Looking For Bargains? This Profitable E&P Company Is A Good Place To Start

For most oil and gas exploration and production (E&P) companies the last year or so has been about survival. The spectacular collapse in oil prices has been followed by a less publicized drop in natural gas to the point where the lows of 2012 are well in sight. Those that were slow to react to the changing environment or who were under hedged when the drop began have found themselves struggling to keep afloat. There are, however, one or two that reacted quickly enough to still be making money, even after prices fell. I am not talking here about the large integrated firms, whose diversity protects them at times like this, but about North American, pure play E&P companies.

With oil looking like it may have finally bottomed out and natural gas about to get the stabilizing effects of winter demand and, at some point, the benefit from exports, many see it as a good time to go shopping for bargains in the E&P space. If the last year has taught us anything, however, it is that false dawns are extremely possible. It would be prudent, therefore, to look first at companies who have remained profitable. Their stock has generally still been hit hard and so has some upside, but reward is only one half of the equation. Risk, which constitutes the other half is still present, of course, but it is manageable downside risk rather than existential risk that can result in a total loss of your investment.

With that in mind I set out to find a profitable E&P operation and preferably one with a bias towards natural gas production. As I mentioned above there are reasons to believe that natural gas is about to form a bottom whereas oil has already bounced around 30 percent off of its lows.

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I didn’t have to look too far. Devon Energy (DVN) is, according to The Natural Gas Supply Association, the 5th largest producer of natural gas in the U.S. What sets them apart from the other pure E&P companies high on that list, though, is positive free cash flow (FCF). They produce just over $3.6 Billion in FCF a year, as compared to negative FCF of $5.69 Billion for Southwestern Energy (SWN) who occupy 4th spot on that list and negative $1.33 Billion for the sixth placed Cabot Oil & Gas.

Of course that continued profitability has come at a price. Devon made deep cuts early in the fall of energy prices. That limits potential growth in the near future somewhat and could have proved costly if what we saw at the end of last summer had been just a dip, but that was not the case. Instead that looks like a smart move now. If we accept that while both oil and gas prices are likely to recover that recovery is likely to be slow, those painful deep cuts look even smarter.

There will be time to respond to any recovery.

Given that profitability, the halving of the stock price since last July has looked overdone for a while, but I was reluctant to jump in until a bounce had started. As the old trader’s cliché says, the market can stay illogical a lot longer than you can stay solvent, so the double bottom reversal pattern evident on the chart in the last month or so gives some much needed reassurance.

Ultimately, no matter what the conditions of any particular market, the job of a corporation is to make money. By keeping focused on that goal and not hesitating to do what was required, Devon Energy have shown themselves to be a solid long term investment, even if we are not yet out of the woods when it comes to pricing. That makes it an ideal early target for bargain hunters.