Devon Energy Stock: Limited Upside Near Term (NYSE:DVN)

I get a lot of questions about oil and natural gas producer Devon Energy (NYSE:DVN) and whether it’s a good buy at current levels, down more than 25% from its 2022 peak even after factoring in the benefit of DVN’s dividend payout.

In late April, I wrote a bearish piece on Haynesville Shale focused natural gas producer Comstock Resources (CRK) based on a simple model I created of the company’s breakeven costs and free cash flow potential. My conclusion was CRK will struggle to generate free cash flow this year even if it further reduces planned capital spending.

In early May, I followed up with a bullish article on Haynesville and Marcellus producer Southwestern Energy (SWN) based on a similar cost and free cash flow model to what I used for CRK. In this case, however, SWN benefits from a lower cost structure and better near-term hedge protection. A simple discounted cash flow model projects a target of near $9 for SWN.

Devon is a more complex company than either SWN or CRK because it’s much larger, produces a more diverse mix of commodities, and produces from a longer list of oil and gas fields around the US. DVN’s two largest assets include acreage in the Delaware Basin of the Permian and the Eagle Ford Shale of Texas; however, the company also has smaller positions in the Anadarko Basin in Oklahoma, the Powder River Basin in Wyoming and the Williston Basin of North Dakota.

Regardless, we can still construct a similar breakeven cost model to that used to assess both SWN and CRK and use it to derive a discounted cash flow target for DVN.

Devon’s Breakeven Costs

Let’s start by examining Devon’s breakeven costs and realized pricing in Q1 2023 of this year, which the company reported back on May 8th:

Oil accounted for just under 50% of DVN’s Q1 2023 production and NGLs like ethane, propane and butane chipped in an additional 23.3%. In short, while DVN produces a large amount of natural gas – more than 1 billion cubic feet per day (BCF/Day) in Q1 – it’s primarily an oil and liquids producer.

As a result, I evaluate all of DVN’s costs and pricing realizations in terms of barrels of oil equivalent (BOE). There are roughly 6 million British Thermal Units (BTUs) of energy in a barrel of crude oil so, by convention, we convert gas volumes to oil volumes using a ratio of 6,000 cubic feet of gas to 1 barrel of oil equivalent.

My table also lays out the major costs DVN faces in its business.

The list includes capital spending (CAPEX), which for DVN, like most exploration and production (E&P) companies, is primarily the cost of drilling and completing (fracturing) new wells. In Q1 2023 DVN spent a little over $1 billion in CAPEX, which works out to $17.55 per barrel of oil equivalent produced.

Lease Operating Expenses (LOE) are primarily the ongoing operating cost and maintenance cost associated with existing wells and producing acreage. In Q1 2023 total LOE was $327 million or $5.67 per Boe.

Gathering, Processing and Transport – basically the cost of moving oil and gas via pipeline and stripping NGLs from the raw natural gas stream – was $166 million in Q1 or around $2.88 per Boe. And production and property taxes – not income taxes but a tax paid based on oil and gas production revenues – totaled $3.47/Boe.

The other line items should be familiar to most investors including General and Administrative (G&A) expenses, Interest paid on debt and income taxes.

Sum up all these costs, and I calculate DVN’s free cash flow cost breakeven for Q1 2023, based on actual results, at $35.10/Boe.

Realized Pricing and Margins

Now, look at the Realized Pricing Deck section of my table.

The company produced 320,000 bbl/day of oil, which works out to roughly 28.8 million barrels for Q1 2023. Since total production in Q1 was 57.66 million Boe, oil accounted for just under half of DVN’s Q1 production as I noted earlier.

In Q1 2023, DVN reported that the average price of benchmark WTI crude oil – the WTI benchmark crude is delivered to Cushing, Oklahoma – was $76.17/bbl and the company’s realized price after hedges was $74.22/bbl.

So, DVN’s realized pricing for oil was 97.5% of the benchmark; because of where DVN’s acreage is located, and the company’s access to pipeline takeaway capacity, there’s very limited regional pricing discount across DVN’s producing regions.

Of course, $74.22/bbl is a lot higher than that $35.10/Boe cash cost calculated earlier, so if DVN produced only oil it would be extremely profitable at Q1 2023 pricing.

However, natural gas and natural gas liquids volumes account for the other half of DVN’s production profile and pricing there is far less favorable than for crude oil.

In Q1, DVN reports that it realized $24.12/bbl or NGLs produced, which is 31.7% of the value of the average price of a barrel of crude oil in the same period. While that might seem like a huge discount, it’s not. Most oil and gas-focused producers I follow, including SWN I wrote about recently on Seeking Alpha, have guidance assuming NGLs pricing somewhere in the 25% to 35% of WTI range.

Then there’s natural gas, which in Q1 2023 accounted for almost 27% of every Boe DVN produced.

Here regional pricing discounts are a significant headwind. Benchmark US natural gas futures are priced for delivery to Henry Hub, a pipeline distribution point in Erath, Louisiana on the Gulf Coast. However, natural gas produced in different regions of the US trades at prices that differ widely from Henry Hub.

For example, most of DVN’s gas production in Q1 2023 – about 62% of the company’s 1.03 bcf/day of production in the quarter – comes from the Delaware Basin, which is the western part of the Permian Basin located in Texas and New Mexico. In Q1 2023, the company’s average realized pricing for gas volumes in this region was $1.90 per thousand cubic feet (mcf).

So, the value of Delaware Basin gas DVN produced in Q1 2023 was just over 55% of the value of the same volume of gas delivered to Henry Hub.

This is not a Devon-specific problem. There’s insufficient pipeline capacity to move natural gas out the of the Delaware Basin region to markets where demand and price realizations are higher, so gas priced at the regional Waha Hub in west Texas trades at a chronic discount to Henry Hub:

Pipeline outages and maintenance schedules can further exacerbate the regional oversupply of natural gas.

For example, the El Paso Line 2000 pipeline moves around 600 MMCF/day of natural gas per day from the region to the California border; since the southern California market is chronically short of gas supply, prices there are much higher. However, a rupture in this line back in August 2021 forced it to be shut down and it wasn’t reopened until mid-February 2023.

In May of this year, throughput through the Permian Highway Pipeline system, which transports gas from Waha to the Gulf Coast of Texas, was reduced by 1 Bcf/day for more than a week.

And in April 2023, Kinder Morgan (KMI) reduced throughput on its eastbound Gulf Coast Express Pipeline for scheduled maintenance, driving a sharp drop in Waha prices to negative $0.51/MMBtu on Tuesday, May 9, though prices recovered by the end of that week.

The good news is that planned pipeline capacity expansions should help to relieve some of these large Waha pricing differentials though, as I’ll detail a bit later on in this article, that’s more of a late 2024 to early 2025 story for DVN.

Moving back to the Q1 2024 free cash flow model depicted in my table, if we multiple Q1 2023 realized pricing for oil, NGLs and gas by their respective share of total DVN production, we derive a realized value of $46.65/Boe.

And, if we compare that realized price to the breakeven price of $35.10/Boe calculated earlier we get a cash margin in Q1 2023 of $11.55/Boe. Just to confirm we have calculated DVN cash costs correctly, if we multiple the $11.55 in cash margin per Boe by total production in Q1 that yields a free cash flow estimate of over $665 million for Q1, pretty much dead on the company’s actual reported Q1 2023 FCF.

So, let’s step this analysis forward and derive a model for full year 2023 based on management’s latest guidance:

Full Year 2023 Cash Flow Projections

Management provided updated guidance for 2023 capital spending, production, price realizations and costs on May 8th following the release of its Q1 2023 earnings.

Here’s a table that presents my 2023 model based on the mid-point of management’s guidance:

Having explained the meaning of all these line items for Q1 2023, I won’t run through all the line items here in depth.

However, let’s run through just two additional assumptions I’m making:

Production & Property Taxes

DVN guidance indicates that it’s looking for production and property taxes to come in at between 7% and 8% of total upstream sales.

My model projects total production of 238.3 million Boe this year at an average realized price of $43.57/boe (more on this in a moment), yielding total upstream revenues of close to $10.4 billion. Using the 7.5% midpoint of management’s guidance that’s almost $779 million in production taxes or about $3.27/Boe in costs. That’s pretty consistent with the $3.47/Boe in Q1, so I believe it represents a reasonable estimate.

Realized Pricing Deck

Estimating this is a bit more complex, particularly for natgas pricing.

For oil, DVN has significant hedges in place for the remainder of 2023 including 84,500 bbl/day hedged for both Q2 and Q3 2023 and 81,000 for Q4 2023. Since the company produces north of 320,000 bbl/day of oil that means DVN has hedged roughly one quarter of expected production over the next few quarters.

However, these barrels are all hedged using price collars (options) with a weighted average floor of between $69.41 and $69.63/bbl.

Take a look at the WTI oil price futures curve right now:

This chart shows current pricing for US WTI oil futures through the end of 2025. I’ve also labeled the December 2023 oil futures price at $68.90/bbl.

Bottom line: The current calendar strip price (futures curve) pricing for oil is at or above the floor price for DVN’s collar hedges. So, since I will use the calendar strip to estimate free cash for 2023, I’m not expecting DVN’s oil hedges to help the company in terms of cash flow much this year.

That’s certainly consistent with what we’ve seen year-to-date – in Q1 2023, for example, DVN’s oil hedges actually cost the company about $0.10 per barrel of oil produced (a trivial amount for a company of DVN’s size).

So, in my model I just ignore oil hedges for 2023 estimates.

Of course, should oil prices drop significantly from current levels this would provide an offset, helping to shield cash flows from lower commodity pricing. On the flip side, the top of DVN’s collars ranges from $94.29 to $94.84/bbl. That means that unless there’s a massive jump in oil prices by year-end those hedges won’t act as a headwind for DVN’s results either.

So, my realized oil price assumption for DVN in 2023 represents the actual results from Q1, actual trading in oil futures so far in Q2 and the current futures curve (calendar strip) for oil delivered for July through December 2023.

Finally, management has guided to realized oil prices of between 95% and 100% of the WTI benchmark. So, to convert WTI futures prices to DVN’s actual realized pricing I’m multiplying by 97.5%, the midpoint.

NGLs realized pricing estimates are similarly straightforward. Management guides to a barrel of NGLs at 25% to 35% of the value of a barrel of WTI. So, I used my WTI projections outlined above and assumed the midpoint of guidance (30% of WTI), factoring in actual results in Q1 2023.

Natural gas realizations are a bit more complex, due to regional pricing differentials and the company’s extensive hedge book, here’s a quick look at my estimates:

Simply put, DVN has a mix of fixed price swap hedges and options collars hedging a significant portion of production at prices well above the current calendar strip for gas.

So, what I’ve down here is to break down gas production by quarter. This table includes the actual gas volume produced in Q1 2023, swaps and collars for each remaining quarter of the year and the amount of production left to be sold at prevailing market prices in each quarter.

I am using actual gas pricing data for Q2 to date, the NYMEX futures curve for July through year-end and management’s guidance for price realizations at 60% to 75% of the Henry Hub benchmark (the midpoint is 67.5%).

All told, the company’s full year cash breakeven cost is around $32.80 per Boe and I’m estimating their actual realized prices -based on the current pricing in the futures market – at around $43.57/Boe.

Based on my cost model, realized price estimates and DVN’s expected 2023 production, the company is on track to produce about $2.57 billion in free cash flow for 2023 as a whole.

Wall Street Estimates Look Stale

Per Bloomberg, the consensus on Wall Street estimates DVN’s free cash flow for 2023 at $3.15 billion, which is materially higher than the figure I just derived.

However, a quick glance at these estimates shows that most date from early May, shortly after DVN announced its Q1 2023 results and updated guidance. And the futures curve for oil prices has deteriorated since that time:

As you can see, the entire futures curve was much lower on June 13th (when I constructed my model) as compared to May 10th, around the time most Wall Street estimates for DVN included in the consensus were published.

August 2023 WTI futures, for example, were trading around $72.35/bbl back in early May compared to about $3/bbl lower today. And, if I adjust my projected oil and NGL price realizations for DVN higher by about $3/bbl, more in line with the early-to-mid May trading range, my full year 2023 free cash flow estimate jumps over $3 billion, close to in-line with the consensus.

Two implications worth mentioning.

First, creating models to derive free cash flow and cash flow breakevens is subject to error, uncertainty and its (far) from an exact science. However, the model I just presented appears to represent a good rough estimate of DVN’s free cash flow generation potential that’s in-line to slightly conservative relative to Wall Street estimates.

Second, if you are trying to value DVN based on the current reported Wall Street consensus for earnings or cash flow, DVN might look “artificially” cheap. That’s because the deterioration in oil prices since that time will likely result in lower estimates for earnings and cash flow as models are updated.

Let’s put this model and these estimates to work to derive a valuation for DVN:

Deriving a DCF Target

Commodity prices, especially for crude oil, are the biggest risk facing DVN. And saying that estimating commodity prices over the next few months, let alone the next few years, is difficult would be the understatement of the century.

However, let’s make a few assumptions regarding the path of commodity prices and see what that could mean for DVN’s valuation.

First up, as you can see in my chart above, the WTI oil futures curve is in backwardation over the longer-term, meaning the price of oil for delivery in several months’ time is lower than the current quote. The average price of oil futures for delivery in 2024 is $67.05/bbl and for 2025 it’s about $64/bbl.

So, my first valuation scenario is based on the realizations I calculated for 2023 above, oil at $67/bbl in 2024 and $64 for 2025 and thereafter. I’ll assume oil realizations at 97.5% of WTI for DVN in-line with management guidance for 2023 and we’ll leave NGLs priced at 30% of WTI.

For natural gas, here’s the futures curve through the end of 2025:

The calendar strip price for gas in 2024 is about $3.45/MMBtu and for 2025 it’s $3.95/MMBtu.

For my first scenario I’ll use my previously calculated price realization for gas in 2023, $3.45 for next year and $3.95/MMBtu for 2025 and thereafter. For my first scenario, I’ll also assume that DVN continues to sell its gas for a price realization of 67.5% of Henry Hub.

Finally, note than DVN’s hedges for both oil and gas in 2024 and beyond are small enough we can ignore them in modelling free cash flow beyond this year.

So, based on these realizations and the full year 2023 cost curve for DVN I outlined earlier, I calculate that DVN can generate roughly $2.57 billion in FCF for 2023, $2.0 billion in 2024 and $1.9 billion for 2025 and thereafter.

Let’s plug that into a simple DCF model:

I’m using a discount factor of 9.5% for DVN. Debt accounts for about 17% of DVN’s capital structure and has a cost of 4.3% annualized. Meanwhile, I’m using a cost of equity capital (stock) of 10.4% annualized derived from a Bloomberg model based on the risk-free rate of interest in the US and DVN’s beta (volatility relative to the S&P 500).

The results aren’t very encouraging — using the assumptions I just outlined and that 9.5% discount rate I calculate a DCF valuation of $25.74 for DVN, just over half the stock’s current quote around $50.

The good news is that I believe these estimates are far, far too low.

Earlier on I explained how DVN’s natural gas price realizations are low due to the lack of adequate gas pipeline takeaway capacity in its most important gas producing region, the Delaware Basin of West Texas.

However, over the next few years a number of pipeline expansions and new pipelines are due to commence service, which should help producers in the region including DVN, move more gas to markets like California, Mexico and the Gulf Coast, where realizations are far higher.

The Energy Information Administration maintains a list of pipeline projects and expansions currently underway that’s on their website here.

The list of pipelines includes a roughly 0.57bcf/day expansion of Kinder Morgan’s existing Gulf Coast Express Pipeline, a 0.55 bcf/day expansion of the Permian Highway pipeline and a 0.5 bcf/day expansion of the Whistler Pipeline all due to enter service in late 2023 or early 2024.

An even bigger project is the new Matterhorn Express Pipeline with capacity of 2.5 bcf/day — a joint venture between a number of companies including DVN — that’s due to enter service late next year.

Bottom line is that the assumption in my first DCF scenario that DVN’s gas realizations would remain at 67.5% of Henry Hub is too harsh. While that makes sense for 2023, I suspect by 2025 price discounts will tighten as new pipes enter service.

In the first three quarters of 2022, before maintenance on Permian gas lines expanded the Waha-Henry Hub differentials — DVN’s pre-hedge natural gas price realizations averaged 84.4% of NYMEX Henry Hub, a significant uplift to this year’s guidance range of 60 to 75%.

So, we’ll keep the 2023 gas price realizations unchanged as outlined in my model above, boost 2024 to the top end of guidance (75% of Henry Hub) and boost 2025 and years after that up to the 84% average seen in the first 9 months of last year.

Of course, the proverbial elephant in the room is the outlook for WTI oil prices, since that underpins most of DVN’s free cash flow either directly or via the relationship to NGLs prices.

A detailed discussion of my outlook for oil prices is beyond the scope of an article dedicated to valuing DVN. Suffice it to say that the current price of oil is depressed due to concerns about global economic growth and the potential for a global recession to crimp demand:

In particular, since late last year, the relationship between trends in WTI (and Brent) oil prices have been correlated to the outlook for the Chinese economy, the world’s second largest consumer of crude oil.

This chart shows the Citi Economic Surprise Index in blue. This index shows the performance of incoming Chinese economic data relative to analyst expectations ahead of the release where a rising number suggests the data is beating expectations and a falling index the opposite.

I’ve overlaid a simple price chart for WTI on a separate scale.

As you can see, WTI prices slid into late last year as the Chinese economy weakened, jumped higher into April as Chinese economic reopening from COVID lockdowns spurred a surge in Chinese oil demand to record highs.

Finally, as the Chinese economic data has started to disappoint since late April, WTI prices have retreated once again to that $65 to $70/bbl level for WTI.

However, while oil prices usually decline amid global economic downturns, demand-led sell-offs tend to be short-lived, especially when the supply side of the equation looks tight.

And, as I explained in this January 2022 piece for Seeking Alpha, global spending on new oil and gas developments has collapsed since 2014, leaving the world with limited oil production growth potential over the next few years and falling spare capacity within OPEC in a normal economic environment.

Finally, clearly Saudi Arabia would like to defend oil prices near current levels, a fact made clear by their recent decision to cut oil production unilaterally by 1 million bbl/day in July 2023.

Bottom line is that I see the $65 to $70/bbl region as a floor for WTI and, even if a likely US recession and global economy slowdown crimps demand near-term, oil prices are likely to recover to the $80+/bbl region longer term. That’s also a level that’s more comfortable for Saudi Arabia, which needs Brent oil north of $80 to balance its budget.

Per Bloomberg, this is also in-line with the consensus on Wall Street for WTI to average about $82/bbl in 2024 and 2025.

So, let’s keep the 2023 oil price realizations unchanged from my initial DVN 2023 cash flow model and boost the 2024 and beyond oil price realization to $82/bbl.

Here’s the new DCF Model based on these more aggressive assumptions:

Under these new, higher commodity price assumptions and the cash cost model I calculated for 2023, Devon should be able to generate around $2.57 billion in free cash flow in 2023, rising to $3.9 billion in 2024 and $4.15 billion per year thereafter.

Under those assumptions, the DCF share price valuation jumps to $60.40, about a 20% premium to the recent closing price.

That looks like a more realistic valuation than my first DCF model and projections are more in-line with Wall Street consensus estimates for free cash flow over the next few years.

However, with oil prices weak in recent months and the US and global economy facing a recession, I still don’t see DVN as “cheap” at current levels despite the decline in the stock price since last summer.

And that brings me to this:

Target, Outlook and Risks

The energy business is deeply cyclical because earnings and cash flows rise and fall with commodity prices. And oil, in particular, is highly sensitive to changes in sentiment regarding the outlook for the global economy.

So, with the global economy facing recession and oil (and natural gas) prices trending lower since last summer, I prefer to demand a larger margin of safety on prospective investments. In other words, I’d rather look for stocks that are trading at a deeper discount to my DCF valuation estimates, and that have more upside potential, to my (rough) estimate of fair value.

For example, in my Seeking Alpha piece on gas producer SWN in May, I calculated a DCF for the stock that was 85% above the trading price of SWN at the time. And that DCF was based on conservative assumptions; in particular, natural gas prices in-line with the current calendar strip and factoring in SWN’s savvy gas hedges.

That’s a large margin of safety and, even if gas prices are somewhat lower than my estimates, SWN still has significant upside.

With DVN, I’m showing just 20% upside to my DCF valuation even factoring in several bits of good news including a sizable recovery in oil prices into 2024 and collapsing Waha-Henry Hub pricing differentials as new pipelines come online.

I still think those estimates are reasonable — even conservative longer term — however, they’re not quite as conservative as those I used for SWN. And the margin of safety — the discount to my valuation — is much smaller.

Simply put, just because a stock falls significantly doesn’t mean it’s cheap. In this case there’s a lot more good news priced into DVN’s stock than in many of the gas producers I follow like SWN.

Longer term, DVN looks like a solid E&P to own. The company was among the first to target free cash flow over production growth and among the first to implement a variable dividend structure that ties shareholder payouts directly to free cash flow generation. For Q1 2023 alone, the company will pay a dividend of $0.72, which annualizes to a yield of about 5.7%.

Management is solid and experienced, DVN has excellent acreage in low cost fields, which is why its breakeven costs are so low. The company is taking steps to address low price realizations for natural gas in west Texas and it has growth potential in several of its core fields.

However, it’s a good company in a tough market right now. The biggest risk is that oil prices remain low through year-end and into early 2024, which would likely result in further downside to DVN’s cash flow projections and DCF valuation.

For investors looking to buy DVN, dips to around $40 would provide a larger margin of safety to my DCF Valuation for the stock.