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An Attractive Play in the Red-Hot Natural Gas Sector

By Ephraim Juskowicz This week's S&P Focus Stock of the Week is Devon Energy (DVN), which carries Standard & Poor's highest investment ranking of ***** (buy). Following several major acquisitions during the past two years, the company has catapulted to rank among the five largest pure oil and gas exploration and production (E&P) firms in the U.S.

With 61% of its North American reserves consisting of natural gas and an estimated 8% gas production growth for 2001 (amid little hedging and adjusted for pooling transactions), Devon is poised to gain from a very favorable natural gas pricing environment. Standard & Poor's believes that natural gas prices will remain strong for the foreseeable future.

In August 2000, Devon acquired E&P firm Santa Fe Snyder. Devon was attracted to SFS because both companies operated in nearly identical regions, providing for potentially significant competitive advantages. At the same time, the deal provided diversification, as DVN and SFS brought Canadian and international activities, respectively, to the marriage. Reflecting synergies and DVN's use of the full cost method of accounting for exploration activities, the deal provided some $30 million in annual cost savings.

Other recent major acquisitions include PennzEnergy (August 1999), and Canada-based Northstar Energy (December 1998). Over the past 10 years, Devon has increased reserves, production and cash margin per share at double-digit compound annual growth rates. Net debt per barrel of oil equivalent (BOE), meanwhile, has remained relatively unchanged.

Following these transactions, the company had 1.1 billion BOE of estimated proved reserves as of December 31, 1999 (restated for pooling transaction, latest information available), with 76% and 24% located in North America and internationally, respectively. North American divisions include Permian/Mid-Continent Basin (31% of total reserves), Rocky Mountains (21%), Gulf of Mexico/Gulf Coast (13%) and Canada (11%).

CHEAPER GAS. Within the Rocky Mountains, which is seen as one of the only gas regions in the U.S. that is still largely untapped, the company is a major producer of coal bed methane (CBM) gas. Unlike conventional gas, which requires drilling very deep wells, CBM gas is drilled from shallow coal seams. As a result, CBM gas is usually cheaper to drill than conventional gas, enhancing unit cash margins.

Construction of the 126-mile Thunder Creek gas gathering system was completed in September 1999, facilitating the transportation of CBM gas to end-markets. Most of the CBM gas within the Rockies comes from the Powder River Basin, where Devon owns 250,000 net acres. With some 350 wells awaiting tie-ins and 74% of its properties still undeveloped, we believe that production of Devon's CBM gas in the Powder River Basin will more than triple in 2001.

The company also has a significant CBM presence the Rockies' San Juan Basin. Overall, CBM accounts for approximately half of Devon's production in the Rockies. Twelve percent of DVN's 2001 capital budget of approximately $1.1 billion (excludes acquisitions) has been allocated to the Rocky Mountains division.

STRONG PROSPECTS. Through its late-1998 purchase of Northstar Energy, Devon established a presence in Canada, where it has a substantial inventory of exploration prospects. We are especially bullish on the potential at Northern Foothills, a deep play. In addition, DVN is positioning itself as producer of coal bed methane gas in Canada. Fifteen percent of the capital budget has been allocated to the Canadian division. Price differentials for Canadian gas have narrowed considerably due to the commencement of several major pipelines and expansions.

Perhaps the greatest impact "wildcat" wells may come from DVN's International division. Spending at International accounts for 24% of the 2001 spending plan, compared with 18% in 2000. The majority of DVN's international activities are located in Azerbaijan (a former Soviet Republic), Indonesia and Argentina. International efforts, especially in Indonesia, generally focus on oil, as gas infrastructure is still in its early stages. Nevertheless, the company recently signed a 20-year gas sales agreement with Singapore Power, thus ensuring that long-term demand will exist for DVN's gas supply. Devon is also pursuing several high-potential prospects in West Africa.

Company-wide, production should rise a dismal 3% this year from the anticipated 2000 level, partially reflecting asset sales. Although remaining strong by historical standards, commodity prices will probably retreat from current lofty levels. This will negatively impact DVN's price realizations and revenues. Unit production and operating, and general and administrative, costs should be flat to slightly lower. Unit depreciation, depletion and amortization is forecast to increase about 6%. Unit interest expense will fall dramatically, partially reflecting DVN's use of innovative debt securities.

Discretionary cash flow per share (DCFPS), a key

industry measure, as well as EPS are forecast to decline slightly to $13.30 and $2.85, respectively. Most industry participants are expected to report lower DCFPS and EPS due to lower commodity prices.

UPSIDE POTENTIAL. The five-year average all sources finding and development cost, which measures DVN's cost to add reserves, is below the peer group average. Unit production and G&A costs are also attractive. Partially the result of acquisitions and its use of aggressive accounting methods, such as pooling of interests and full cost, DVN has steadily increased DCFPS and EPS.

At the same time, net long-term debt to total capitalization is substantially lower than DVN's peers. Finally, with 32 million undeveloped acres, the company has significant upside potential.

The stock trades at 4.2 times estimated DCFPS, a discount to the peer average of 4.7. Based on Devon's superior operating performance, we feel that the company deserves to trade at premiums that are typically assigned to industry leaders. Thus, assigning a reasonable 5.0 multiple, S&P's 12-month target price is $66.50, implying a 15% appreciation from the Jan. 5 closing price of $57.90. Juskowicz is an oil and gas industry analyst for Standard & Poor's

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