Point of View: Devon CEO: High crude prices likely to linger

The "simplistic assumption" that crude prices eventually will fall back "to where they used to be," around $25/bbl, is likely "invalid" in today's market situation, said J. Larry Nichols, chairman and CEO of Devon Energy Corp., Oklahoma City.

"The [price] model that I think a lot of people have, which is certainly a valid one if you look [only] at the last 5-10 years, is that we're going to have very moderate prices that on occasion will spike up for a very brief period of time when we have a difficulty like the Iraqi invasion of Kuwait, and then after a few months will come back down to a more reasonable level," he said.

However, Nichols said, "Now so much of the surplus [world production] capacity in oil has been eliminated." That makes crude prices more vulnerable to various political factors that threaten to disrupt supplies, "whether it's problems in Venezuela with [President Hugo] Chávez, whether it's tribal warfare that exists in Nigeria and occasionally in other parts of Africa, the uncertainties of the political environment in Russia, and of course the largest one of all is the huge uncertainties in the Middle East and other places where Islamic revolutionists are active, which includes places like Indonesia in the Far East."

As a result, he said in an interview with OGJ, "The [price] model we [at Devon] have, that I think is more likely going forward, is that we will have sustained high prices with an occasional spike down when all those troubled areas are peaceful. It won't last very long because not all of those areas are likely to remain peaceful for very long. The normalized price is a high price that will occasionally drop when we have temporary peaceful conditions before it goes back to its normalized high."

Sticking to strategy

As one of the largest and most consistently successful US independents, Devon is sticking to the same strategies that have built the company over the last 33 years, growing through both the drillbit and through mergers and acquisitions, and heavily weighted to North American and natural gas operations.

"We are, if not the largest, [then] one of the largest [companies] in terms of owning acreage in both the deepwater Gulf of Mexico and in Nigeria," said Nichols in an executive briefing of financial analysts Sept. 28.

"We've been building Devon for a long time." In a change from recent years, he said, "We have not done a major acquisition this year, really because we had done about seven in a row, and it was time to catch our breath for a little bit and study the assets. We're having a [nonstrategic] asset sale in a couple of months."

He said, "Three years ago, we made two acquisitions simultaneously [Anderson Exporation Ltd. of Canada and Mitchell Energy & Development Corp. of Houston] and incurred some debt in the process. We wanted to get that debt paid down, and we've done that. So it's been a year to digest what we had and make a few personnel changes. We hired a new senior vice-president of exploration and production [Stephen J. Hadden] and got him on board. We got the decks cleared for the future."

Nichols said, "We spent a lot of time and a lot of money over the last several years building up our exploration portfolio and having apparent success with some really exciting discoveries in the lower Tertiary, [a relatively new play] in the deep waters of the Gulf of Mexico."

In the deepwater gulf, Devon is a partner in four successful exploration wells 150-200 miles south of New Orleans—including Cascade, St. Malo, and Jack—"that have lots of potential," said Nichols. "We are evaluating those, but we haven't yet made any announcements with regard to the size or productive capacity of those fields. We need to do some more testing of those fields before we make any announcements, but potentially it will have a material impact on Devon."

In addition, he said, Devon soon will start an oil sands project called Jackfish in Canada and will drill six or seven wells in the next 18 months in West Africa and Brazil.

Devon is operator of the Dover oil sands field in Alberta, Canada, "which is the world's longest-producing steam-assisted gravity drainage project," Nichols said. "We've been studying the economics of that [production method] for many, many years." So while Jackfish, to the south of Dover, is the company's "first major [oil sands] project," he said, "we've got a lot of technological data on what works and does not work in that area."

Role of technology

"Technology always has been and will continue to be a major influence on our industry," said Nichols. "You can just look at the drilling we're doing in the deep waters of the Gulf of Mexico, where we're drilling in 6,000-7,000 ft of water using these fifth-generation drillships that didn't exist 5-6 years ago. We're using 3D technology and interpretation of 3D technology that also didn't exist 5-6 years ago. So not that long ago, the industry would not have been able to drill prudently in the depths that we're drilling today."

Moreover, he said, "You can look at other resources like the very large position we have in the Barnett shale [in the Fort Worth basin]. When we bought that 3 years ago, no company had ever drilled horizontal wells in these kinds of dark, black, dense shales. Devon pioneered that horizontal drilling and did it successfully, and that has created a whole boom in drilling in that area.

"Even doing that, it still is a reservoir rock that we're only getting out 10-12% of the gas in place. So there is still a lot of gas left down there that today no one has the technology to get out."

Nichols said, "We are funding some science to see if we can't figure out a way to unlock that gas reservoir."

For Devon, the Barnett shale play "has been fantastic, very good," said Nichols. "We're now producing about 1% of the gas consumed in the US just from Devon's interest in that one field. We're spending $200-300 million/year there and will do that for years to come. We've got approximately 14 rigs running continuously year-in and year-out in that one field."

Access lacking

Like other producers, Devon is turning more to deepwater and unconventional oil and natural gas resources because otherwise "there are not a lot of opportunities to grow oil production in North America," said Nichols. "In fact, the only two that we see that are of any major consequence, certainly from the country's standpoint, are the heavy oil in Canada and these major discoveries that we think we are having in the deep waters of the Gulf of Mexico. And Devon is a significant player in both of those areas."

He said, "There has been ever since the [former US President Bill] Clinton administration an effort by the environmental and obstructionist groups to stop exploration for oil and gas in as many places in the US that they possibly can. There's one environmental group that challenges every single lease that the government issues in the state of New Mexico. Makes no difference where it is, whether it's in the middle of a field that's been producing for a long time—it's irrelevant. They challenge every lease. That has had a negative impact on our country's productive capacity and continues through to this day."

However, Nichols said, "I would anticipate that sooner or later these high [energy] prices would force people to engage in a more intelligent debate between the country's legitimate need for a clean environment and the country's equally legitimate need for reasonably priced energy. We are as a country curtailing drilling and exploration in a lot of areas where there is no environmental justification for it at all. And that leads to the high prices. Sooner or later, I would anticipate that the citizens would impose a little more pressure on our politicians to take a harder look at that and not just ban drilling anywhere and everywhere that any obstructionist group wants them to ban drilling."

He said, "So far, though, in this go-round of high prices, the press has been much more responsible in focusing on the real causes for the higher price of oil, which are both the international demand for oil, particularly in places like China, and the dangerous places from which oil is produced around the world. Whether it's in the Middle East, West Africa, Russia, or Vene- zuela, most if not all of our international oil comes from risky places."

Large cash flow

Record-high oil prices and still relatively high natural gas prices have produced more cash flow for production companies than they have been able to reinvest so far, say some analysts. But Nichols claimed the apparent lag of investment behind income is the result of "a whole lot of things. I think there is a good financial discipline within the industry, caused in part because consolidation has forced assets into larger and more prudent hands. Part is caused by a lack of prospects, and part comes from the fact that it is difficult in many places to get permits out of the federal government to drill."

Nichols foresees "more of the same success" for Devon's operations through 2005. "We have always wanted to grow both by the drillbit and by acquisitions. We certainly have a robust drilling budget. The drilling budget this year is roughly $2.5 billion. It will be roughly the same next year, so we're going to drill a lot of wells. We're drilling, I think, more wells in the US this year than anybody. So we will continue to be very active with the drillbit."

As for future acquisitions, Nichols said, "We will look for whatever opportunities that might be there. It is of course more difficult to find acquisition opportunities when prices are high as they are now, but who knows what the future holds?"

He noted that Devon's stock was recently trading at an all-time high. The company announced plans in September to split its stock and move its trade to the New York Stock Exchange.

"The [investment] market is always cautious," Nichols noted. "The market [for publicly traded oil and gas companies] inches up very slowly in terms of where oil and gas prices are because there is always this expectation that prices are going to go back to what some analysts call the normalized price, whatever that is. The normalized price for most of them is the last 3-5-year average."