Devon's Quest for Oil Ends Well

With a major Gulf discovery, the Oklahoma energy company's production prospects have shot up, validating its shift from M&A to exploration

Devon Energy's (DVN) J. Larry Nichols claims to have gotten religion—mergers and acquisitions aren't the only way to grow in the energy industry.

Unlike his custom in the late 1990s, the 64-year-old has been focusing his Oklahoma City company on locating new North American discoveries in recent years rather than gobbling up existing ones. Nichols' new approach appears to be working after news on Sept. 5 that Devon, Chevron (CVX), and Statoil (STL) announced drilling-well test results that showed they can commercialize recent discoveries in the lower tertiary Gulf of Mexico, a deep layer of ancient rock that lies five miles below the ocean's surface. The "Jack 2" well, 175 miles off the Louisiana coast, had a flow rate of more than 6,000 barrels per day.

Before the latest find, the Gulf's declining production prospects had been long known and well-chronicled. And even though no production is expected at the site for several years, the discovery could spell good news for the U.S. oil supply (see, 9/7/06, "Plenty of Oil—Just Drill Deeper"). Depending on how drilling wells develop, the new field could boost the country's total reserves by more than 50%. However, during a conference call related to the announcement, Devon officials conceded abundant "variability" in estimates implying that new discoveries in the area could yield as many as 20 million barrels.

Nichols feels his company's exploration efforts have been vindicated by the news. "With the announcement (on Sept. 5), it clearly has been (worth it) and will be for some time," Nichols said in an interview. "We don't need to do large M&A to be successful." He's quick to add that any such statement doesn't mean he'll never do another deal, however.


  Investors bid up Devon more than 12% on news of the find, with the stock hitting a 52-week high of $74.75 on Sept. 5. The shares are up more than 13% over the past year and finished at $69.86 on Sept. 7.

To be sure, Devon is far from the only player prospecting for oil in the Gulf's deepest realms. Chevron, the San Ramon (Calif.) integrated oil major, is operating the Jack prospect with a 50% working interest, while Devon and Norway's integrated giant Statoil each own 25%. Chevron has had a stake in six discoveries in the lower tertiary, or around half the total, while Devon has four. What differentiates Devon from the pack? Its smaller size, independence, and tight focus on gas production in North America.

"Successful companies need to explore," Merrill Lynch (MER) analyst John Herrlin Jr. said in a Sept. 5 research note. He later added that investors now need to recognize the growth potential of Devon's reserves. Devon's four discoveries in the area could represent up to 900 million barrels of net resource potential. Meanwhile, the company's total reserves amounted to 2.1 billion barrels at the end of 2005.

The company has also spent about 25% of its exploration and development budget on exploration, putting its efforts in this area ahead of most. Energy companies have seen exploration projects fail in recent years, as their rivals outperform by buying others' existing reserves. As a result, last year only 22% of independents' worldwide exploration and development spending went toward the former. Back in 1998, exploration accounted for 38% of spending, according to Bank of America.


  Devon did shell out $2.2 billion in cash for Chief Holdings in May, a pricey deal aimed at bolstering Devon's natural gas holdings in Texas. But it has ended the rampant pace of acquisitions that unsettled investors during the late 1990s. Between 1998 and 2003, Devon bought the North American companies Northstar Energy, Pennz Energy, Santa Fe Snyder, Anderson Exploration, Mitchell Energy, and Ocean Energy. By 2002, Devon's debt had soared above $8 billion, putting its net debt-to-capital ratio above 60%. Since then, the company has trimmed that ratio back to 26% as of the second quarter of 2006, helped by surging revenue from higher oil prices in recent years. Devon's long-term debt amounts to $5.2 billion.

"In the 1990s, it was mainly acquisitions. Today they're much more focused or weighted to exploration than what they'd been before," says Robert Morris, an analyst at Bank of America.

Nichols says he saw potential in high-impact deep-water opportunities in the Gulf of Mexico as early as 2001, intrigued by the emerging technologies for tapping reserves in waters as deep as 10,000 feet and for hunting hydrocarbons below thick bodies of salt. Now the recent results he shared with Chevron and others have fueled more optimism. Cambridge Energy Research Associates (CERA) says the successful test at the Jack discovery is "a significant development for the future of U.S. oil and gas supply." CERA estimates that up to 800,000 barrels per day of light, sweet crude oil and 1 billion cubic feet per day of natural gas could begin flowing from this reservoir in 2012-14. Additional oil resources could be found nearby.


  Devon's oil strike in the deep ocean followed an earlier experience on land. For decades everyone knew there was gas trapped in a broad field of black, hard rock called the Barnett Shale, just north and west of Fort Worth. But nobody knew how to get the gas out, so the shale sat untapped. Then engineers figured out how to crack the rock open by pushing water and sand into it, fracturing it and releasing the gas trapped inside. Thanks to such technological advances, Devon increased its Barnett production from 200 million cubic feet of natural gas equivalent per day in 2002 to more than 600 million today. The area, which accounts for 1.4 billion cubic feet of natural gas equivalent per day, is one of the country's largest onshore natural gas fields.

"Because we're a smaller company, we made a conscious effort to look for opportunities that would have long-term significance," Nichols says.

Still, only time—and the amount of crude that lies more than 20,000 feet below the Gulf's surface—will tell whether Devon's new strategy helps it compete against the global heavyweights.

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