Devon Energy Corp (DVN) — Q2 2019 Earnings Call Transcript

Thank you and good morning. In today's call, I will discuss a few preliminary items before handing it over to our President and CEO, Dave Hager. Dave will share his insights on New Devon's recent performance and direction. After Dave, Tony Vaughn, our Chief Operating Officer, will highlight some operating achievements from the quarter. We will conclude our prepared remarks with Jeff Ritenour discussing our financial outlook for 2019. Please note that the comments made during this call will include forward-looking statements under U.S. securities law, which carry risks and uncertainties beyond our control. These statements do not guarantee future performance, and actual results may vary significantly. After our prepared remarks, we will open the floor to your questions. Now, I will hand it over to Dave.

Hello, I'm going to start over because my microphone is not on. I apologize. Thank you, Scott, and good morning everyone. The second quarter is another outstanding one for the New Devon. Across the portfolio, our teams are delivering results that continue to exceed production and capital efficiency targets for successfully driving down per unit costs and maximizing margins. Before we get into details of the quarter, let's begin with a brief overview of what defines New Devon. For those of you that are new to the story, Devon is nearing the completion of its transformation to a U.S. oil growth company, allowing us to focus entirely on our world-class oil assets in the Delaware Basin, Powder River, Eagle Ford and STACK. The simplification of our portfolio unleashes the potential of our U.S. oil assets, which reside in the very best parts of the best oil plays in North America where we possess a multi-decade inventory of high return growth opportunities. With these advantaged attributes, New Devon is positioned to deliver sustainable growth and thrive in today's commodity price environment. This is evidenced by several value-enhancing accomplishments year-to-date. First, oil growth continues to exceed our plan, and we are now raising our full-year production outlook for the second time this year to a 19% growth rate. This represents a 400 basis point improvement compared to our original budget expectations heading into the year. Importantly, the strong well productivity driving oil growth higher is complemented with a step change in capital efficiency, resulting in a $50 million reduction in our 2019 capital outlook. Keep in mind, our 2019 capital budget already had $200 million in efficiencies built into it compared to 2018. So far this year, we have brought online 20% more wells for 10% less capital compared to 2018. Any way you slice it, these are outstanding results. We have also taken action to materially improve our corporate cost structure. Our operating G&A cost savings initiatives are exceeding the plan by a wide margin and now we're on pace to achieve more than 70% of those $780 million annual savings target by year-end. The impact of the savings plan is massive with a PV10 benefit over the next decade of more than $4 billion. This is equivalent to roughly 25% of our current enterprise valuation. This capital and cost discipline translated into free cash flow in the quarter. And coupled with our accretive sale of Canada, we have achieved nearly $3 billion of excess cash inflows this year. With these inflows, we are delivering on our promise to reduce leverage and return capital to shareholders. In fact, our leverage has now declined by 80% from peak levels and we returned more than $4 billion of cash to our shareholders through dividends and buybacks. All in all, it has been a fantastic start to the year as we have executed at a very high level on every single strategic objective underpinning the New Devon. And given the commodity price variability we must navigate through in this space, I firmly believe the investment appeal of New Devon is further distinguished by our strategic approach to the business. We all know there have been some messy and surprising results in the industry of late, but I want to be clear about our unyielding commitment to excellence, discipline, and consistency of results. New Devon's financial-driven model is designed to deliver peer-leading returns on invested capital, to generate sustainable cash flow growth and growth rates in cash flow, and to return increasing amounts of cash to shareholders. And as you can see from our recent results, this model is working. The key to this progressive and balanced operating model is the quality and multi-basin diversity of New Devon's asset portfolio, which has some of the lowest breakeven points in the E&P space. This asset quality and low-cost advantage allows us to build a margin of safety into our operating plans, which is demonstrated by our ability to fully fund our capital program at less than $50 WTI pricing, even after accounting for the recent weakness in gas and NGL strip pricing. With our multi-basin diversity, we have the capability to dynamically allocate capital between opportunities to optimize our rate of return. This flexibility is evident with our recent redeployment of capital from the STACK to higher return opportunities in Delaware and Powder River. Lastly, to provide an additional level of certainty to our operational execution, we are proactively managing commodity risk through an active hedging program and have taken steps to further fortify our balance sheet by aggressively reducing leverage ratios, to less than one times net debt to EBITDA. Put another way, our operations are now backstopped by a fortress balance sheet. I want to end my prepared remarks today with a few preliminary thoughts on our outlook for next year. As I mentioned earlier, Devon is trending ahead of plan on all the operational objectives supporting our three-year outlook, and we have significant operating momentum heading into next year. While it is still a bit too early to provide any detailed targets for 2020, I can tell you based on the trajectory of our business, I expect efficiencies to continue to lower our breakeven capital funding levels and to further improve our corporate level returns. Furthermore, given our low maintenance capital, we have the substantial flexibility to deliver a desirable combination of both free cash flow and highly competitive oil growth rates at today's strip pricing. More specifically at the asset level, we plan to allocate more capital to the Delaware to better leverage the well productivity and capital efficiencies this franchise asset is delivering, and we will continue to tailor STACK activity to the current commodity price environment. As our planning process firms up, we will provide more specific details on our 2020 outlook this fall. And with that, I will turn the call over to Tony Vaughn, our Chief Operating Officer.

Thank you and good morning. As Dave touched on New Devon's operations are hitting on all cylinders and I'm quite pleased with the positive business momentum we continue to demonstrate in the second quarter. Each asset in our portfolio is executing at a very high level fulfilling its respective role in our portfolio. I am quite proud of the results the organization has generated and the strong performance as a result of the quality of our people and they're delivering results. For today, I will focus my comments on our Delaware Basin operations, which are the driving force behind New Devon's growth year-to-date. Our high-margin production in the Delaware continues to rapidly advance in the second quarter, growing 58% on a year-over-year basis. The key driver of this robust growth is the high impact wells we have consistently brought online that rank among the very best in the industry. In the first half of the year, we commenced production on more than 50 new wells, diversified among the Leonard, Bone Spring, and Wolfcamp formations that achieved average 30-day rates of around 2500 BOEs per day. These high-impact wells reflect the quality of our underlying asset base, our staffs' top-tier planning and operating capabilities, and our willingness to deploy cutting-edge technologies to improve well productivity, and capital efficiency in the economics for this world-class play. Looking ahead, as we transition more activity through the Wolfcamp, which will account for as much as 65% of our program in coming years, I'm confident in making the prediction that our Wolfcamp well productivity and capital efficiency will improve from the impressive baseline we have established this past year. Furthermore, with the substantial amount of acreage trades we have completed in the state line area, our future results will benefit from higher working interest in these high impact operated areas and from less exposure to certain lower returning non-operated activity scattered across the basin. With this world-class leasehold position in the Delaware, our team has successfully transitioned to full-field development across a significant portion of our core areas. Our outstanding results year-to-date are benefiting from the learnings obtained from the appraisal work we performed in prior years. Through this appraisal activity and our work in other plays across the company, we have a strong understanding of the subsurface that allows us to identify the best landing zones, understand parent-child dynamics, along with the appropriate well density per section and deploy optimized completion designs to capitalize on that knowledge. Importantly, through this process, we have learned how to better size and scale these projects to optimize capital efficiency and returns. Our go-forward development projects are striking a healthy balance between present value and rate of return delivering an optimal outcome for shareholders. Overall, as our results indicate, we are well up on the learning curve and are very confident in our Delaware asset. Specifically in the Wolfcamp formation, which will be our most active target going forward, we have a very good understanding of lateral and vertical connectivity. We have settled on a development spacing of about 4 to 8 wells per landing zone depending on the oil column, pressure connectivity, and the subsurface variability in Southeast New Mexico. Our recent success with our Fighting Okra and Flagler projects are examples of this pragmatic spacing approach with strong returns. Importantly with our significant acreage position, we have the depth of inventory to deliver top-tier results in the Delaware Basin for many years to come. At today's drilling pace, the currently identified 2,000 higher return risk locations we have identified equate to 16 years of operated inventory. This inventory is a result of a detailed subsurface evaluation across our entire position rather than generalized acreage math. With a depth of STACK play resource across the Delaware, we expect our high return inventory to continue to expand as we capture additional efficiencies and further delineate the rich geologic column across our entire acreage footprint. Now, I'd like to transition to a storyline that's often overlooked, but critical to our recent success in the Delaware and that is the work we have performed in the field to improve the profile of our base production decline. So far year-to-date, our gross operated base production has outperformed our budgeted expectations by approximately 10%. This dramatic outperformance was accomplished through the use of leading-edge data analytics that has helped to minimize downtime in the field. We have also successfully boosted existing well productivity through proactive gas lift, rod pump optimization while reducing maintenance costs. This thoughtful and innovative work is delivering some of the best returns and value uplift in the portfolio with minimal cost. Lastly, I want to conclude my remarks in the Delaware by highlighting the good work that we have performed to maximize the value of our barrels produced. Beginning with our oil realizations, a major victory for us has been the avoidance of price deducts associated with the new West Texas Light index. We have leveraged our operating scale and acreage dedications in the area to attain multiyear contractual guarantees that ensure we receive Midland WTI pricing with gravity protection up to 60 degrees API. Coupled with the good work our marketing teams have done in the hedging and firm transport front, our light oil realizations are near WTI pricing levels and importantly the regional gas price weakness experienced by the market has been mitigated by our attractive basis swap position. On the cost side of the equation in the Delaware, we have also been able to lower expenses and enhance our margins through the scalable field level infrastructure our teams have built out over the past several years. This foresight has helped us reduce per unit LOE costs by more than 60% from peak levels. One of the most meaningful sources of LOE savings is the extensive water infrastructure we have proactively built out. We now have nearly all of our produced water connected to pipes. The infrastructure is fully integrated with 8 recycling facilities, 40 operated saltwater disposal wells, and several third-party water systems. With this infrastructure, we avoid the extremely high expense of trucking in the remote desert of Southeast New Mexico that can easily exceed a couple of dollars per barrel, and we're able to source over 80% of our operational water needs from produced water at very low cost. The bottom line is, the hard work and thoughtful planning from our operations is paying off, and our positions allow us to capture additional value per barrel that many of our competitors cannot. And with that, I will now turn the call over to Jeff Ritenour.

Thanks, Tony. I'd like to spend a few minutes today discussing the progress we've made advancing our financial strategy and briefly provide context on several key metrics that are improving within the updated 2019 outlook we issued last night. A good place to start today is with our improving financial performance for the quarter. Our operating cash flow increased 23% year-over-year to $623 million. This level of cash flow fully funded our capital requirements and generated nearly $60 million of free cash flow for the quarter. With the free cash flow, our business generated coupled with the proceeds from the sale of Canada, Devon's cash on hand increased to $3.8 billion at the end of June. Subsequent to quarter end, we utilized a portion of this cash on hand to redeem $1.5 billion of low premium senior notes that were due in 2021 and 2022. With this redemption activity, Devon has now completely cleared its debt maturity runway until late 2025. Given our strong liquidity, we expect to reduce additional debt in the second half of 2019. We will finalize the size and timing of our debt reduction activity in the near future, but we are well on our way to achieving our debt reduction goal in addition to debt reduction. Another key financial priority is our ongoing share repurchase program, which is the largest program by a wide margin in the E&P space. Since the program began in 2018, we have repurchased 125 million shares at a total cost of $4.4 billion, and we are on pace to reduce our outstanding share count by nearly 30% by year-end. To advance our share repurchase activity in the second half of 2019, we expect to utilize cash on hand to reach our goal of $5 billion by year-end. Any upside from higher commodity prices or asset sales would be earmarked for additional return of capital to shareholders. I'll wrap up my comments today by covering a few key guidance items from our updated 2019 outlook. This updated outlook reflects the improvements our retained business has achieved year-to-date and incorporates the impact of Canada's restatement to discontinued operations. On the production front, as Dave touched on earlier, our light oil growth is running at least 400 basis points ahead of our original budgeted expectations. For the second half of the year, we expect the strongest oil growth to occur in the fourth quarter, driven by the timing of activity in the Delaware. This production profile positions us with strong volume momentum heading into 2020. Importantly, we are delivering this incremental oil growth with better than expected well productivity and capital efficiency. Because of this positive trend, we are lowering the midpoint of our capital spending outlook in 2019 by $50 million to a range of $1.8 billion to $1.9 billion. We also continue to make substantial progress on the cost reduction front. With the scalable growth we are achieving in the Delaware and the Powder River, coupled with the benefits of Canada exiting the portfolio, we project total company per-unit LOE cost to improve 15% versus our original budget. Our G&A initiatives have also delivered a steady cadence of successful cost reductions year-to-date. We estimate that we have captured approximately $190 million of overhead savings to date on a run rate basis. And this momentum is projected to reduce G&A by more than 15% versus our original budget. With the progress we've made year-to-date, we are well on our way to attaining more than 70% of our $300 million, three-year savings goal by the end of 2019. Shifting to interest expense with the $1.5 billion debt redemption we completed at the end of July, we are lowering our net financing cost forecast by approximately $50 million to a range of $250 to $270 million. All in all, we are executing at a very high level on the key financial objectives underpinning our three-year plan. We have significant operational momentum heading into 2020, and we are positioned to deliver free cash flow and attractive growth. With that, I'll turn the call back over to Scott for Q&A.

Thanks, Jeff. We will now open the call to Q&A. Please limit yourself to one question and a follow-up. If you have further questions, you can re-prompt if time permits. With that operator, we'll take our first question.

Yes, good morning. You mentioned that you're now in what you call pure development mode on the Delaware Basin. So I was just wondering if you could talk about some of the implications for capital efficiency wise. I perceive that your capital efficiency has improved but maybe give us some more details on what's going on there and also maybe you could shed some light on the acreage trades that you could get, some acreage in that neck of the woods and Todd, which has been really productive rock?

Good morning, Arun. This is Dave. I'm going to start off with just a summary comment here and then we'll turn over to John Raines, who is our Delaware Basin, Vice President of that business unit to give some detailed comments about what you asked. What I think that is, you hit on the key, one of the key elements about New Devon that we have to continue to emphasize, is that in the Delaware Basin and in most of our plays, we have moved out of an era where we were doing quite a bit of the appraisal work and moving into a much higher percentage that's pure development work. That leads to increased capital efficiency, lowering of the well cost, growing the best wells in the best zones, and higher rates. It also obviously allows us to lower the well cost as we have consistent capital, our consistent rigs in the same area. And so you see higher quality results and you see very consistent results. We've demonstrated that clearly with the first two quarters of results in 2019, and we will continue to deliver on that in the future. So with that, I'll turn it over to John to answer more details about what that means.

Yes, this is John. Thanks, Arun, for the question. It's a good one; it's one, it's a story I'm pretty excited to tell. I think to properly tell the story, I'll take you a little bit back to 2018. So if you go back to 2018, specifically with respect to our Wolfcamp, we really leaned in on developing two-mile laterals and when we did that, we had a lot of learnings from these two-mile laterals. And I'll talk about some of those specifically. Drilling, as you noted in the ops report, we've improved our performance by 20% on drilled feet per day. These improvements are largely driven by moving away from a pure slim hole design to a slightly larger hole and casing sizes. The result has seen better tool reliability that are ROP or rate of penetration and significantly reduced NPT. On completions as noted, we've seen about a 40% improvement in feet per day. The real driver here is much more consistent work with our dedicated frac crews, and we've also engineered certain more prevalent problems out of the system. To date, we've seen fewer horsepower, wireline, and completion sleeve issues. That again were much more prevalent in the past and this has significantly reduced our NPT. I'd also note on completions that we've reduced our flat time. So our flat time is essentially the time it takes to swap wells on a zipper job or to rig up and rig down. And to say that differently, we've basically substantially improved our onsite logistics. And finally, for facilities, we've successfully deployed our first standardized train design on our Flagler project versus our 2018 baseline; this project delivered facilities at a per well cost of roughly 50% versus our baseline. This new design has really brought some much-needed standardization to our facilities and the simpler design has resulted in less equipment and associated cost, much lower construction costs, and other supply chain savings. I'd say if you had to look at our total costs, in addition to just the cycle times we've mentioned in our operations report, by year-end, we feel pretty good that we're going to be able to reduce our non-Wolfcamp wells by 10% to 15% total. And that does include some larger completion designs on some of those wells. And if we look at Wolfcamp, we're really striving towards a 15% to 20% type of reduction. So I'm very proud of the work that the team has done there.

Acreage trade?

Yes, Arun. I think your second question was around acreage trades, and I bet you're more specifically referring to the 5,500 acres at Todd. And so this is also a pretty fun story to tell. I think it shows how much success you can create by having a really intentional effort. So the 5,500 acres, again to go back in time has to be considered as a multi-year effort. If you really go back to the Todd area. This was an area that the team identified early on as being a good zip code. I think I've referred to the parent Boundary Raider well being drilled several years ago, even on a previous call. So it was really at that point that the team got pretty creative about consolidating our position here and upping our working interest. As for the 5,500 acres itself, this is really a product of the team being creative in the land team in particular, being able to execute on our consolidation strategy. This acreage did not come to Devon via one or two large deals; rather this acreage came to Devon over the course of three years and over the course of more than a dozen trades. These trades ranged in size from smallest 40 acres to as large as 2,000 acres. So you can see that the team has really been effective in the hand-to-hand combat out here.

Great. And just my follow up is that you guys have put out previously called the 12% to 17% I believe, the oil growth target from the New Devon properties. This morning or last night you highlighted more capital going to the Delaware from the STACK. So I was just wondering if you could maybe give us a little bit more thoughts on initially how you're thinking about how much capital would shift from the Delaware. Is it rig line or two or just maybe some broad thoughts on that?

We're still working through the specifics of that. We are conducting extensive modeling on our 2020 capital program to identify what will yield the best efficiencies. However, we can indicate that capital directed towards the Delaware will continue to rise in 2020, which is justified given the exceptional results we're achieving there. Additionally, we're seeing strong performance in other areas of our portfolio. It's not that other segments are underperforming; rather, the Delaware is excelling, allowing us to raise our production guidance while reducing our capital guidance. At this stage, I can't share exact details as we are exploring different scenarios, but it's an advantageous situation for us. We expect to gain even greater capital efficiencies than initially estimated when considering the options available for our 2020 capital program.

Thank you. Good morning, everybody. Dave, I'm not sure who wants to take this one, but just looking at the cash margin disclosure that you've given us, which is obviously very, very helpful. The highest margin in the portfolio right now is in the Powder River. So I'm wondering if you can just give us an update there as to how that translates to returns at the well level because obviously embryonic play one assumes the well costs are still being optimized and just discuss how you see the evolution of that play as it relates to the risk inventory and just how relative incremental capital allocation might evolve towards the Powder over time?

Yes, you're right, Doug, and good morning. The Powder has the highest oil percentage of any of the plays that we're involved in; and so that play does have very high margins associated with it. And obviously, it's a very sensitive figure to oil prices that you generate on that play. We're extremely pleased with the results we're getting so far in the Powder where we've now entered into the full development mode on the low-risk Turner play. That will constitute the bulk of the growth that we're going to realize over the next three years. And then we're excited as well about the Niobrara. We have not said too much about our first Niobrara well. We're just following that well back at this point, but so far so good I would say. One thing to be cautious about by the way on the Niobrara is that you really can't compare our Niobrara to other industry players' Niobrara out there; we are at, from a thermal maturity standpoint, we are in the heart of the oil window throughout the geologic column, including the Niobrara on our acreage, and that is not the case for some of the other industry players that have a much more gassy count Niobrara. So we're excited although, again that's the smaller part of our overall growth story over the next three years. But the returns are very competitive with those in the rest of the portfolio and that's why we have four rigs working out there right now.

Just on the risk inventory, Dave, what's the current gross inventory if you like versus the, I guess you are 100 locations that you've identified to date?

Good morning, Doug. As you see in our main inventory disclosure slide, the high-quality risk inventory for the Rockies are sitting about 650 gross operated wells. And again, I’ll just remind you on all of that inventory, we've stripped out any non-operated locations. We've also stripped out any risk locate, our unrisked locations and we're just focused in on those locations that we think we can drive high-quality returns on. The inventory is a balance between all of those targets that Dave noted a moment ago, including some very high return Parkman and Teapot locations. And so when you look at it from an unrisked basis, the numbers obviously get a lot bigger. Those are very kind of preliminary risks high-quality locations. When we look at it from a total unrisked basis, we see several thousand Rockies operated locations as potential. And again, we're in the middle of trying to unlock that today with some of the appraisal work we're doing in the Niobrara. We would note also there are several other prospective targets that other companies are testing. We're watching that very closely as well.

I appreciate the answers, guys. My follow-up hopefully is a quick one, Dave, just the reallocation of capital from the STACK. And I guess the Eagle Ford is back to seeing some activity it seems. Can you just clarify are these, should we think about these assets just as ex-growth or absolute decline in particularly in the STACK? On a similar context, just what are the triggers that might cause you to change activity levels if oil stays under pressure?

Doug and for everyone, I think it's important to understand that we really have a dynamic capital allocation model, and what that means is that we really look at what are generating the highest returns throughout our portfolio. And we obviously take into account commodity prices when we make that decision. We have the ability with the inventory levels that we have to grow any of the assets if we so choose. But we don't think about it so much about whether or not we are growing an individual asset or not. We allocate our capital out of what we consider to be the highest return opportunities and growth is an output of that given where we think we're getting the highest returns. If we were less dynamic, frankly, with our capital, we could allocate it more proportionately to all of our plays so that they all grow because we have the inventory to do that, but we don't think that's the way to optimize the value of the company. So with this, obviously we've had some weakness in natural gas and NGL prices here. And with that, we've made the decision to reduce the activity somewhat in the STACK and to reallocate that capital out to the Delaware and the Rockies given the higher returns in this point.

Good morning. My question sort of takes on what they were just asking. You all certainly have done a lot for shareholder returns here now in the near term in the last several quarters. But my question would be this market continues to stay rational as it is. I'm just wondering how do you balance, do you re-up the shareholder buyback program or how do you balance that versus the growth program that you're outlining?

Well, we are going to stick to our, I think the overall message first and foremost is that we are executing from an operational perspective at a very high level. We are going to continue to stick to that plan and we're very confident that that execution is going to continue. We think that we have the asset base, and there is a cost structure that we can deliver both, that we can deliver free cash flow yield. It's competitive, not only within the space but within other industrial companies, while still delivering significant growth. So, we are planning and our plans are based on delivering both of those. With that overall thought, that's part of the work that we're doing in regards to 2020 and beyond is what is the optimum level to ensure that we deliver on those metrics. So but the good news is with our low breakeven, the continued increasing capital efficiency, that continued reduction of the cost structure, and the growth in revenue is going to come as we grow our light oil production, we think we're as well-positioned as just about any company out there in the space to deliver on that.

Thank you for your interest in Devon today. If you have any other questions, the IR team will be available throughout the day. I appreciate your time today.