Devon Energy

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 4/5

Devon Energy is an independent energy company engaged in the exploration, development, and production of oil, natural gas, and natural gas liquids (NGLs), primarily in the U.S. Their operations are heavily weighted towards U.S. shale.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Devon Energy operates in the volatile commodity market, making moats more difficult to establish and maintain.

Business Overview

  • Revenue Distribution: Devon Energy’s revenue primarily stems from the sale of crude oil, natural gas, and NGLs. The mix of production and pricing has a significant impact on revenue. DVN’s production is heavily weighted towards U.S. shale basins. For the nine-month period ended September 30, 2023, they reported an increase in revenue from oil, a decrease in revenue from natural gas and an increase in revenue from NGLs compared to the same period in 2022.

  • Industry Trends: The oil and gas industry is inherently cyclical and experiences substantial volatility. Recent trends include a global energy transition, geopolitical instability and demand uncertainty. High commodity prices are boosting profits for many companies, while increased governmental focus on climate change is putting companies at higher risk.

It’s important to track these commodities prices as they have a huge impact on company’s financials.

  • Margins: Devon’s margins are influenced by production costs, transportation costs, and commodity pricing. While they are working on cost-cutting measures and improving operational efficiency, fluctuating commodity prices directly impact their profit margins. They reported that production expenses decreased primarily on lower workovers, facility lease operating expenses were increased because of increased property taxes, while marketing and transportation expenses were down primarily from lower transportation expenses.

  • Competitive Landscape: The oil and gas industry is highly competitive. Companies often compete to acquire valuable resources and optimize production costs. Competitors include large multinational oil and gas companies, independent producers, and integrated energy companies. Some of the larger competitors are also their partners in some of the ventures, and the companies compete for funding, investment and acquisition.

This is a commodity business which means the ability to differentiate is very low, which reduces the possibility of a competitive advantage.

  • What Makes Devon Different: Devon focuses on low-cost production in the most productive basins and emphasizes on a disciplined capital allocation. They have also implemented ESG measures including a methane emissions program. The company is also working on carbon capture and utilization. They have recently acquired Validus Energy which operates on the Eagle Ford Shale and has some of the lowest cost production metrics in that basin. The acquisition of Validus Energy is to enhance company’s operating and capital expenditure efficiency.

Moat Assessment

Moat Rating: 2 / 5

  • Intangible Assets (1/5): Devon does not have any particularly strong brand recognition in the commodity business. They do have some proprietary technology relating to drilling and production, but are not durable, or differentiated enough to give them a wide moat. Their land rights, and acreage in certain areas does give them an advantage. However, these land rights are not exclusive, and can be matched by its competitors by paying higher prices.

  • Switching Costs (1/5): There are essentially no switching costs for their customers, as it’s a commodity product. When selling oil and gas, it is the same as the next seller.

  • Network Effects (1/5): There is no network effect for DVN.

  • Cost Advantages (3/5): Devon does have a focus on low-cost production in most productive areas, but this is highly dependent on their operational efficiency. They do own infrastructure like pipelines, but they are not completely exclusive to Devon, so they are not strong source of competitive advantage. Other oil companies can establish competing structures. They do have a track record of operational efficiency and cost cutting, which translates into some source of competitive advantage.

  • Size Advantage (2/5): Devon does have some size advantages, due to economies of scale but those advantages are not extremely significant as many oil companies share the same vendors, and infrastructure. Bigger companies can also implement better technologies.

Overall, their reliance on commodity markets and the lack of durable differentiation contribute to the low moat rating. While operational efficiency gives them some minor competitive edge.

Risks to the Moat

  • Geopolitical Risks: Global political events can severely impact commodity prices, affecting the profitability of operations. The Russo-Ukrainian war is a great example for it, leading to higher prices and supply chain disturbances.

  • Technological Disruption: A shift to renewable energy sources presents a long-term threat, as new technologies may reduce dependence on fossil fuels. Government regulations regarding ESG are forcing firms in this sector to invest more to be compliant with the rules.

  • Fluctuating Commodity Prices: Oil and gas prices are notoriously volatile and can significantly affect revenue and profitability and are beyond management control. For example, higher oil prices lead to higher profitability, while a decrease can cause financial strain.

  • Operational Risks: Drilling accidents and operational disruptions can halt or reduce production, causing significant losses. A major hurricane or wildfire in their production area is also a huge risk to their production.

  • Environmental Regulations: Stricter regulations to reduce emissions and improve sustainability could lead to higher compliance costs and even production restrictions.

  • Economic Downturn: As a commodity company, they are highly exposed to economic turndowns that can decrease oil demand, reducing oil prices.

  • Competitive Pressure: As competition is high, they might struggle to find the right prices and continue making profits.

Business Resilience

  • Financial Stability: Despite these challenges, Devon has shown good financial discipline. They have reduced debt through asset divestment, and maintain considerable liquidity to endure economic downturns.

  • Operational Expertise: They have gained expertise in their operations, allowing them to manage resources and production efficiently. They have also shown a commitment to innovation and operational efficiency that can help them recover from adverse conditions.

  • Geographic Diversification: By operating in several key U.S. basins, they are diversified and can move capital to more attractive areas. However, they don’t have a lot of diversity, because of operating only in US shale.

  • Technological Capabilities: They have implemented various technologies that are helping them reduce costs, improve efficiencies, and increase recovery of hydrocarbons. For example they have started using AI to reduce costs.

Overall, their reliance on commodity prices is the biggest concern when it comes to their resilience.

Financials

  • Revenue: DVN’s revenues increased YoY, from $11,040 million in 2021 to $21,635 million in 2022, and in the nine month period of 2023 they recorded 14.24 billion compared to 19.97 billion in the same period in 2022. The biggest increase was mainly driven by higher oil and gas prices, rather than an increase in volume produced. The prices are driven by supply-and-demand dynamics that the management cannot control. If these prices fall, company revenues and profits will drop quickly.
  • Profitability: Devon’s profitability is also linked to commodity prices as mentioned before. In 2022, they generated a net profit of $6,520 million. As of the first nine month in 2023, DVN’s net profit is 3.5 billion compared to $5.2 billion for the same period in 2022. That decrease was mainly due to the drop in energy prices in 2023. Therefore, the company is highly dependent on energy prices, that make it highly volatile company.

The cyclicality of the commodity market, means there can be massive swings in the companies financials

  • Balance Sheet: DVN’s balance sheet is well-managed. As of 2022, they have $5.91 billion in cash and short-term investments and a total equity of $18.9 billion. That gives the company a strong foundation to endure economic downturns. Their long-term debt is at 8.8 billion, while the total liabilities come out to be $28.4 billion. As a result, debt doesn’t seem to be a large concern for the company, and the company has the flexibility to quickly reduce that debt, as evident from prior actions.

  • Cash Flow: Devon’s free cash flow was $1,134 million in Q3 of 2023, down significantly from $1,763 million in Q2 of 2023, because of declining profits. But they still have solid cash flow.

All of the financial are highly impacted by commodity prices, as they are commodity producers. This makes the company less predictable.

Understandability

Understandability: 2 / 5

  • The core business of DVN in producing oil, gas and NGLs is relatively straightforward. However, understanding the market complexities, financial implications, and government regulations related to the sector are complicated.
  • The various technicalities involved in oil and gas extraction are not always easy to understand. Therefore the layman investor will need to understand the commodity cycle, exploration, production, refining, transportation and other technical aspects. That makes it less easy to understand.

Balance Sheet Health

Balance Sheet Health: 4 / 5

  • DVN has a strong balance sheet with large cash reserves and a respectable level of debt, which gives them enough financial flexibility to operate under changing conditions and market prices. They also have a lot of liquid assets, making them very resilient in bad periods.

  • Their debt is also actively managed, and are always reducing it by a combination of paying down debts and asset divestment.

  • However, the company is very susceptible to market fluctuations, as is inherent in commodity businesses. While they have reduced debt recently, the long-term trend in the industry is to operate with a higher leverage.

Recent Concerns / Controversies / Problems

  • Market Concerns: Investor’s seem to have concerns about production cuts in the near future due to the decrease in the amount of active rigs, and therefore their growth prospects are limited. Other concerns also revolve around the company being exposed to falling oil and gas prices.

  • Company’s Perspective: Management has stated that their production is highly resilient to commodity downturns. They are focused on maximizing free cash flow and maintaining dividend payouts. They are actively focused on operational excellence, and implementing new cost cutting initiatives, which should increase profits even at lower prices.

The management does acknowledge the inherent volatility in the market, and their approach is to remain nimble and adaptable.

  • Share Buybacks: During its earnings call, company’s management touted that more share buybacks are to be expected. However, share buybacks have been a center of debate, and while it does help shareholders it can also hurt company’s financial flexibility by limiting its ability to invest into new production sites and other capital expenditures.

  • Acquisition: They also acquired Validus energy which is increasing their debt, but this also increases their operating efficiency. However, with acquisitions there is always risks involved, including overpaying and inability to fully integrate the assets in the portfolio.

  • ESG Regulations: Increased focus on ESG from governments is going to affect the company’s financial performance and strategies and will require substantial capital to invest into new carbon capture and other sustainable technologies.