Devon energy fights off permian problems – devon energy corporation (nyse dvn) seeking alpha 2015 electricity increase

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A major concern in the US upstream space and a common theme of several of my recent articles is the rising pricing differential for oil & gas sales in and around the Permian Basin. Light sweet crude sold in Midland, TX, fetches a price that is ~$12/barrel below what that upstream player would have gotten if that sale had happened in Cushing, OK, home to the West Texas Intermediate benchmark. Natural gas sold at Waha Hub prices, which is the major gas hub in West Texas, fetches below $1.50/MMBtu. If that natural gas was sold in Erath, LA, home to the Henry Hub benchmark, it would fetch closer to $2.85/MMBtu.

Devon Energy Corporation ( DVN) has declared that the Delaware Basin is going to be one of its two core growth assets going forward, with the other being its STACK operations in Oklahoma. However, in order to grow its Delaware production streams Devon Energy Corporation first needs to ensure it will get a reasonable price for its oil production. Let’s go over how management is combating the differential crisis in the Permian Basin. Getting a good price for Permian oil

For the period lasting from Q2 to Q4 2017, Devon Energy Corporation hedged 20,000 bpd of its oil sales at an average discount of $1.02/barrel to WTI. Those hedged volumes rise to 28,000 bo/d in 2019, with the average differential to WTI falling down to $0.46/barrel. Realizing just a buck off WTI is much better than realizing over ten dollars less than WTI, highlighting the tremendous value these hedges offer Devon Energy Corporation.

During the first quarter of 2018, Devon Energy pumped 36,000 bo/d out of the Delaware. Its current eight rig, two/three completion crew program is expected to produce a significant amount of production growth this year. Based on its expected 2018 production exit rate, it is likely Devon will pump out ~45,000 bo/d from the Delaware on average in Q4 2018. Based on those assumptions, roughly half of Devon’s remaining oil sales this year of crude produced in the Delaware is protected by basis swaps, with that protection carrying on into 2019.

Financial hedges are one way to shield its oil & gas realizations. Devon Energy can also secure firm transport on long haul pipelines that enable its output to reach more favorable markets and thus fetch better realizations. Roughly 40% of its 2018E Delaware oil output will be transported along the Longhorn Pipeline.

Magellan Midstream Partners L.P. ( MMP) bought the Longhorn Pipeline back in 2009 and completed a project that reversed the flow of the pipeline in 2013. This allowed for Permian produced crude to be shipped across Texas to the Gulf Coast. Over the next two years, Magellan Midstream completed an expansion of the system which increased the Longhorn Pipeline’s transportation capacity to 275,000 bo/d and later added a new origin point at Barnhart, TX, which is near Midland (Crane, TX, was the previous main origin point and that too is near Midland).

Light sweet oil based on Louisiana Light Sweet pricing, based primarily on crude supplies in St. James, LA, and supplies capable of travelling through the Capline Pipeline, generally fetches a $3-4/barrel premium over WTI depending on the Brent-WTI differential. Brent trades at a premium to WTI, and LLS tracks closer to Brent, so when Devon Energy sells oil produced in the Delaware Basin at prices based on LLS, the firm is better able to offset part of the massive WTI-Midland differential.

Devon Energy doesn’t break down its realized crude price on per play basis so it is impossible to gauge the exact impact this strategy had on its Delaware Basin financials last quarter. However, as half of its 2018E Delaware oil production is protected by basis swaps and another 40% is going down to the Gulf Coast to fetch LLS-based prices, it is clear this strategy is yielding material upside for Devon Energy Corporation.

On the dry gas side of things, Devon Energy notes that most of its natural gas is being sold in West Coast markets. During the firm’s Q1 2018 conference call, management was asked about Permian gas takeaway capacity in light of surging regional supply. Management replied:

“We think that there is an ample amount and a strong amount of new build gas processing that’s happening both in New Mexico but largely even on the Texas side, which really gives us plenty of access to gas processing. So we don’t see any constraints there at all.

When it gets to the residue side… really the way that we market our gas and the benefit we have being in New Mexico, is that we can tie-in relatively easy to very large pipes. This would be El Paso and Transwestern and Northern Natural and others that tend to go west and move a lot of volume out west. And so any limitations that we would have are really mitigated just because of location and geography.”

Devon is effectively saying that while it won’t be able to get ideal prices for its Permian dry gas production, it will be able to at least find a buyer for that output. This removes the risk of forced well shut-ins due to flaring concerns, but still indicates that there just isn’t much Devon can do on the gas realization front.

Berkshire Hathaway Inc’s ( BRK.A) ( BRK.B) Northern Natural gas pipeline network is split into two, with the portion that could cater to Devon Energy’s supplies stretching from West Texas/SE New Mexico through Oklahoma and Kansas. Kinder Morgan Inc.’s ( KMI) El Paso gas pipeline network is capable of carrying gas from the Permian Basin to buyers in Texas, New Mexico, northern Mexico, Oklahoma, Arizona, and California.

Energy Transfer Partners L.P.’s ( ETP) Transwestern gas pipeline network is capable of carrying Permian gas to buyers in Texas, New Mexico, Arizona, and California. Various connections to other gas pipeline networks along those three systems further enhance their shipper’s ability to fetch better gas prices.

Devon Energy produced 97 MMcf/d of natural gas and 11,000 bpd of natural gas liquids in the Delaware during the first quarter of this year. Generally speaking, one thousand cubic feet of natural gas is equal to one million British Thermal Units, but often the BTU content in US upstream natural gas sales is ~10% over that.

From Q2 to Q4 2018, Devon hedged 93.5 MMBtu/d of its gas sales at Panhandle Eastern based-prices (average discount of $0.48/MMBtu to Henry Hub) and 53.5 MMBtu/d of its gas sales at El Paso based-prices (average discount of $1.17/MMBtu to Henry Hub). While its Panhandle Eastern differentials are much stronger, keep in mind that hedging program drops off in 2019 to just 5 MMBtu/d at an average differential of $0.81/MMBtu to Henry Hub.

Devon Energy’s El Paso hedging program rises to 60 MMBtu/d in 2019 at an average differential of $1.58/MMBtu. While its West Coast gas realizations are much stronger, it isn’t apparent that Devon has secured enough long-haul pipeline capacity to offset weak regional realizations (most of which are already locked in via its basis swaps hedging program).

Ultimately, Devon’s Delaware economics are based primarily on where its crude/condensate, and to a lesser degree natural gas liquids, realizations end up. Devon Energy appears confident that it has secured enough gas takeaway capacity to support its growth ambitions, mitigating flaring concerns that will eventually sharply curtail the production growth of Permian firms that don’t have firm transport capacity on pipelines out of the region. Final thoughts

Devon Energy Corporation is just at the beginning of its Permian Basin growth story, but past experiences with onerous pricing differentials at other plays taught management hard lessons they didn’t soon forget. By mitigating its oil differential risk and securing ample levels of gas takeaway capacity, Devon Energy Corporation can continue onward with its Delaware Basin growth strategy unhindered by the short-to-medium term risks befalling those without those two crucial things. Thanks for reading.