Thursday, May 13, 2010

Devon Energy (NYSE:DVN): The Death Throes of the Barnett Shale? Downgrade Devon - Bernstein

Bernstein Research is making a rather significant call on Devon Energy (NYSE:DVN) downgrading the name to Market Perform from Outperform and lowering their target price to $79 (prev. $88)

Recent frac data from the Barnett Shale shows a play in severe decline, with operators over the second half of 2009 expending more and more effort and capital to recover less gas per well. A number of operators continued to drill new wells in the Barnett through the second half of 2009, despite the deteriorating economics. We believe that F&D costs will continue to rise sharply in the Barnett, providing a headwind for companies that are exposed to the play.

The average number of frac stages per well surged in 2009 for Devon; the company went from an average of 5.0 stages in the first quarter to 6.2 stages in 2Q09 and eventually 7.0 stages in 4Q09. Over the same period Devon's average IP rate hovered around 1.3 mmcfd, and the 2009 average IP rate was flat from 2008 despite the increase in stages. Similarly, Chesapeake increased its number of frac stages by 46% in 2009 but saw average IP rates rise just 10%. This means that in a flat service price environment, both companies would see significant inflation in F&D costs.

Adding more frac stages seemed to increase IP rates on average, but the correlation within 2009's wells between stages and IP remained weak. Doing more frac stages also failed to prevent very small wells, which lowered average results. For Devon, 15% of all horizontal Barnett wells had IP rates below 0.5 mmcfd, which is very poor, and 17% of wells drilled with 6 or more frac stages were that small, too. For Chesapeake, only 3% of all wells had IP below 0.5 mmcfd, but 7% of wells drilled with over 6 stages did, illustrating that doing more frac stages doesn't decrease risk, and may increase it.

The Barnett's well failure rate also continues to rise over time. As of the most recent data available, 15% of Barnett horizontals drilled in 2004 were no longer producing, and 14% of wells drilled in 2005 had failed, as well. The trend appears clear that after 3 years operators can expect around 12% of wells to have failed, and that the failure rate shows no signs of flattening yet.

Bernstein believes that the Barnett provides a helpful case study in what the end of shale play's life looks like. Despite clearly declining economics, operators continued to drill more and more complex wells in 2009, hoping that their strategy would yield results. It is particularly surprising that the Barnett declined so sharply in 2009, since a dramatically lower well count should have enabled operators to pick their best prospects. Due to the declining economics, investors are best advised to look ahead to other operators and other plays, where the probability of improvement over time is much higher.

Devon, in particular, is too exposed to the Barnett, which accounts for over 30% of pro-forma production. Devon's wells are worse than Chesapeake's, yet the company continues to invest there, which will lead to structurally higher F&D. Although the firm is bullish on gas prices, they think Devon faces too many challenges to recommend it at these levels.

Large E&Ps tend to have diversified asset bases across many plays but often there is one field that is so large that the company's performance is inextricably tied to it. This, Bernstein believes, is that case of Devon, with regard to the Barnett Shale. Devon was a first mover in shale gas, entering the Barnett long before others believed in the possibility of producing gas from shale, but the company has remained concentrated in the Barnett such that it will account for around 30% of production once the asset sales currently underway are completed. Since shale wells have a high decline rate, this means that if the Barnett stops growing or declines it will be very challenging for Devon as a whole to increase production. However, their work suggests that the returns and economics in the Barnett are becoming continually less attractive for Devon in the Barnett, suggesting that the company finds itself in a strategically challenging spot.

Notablecalls: First of all, to really understand the significance of the call, read this:

A contrarian makes another call – this time, natural gas

Henry Groppe, the grand old man of oil & gas forecasting says shale gas ain't the miracle cure.

Bernstein's comments seem to confirm this theory.

So, what to do with Devon (DVN) here?

Barnett Shale (and possibly all of shale gas) may not be working out as expected and that's partly the reason why natty gas price is beginning to lift its head.

But what good is a higher natty gas price, if Devon can't get much from Barnett?

That's the question.

I think DVN should trade down on this downgrade. But I'm not sure.

Maybe buying natty gas is THE trade here?

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