitalize on them.  Put simply, businesses should stick to what they are good at and let others do the rest.  Devon may have realized from its follies in the Cline Shale that as a company it is not very good at the early stage of shale production - the exploration stage.  Devon is probably best at quickly and cheaply drilling wells, which is useful in the development stage of the formation, which comes after the processes have been tested and perfected and need only be repeated across all the acreage.  This theory is consistent with Devon's purchase of Eagle Ford assets ready for development.  What this means for Devon's strategy in the Cline Shale is Devon might want to lay low for a while and let other companies explore and delineate the Cline.  

If you read their December investor presentation, you'll notice the executives are taking steps to distinguish Devon's future activities.  One of their first slides refers to "The New Devon."  They also talk a lot about how in the future Devon will be intentional about pursuing production growth in North American oil in the future.  To me, that means "we will seek out development stage opportunities" because that is the stage where production starts to climb quickly.  Furthermore, the executives illustrate with this graph that only 10% of the companies operations budget is allocated to exploration activities.

The cool thing about being a big oil company is you can use money to make up for your shortcomings.  All Devon has to do is find a company with similar acreage that has the drilling and fracing process perfected and buy them up - trade secrets and all.  It may be expensive, and it may appear that they overpay that operator - similar to the Eagle Ford purchase - but if that's what it takes to get to the development stage, so be it.

"Bail" doesn't mean abandon.
Lastly, it should be noted that when I used the verb "bail" to describe Devon's actions, I didn't mean for it to indicate that Devon had abandoned its acreage in the Midland basin.  I can't remember the exact number, but before last August I think Devon had committed 7 or 8 rigs to the Cline.  Then in August they announced that due to a lot of variability in their Cline developments they would go down to 2 rigs and focus on "mini-developments."  That announcement represented a significant retreat from their original position, but not a full retreat. Actually for an oil company of Devon's size, it would never make sense to completely pull out of an any area, because if they did, their acreage would lose significant value - possibly hundreds of millions of dollars.  This is because not only would they not be performing operations to keep leases from expiring, but also any operator looking to buy that acreage would see that Devon doesn't consider it very prospective and thus they would be less willing to pay for it.  Thus, keeping at least a few rigs operating in less than stellar acreage, though expensive when you consider the costs to drill and complete a well, is actually cheap when you consider the alternative loss in value of the entire acreage.

So, I think these two rigs Devon has committed to the Cline may be drilling and exploring in earnest, or studying completion techniques, but they are probably not enough to propel the company towards a major development program in the Cline anytime soon.  It's seems more likely that they are there to act as a place holder - drilling to hold acreage and representing to other potential buyers that the areas is worthwhile.

Forgive me for using a colloquialism, but I think, for the reasons mentioned above, that Devon is going to pussy-foot around in the Cline for a while - probably for another 6 months at least.  By that I mean Devon is not going to allocate enough capital to really make a difference in its acreage - they are just not going to learn much with two rigs working on "mini-developments" like they announced.  And I'm not exactly sure what the role of Devon's partnership with Sumitomo plays here, but I'm guessing it just further enables Devon to be ambivalent because it means they get to play with other people's money.

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