Point of View - Devon Energy puts early focus on long-term strategy

Devon Energy Corp., Oklahoma City, has grown through a series of mergers to become the largest US independent oil and natural gas company, with 650,000 boe/d of oil and gas production and an enterprise value of $20 billion.

Its combinations included Anderson Exporation Ltd. of Canada, Mitchell Energy & Development Corp. of Houston, and, most recently, a $5.3 billion stock swap with Ocean Energy Inc., Houston.

"It's what we planned," said J. Larry Nichols, chairman and CEO of the company that he cofounded with his father, John W. Nichols, in 1971. "We started this company with my father, myself, an accountant, and a couple of clerical staff," Nichols recalled. "When we started, he had all of the titles, which was appropriate." John Nichols, now 88, retired "somewhere in the 1980s—it was never clear-cut—but "still comes to the office" frequently.

Devon formulated plans to build for the future "in 1987-88, when we assessed where we were, having gone through the bust of the mid-1980s," Nichols said. "Devon at that time was a private company, and we had a variety of partnerships that we had created, booked some drilling funds as well as some production programs put together with European investors. And so we had a variety of entities that we were running and a good number of shareholders for a private company."

At that time, he said, "We looked at the world and asked, 'Should we go back to being a purely private, simplified structure, or should we go public?' The more we reviewed the world that existed then, we thought there were a lot of changes that were going to cause the smaller publicly traded independents to go away—the tax reform act of 1986 and a whole list of factors. Having gotten burned so badly [in the oil industry's earlier boom and bust], the banks were no longer as willing to fund the independent sector.

Acquiring from the start

"We had been doing acquisitions since my father and I started the business in 1971. We had some skill in putting deals together, and there was a chance we could emerge as one of the larger companies. At that time, there were 400 publicly traded [oil and gas] companies, and we thought out of that morass, there would be a handful—maybe two handfuls—that would emerge that were focused on North America in taking advantage of fields and exploration opportunities [as] the majors were increasingly looking at the international arena," Nichols said.

Nichols and his father saw "an opportunity for us to come in and apply modern technology to old areas and try to build up a sizable US oil and gas company. Within a few years, we realized the same was true in Canada and quickly broadened our horizons. We realized that sooner or later natural gas would be recognized as a valuable commodity and would go from being a surplus commodity and waste fuel that it was in the early 1950s. That pendulum would gradually swing to where it was a fairly scarce commodity and would be priced accordingly."

So, said Nichols, "Our goal was to try to create a strong, powerful company very focused on quality assets—both quality production as well as quality exploration—heavily weighted toward natural gas and heavily weighted toward North America. We never really realized we'd get this big, but we thought we would grow," he said. "I didn't really think the consolidation would go this far. But each year, you look at where you've grown, the quality of people you've put together, and you look for opportunities and sort of climb each mountain as it comes."

Since 1971, he said, "We've done one meaningful [merger and acquisition] transaction almost every year, relative to our size. In hindsight, some of those we did in the early 1970s were pretty small." In the process, he said, "We've been trying to build the organization so that, as the consolidation opportunities started to diminish, we would have a suite of exploration properties that we could grow increasingly by the drillbit. And that's where we are now."

Nichols said, "As an independent, we have the largest acreage in the deep waters of the Gulf of Mexico. We're the largest owner of acreage in the Mackenzie Delta, the [Canadian] Beaufort Sea. So whether it's the deep waters of the Gulf of Mexico or the frontier lands in northern Canada, we're there, and we're there in strength." Devon also is in "lots of places in between, like the Barnett shale, a really quality asset, now the largest gas field in Texas; a field where we operate about half of the production."

Nichols won't pick any one of Devon's acquisitions as the keystone of the company's successful strategy. "They all fit," he said. "Each one sort of let us continue with the next one."

He remembers, "There were several that the board said, 'It's a great deal if you can pull it off, but don't get set on it because it's a long shot.' When we bought the exploration-production part of Pennzoil [Corp.], PennzEnergy, the board thought that was going to be exceedingly difficult to do, but we pulled it off."

Devon's strategy has been "to look at the portfolio that we have at the moment and look for things that would enhance the quality of what we had and give us opportunities that we don't have," said Nichols. "We wanted Anderson because that made us the second-biggest acreage holder in Canada—the largest US independent acreage holder in Canada—which gave us access to all the exploration opportunities that are in Canada.

"We wanted Mitchell because it had what has turned out to be one of the fastest-growing gas fields in North America, where we've drilled—I've lost count of how many—hundreds of wells without a dry hole. We have now 16 rigs running day-in and day-out all year long," he said. "We bought Ocean because of the quality of its deepwater [operations] and because it enhanced what we had internationally."

As a result, said Nichols, "Really for the first time in our career as a company, you can look at our asset portfolio and not see any significant holes. We have balance between close-in exploitation opportunities like the Barnett shale [in the Fort Worth basin] and the coalbed methane. And we have rank wildcat exploration in the deep waters of the Gulf of Mexico and internationally, so we're balanced between having a lot of low-risk drilling but yet having some high-risk exploration opportunities. We're balanced geographically with a budget that's spread out across the deep gulf, the shallow gulf, onshore Texas, New Mexico, Wyoming, Canada. We've got significant exposure in all major exploration areas in North America, plus a little internationally."

Combining cultures

Merging the cultures of the various companies wasn't as hard as some might think, said Nichols. "I think some people make much more of corporate culture [differences] than is really there," he said. "Most people in this business have worked in various companies in their careers. And all of our mergers and acquisitions have involved companies that are in exactly the same business—exploration and production, which is a narrow and precise business. It's not that hard for anyone to adapt from one company to another."

Moreover, he said, "I can understand that a lot of mergers of big companies in different businesses don't work when they don't achieve the necessary synergies. But when you combine companies that are in the same business, you know the synergies are there."

Nichols acknowledged, "Ocean Energy had more assets in deep water, but we had assets in deep water too, so we understood what they were doing."

In combining employees following the mergers, he said, "We try to pick the best, the most aggressive, the hardest-working, the most productive employees from each company. It may be difficult to merge companies where many of the employees have spent their whole careers at one firm. But no one at Devon has been here his entire career but me.

"Where we plan to go from here is to make it all work," said Nichols. "We've got a $2.5 billion budget this year, the Devon-Ocean combined budget. We had very good success in the first quarter. We hope to continue having success through the rest of the year."

Access concerns

However, he said, "One of the challenges facing any company in North America is there are lots of areas you'd like to drill in—areas where the industry historically has drilled in—where there are constraints that have been imposed in the last decade that make it difficult. 'Access' is a word you hear from all [E&P company] CEOs these days."

He said, "In North America, access is the major hurdle. And it's not a question of opening new pristine areas, as some would have you to believe. It's more a matter of allowing us to continue to explore in areas where the industry has historically explored without any environmental degradation. One of the advantages that Devon has is that, having the broad portfolio that we do—stretching from one end of North America to the other—if there is an area where there are some difficulties, we can shift our capital to the areas where we are able to continue to move aggressively to build our reserves and build our production."

Nichols is hopeful that government officials eventually may be persuaded to open up some of the areas now closed to oil and gas exploration. "What is happening now for the first time is that lots of different industries around the country are telling congressmen and senators, 'We are really getting hurt competitively by high energy prices.' Congressmen and senators are not just hearing from the oil and gas industry as they have for the last decade [as] the industry has been telling them there's going to be a problem here sooner or later. The industry has been correctly predicting that we were going to get to where we are now.

"Now industries in states that had remained quiet are telling their congressmen, 'These high energy prices are forcing us to export jobs, and therefore let's strike a little better balance between the country's legitimate need to have a clean environment, its legitimate need to make sure the oil and gas industry explores for natural gas in an environmentally sensitive way, and on the other hand, the country's equally legitimate need and right to have reasonably priced energy.' Hopefully, as that message gets delivered to our government leaders from people outside the industry, we'll be able to strike a more appropriate and reasonable balance between those legitimate needs of the country. But that will take a while for that political process to work."

Natural gas focus

Meanwhile, Devon has positioned itself to cash in on recently higher natural gas prices. "When we did Anderson and Mitchell almost on top of each other, some of our critics wondered why [we would] want to own natural gas in North America, because gas prices had been fairly low. What we saw was the long-term cycle that was temporarily being masked by a slow economy and warm weather. We knew that long-term supply was being more constrained and demand was continuing to rise and that, sooner or later, prices were going to have to go up. And indeed they have," said Nichols.

"By moving aggressively before a lot of other companies did and establishing our position while we could establish it fairly cheaply, we're really in an ideal position as the largest US independent producer of natural gas. We produce about 4% of the natural gas consumed in North America, ahead of some of the majors," he said.

A major challenge facing US oil and gas producers, said Nichols, "is the underlying decline rate for oil and natural gas in the US is getting steeper. On the other hand, we have new technology that allows us to go into other areas like the deep waters. It's one of the advantages in building up a company of this size, where you can afford to participate in a $50 million well and have a meaningful interest. Smaller companies just can't do that."

He said, "We're excited about the deep gulf. There will for sure be some dry holes drilled there, as there always are in new frontiers. But the deep gulf offers the opportunity to discover some significant natural gas reserves."

Devon is weighted "about two-thirds gas, one-third oil. And while we look for the gas, because that's the commodity with the greatest upside, there are always areas, not only offshore but also onshore, where new technology will let you go in and discover new oil fields. We're doing that both in Canada and the US," said Nichols.

Devon has no fear of competition, despite the tightening natural gas market in North America.

"There clearly is going to need to be long-term importation of LNG. It does not worry us at all from a competitive standpoint, because we will have the price advantage of producing gas and transporting it right here in North America. When one of your largest fields is within eyesight of the skyline of Fort Worth, you really don't worry about competing with someone who has to liquefy gas and transport it halfway around the world," said Nichols.

Meanwhile, he remains focused on the long-term outlook. "There are a lot of shareholders and analysts who are focused on quarter-to-quarter [company performance]. And there are some companies that are increasingly trying to satisfy that demand. What they're doing is drilling all of the projects they can to enhance short-term production and spending no money on longer-term projects. That will work for a year or two. But if you haven't spent any money on longer-term projects, pretty soon you're in trouble," Nichols said.

Career highlights