Vol. 58 No. 7

July 2006

J. Larry Nichols, CEO, Devon Energy

John Donnelly, JPT Editor, jdonnelly@spe.org

How have recent high oil prices affected your E&P program?

Our capital budget has tripled over the past 5 years. Part of that has come from higher oil and gas prices, but part of that has been because we have been growing the size of the company. While oil and gas prices have had some impact, we recognize that prices are volatile, and we are not relying on them staying at their current elevated level.

How did last year’s hurricanes in the Gulf of Mexico affect your operations?

We were affected some, but not as badly as a lot of other companies. We had three platforms that suffered damage—they actually sank—but they were not critical platforms. They were in the area of other platforms, and we just rearranged our production scheme without having to rebuild those platforms. We were affected by some third-party pipelines that resulted in about 80,000 BOPD being suspended for a period. We have restored all but 6,000 BOPD of that now.

You recently acquired Chief Holdings and have made major acquisitions in the past. What is Devon’s philosophy regarding growing through acquisitions or through the drill bit? Does that philosophy change in a high-price environment?

We have always stated that we like both; it depends on the circumstances whether acquisitions are attractive. We certainly have done a lot of acquisitions since we went public in 1988. But because of high oil prices, they are now increasingly difficult. One of the things we have done with our acquisitions is that each time we have bought a company, we have turned around and sold the bottom part of our portfolio, resulting in an ever-increasing quality of our portfolio. It is now difficult to find transactions that are accreting in value and that improve the quality of our portfolio. Chief was one of those rare exceptions.

What is your outlook for oil and natural gas prices?

You have to start with oil because that has such an influence on gas prices. It involves huge political questions that are very difficult to answer. Obviously, the world supply of oil is tight, and in the countries where one could increase production, many of them are difficult to do business in. That is why oil is trading where it is now, because of the political uncertainty of the Middle East, Venezuela, now Bolivia, and Nigeria. Long-term, we think that oil in the area of U.S. $50–55/bbl is probably a reasonable number, but that is not to say that there might not be huge volatility both above and below that number.

Gas is also challenged. In the U.S., companies are denied access in many areas where they could expand production, which has resulted in the supply of natural gas being very tight. We had a mild winter last year, and that helped. 

What is your drilling plan for the Barnett shale this year?

Our program there has expanded because of the Chief acquisition. We will drill about 300 wells this year, maybe more, and expect to have 30 rigs running by the end of the year.

Devon attributes some of the success in that region to technology developed in conjunction with universities. Can you speak a little about that and how much R&D Devon has done with universities?
We do quite a bit of R&D on the Barnett shale. Since we own about half the field, we have a resource base that is quite significant and a lot of historical data that are quite helpful to doing research. The challenge is to figure out how to get more gas out of the original gas that is in place. It is a true engineering challenge, and we have been working with universities to do cutting-edge research on this particular type of rock.

Many operators have cut their R&D budgets over the past decade. Has Devon’s R&D budget changed much over the past several years?

It is growing, primarily because of the position we have in the Barnett shale. When we went public, we were doing no research. Small independents do not have the strength to do that.

Devon’s direction leans toward natural gas and North American assets, in contrast to other major independents and majors. Do you expect that to change?

No, we really don’t. We have always been focused on the U.S. and Canada and consider that as one big gas market, and increasingly one integrated gas market. While we do have some significant oil-oriented international plays that have the kind of risk/reward ratio you would expect, North American natural gas is certainly our focus and will continue to be.

Political risk certainly eliminates a good number of countries and, unfortunately, increasingly so. But we have established an interesting exploration portfolio in Brazil and west Africa, where there are some large fields remaining to be discovered.

Does this strategy require more technical manpower than another?

No, I wouldn’t say that. Certainly the technology that we are using to drill deep wells in the Gulf of Mexico is no different from that used in drilling the same type of well in Brazil or in other offshore areas.

The E&P industry has long worried about the “big crew change” and the aging workforce, and independents, which frequently hire seasoned personnel, may have an even higher median age in their technical staffs. How is Devon handling this situation?

The industry’s current drilling efforts are putting significant pressure on the technical staffs that we all have. We have started a very aggressive internship program; we have reached out to about 20 universities. Last year, we had 200 interns working at Devon, which not only gives those students an excellent opportunity to see what the industry is about but also gives them a chance to see what Devon is about and to see the culture that we have. Conversely, it gives Devon an opportunity to evaluate their abilities, so it is a mutually rewarding experience that we intend to continue for a long time. 

Devon has grown from a small company to one of the major independents operating today. Can you share your thoughts on this growth, what lessons you have learned, and what you might have done differently?

We have been very fortunate to have had a good business plan that fit the environment that we were in. Just because of the consolidation that has taken place in the industry, it would be very difficult for another company to do what we have done. When we went public in 1988, there were 400 publicly traded oil and gas companies. Now, we are down to about 100. If you start with a base of 400, it is a whole lot easier to be a force in the consolidation than if you are starting now.

Has that consolidation been good for the industry?

I think it has. There were a lot of reasons in the 1970s and 1980s for those companies to exist. The tax reform act of 1986 changed the way oil and gas companies were funded—drilling funds and income funds no longer worked. So there were a lot of very small companies that did not have the size or the prowess to really pursue a lot of high-level technologies. For example, in the Barnett shale, because of our size and strength, we can afford to engage in long-term research on how to get more gas out of there. If you are a small company that can drill only five or 10 wells, you do not have the size or the asset base to pursue that kind of research. So that consolidation has definitely been a help in making our industry more efficient and more able to find more oil and gas.

What is the optimal size of an independent, in which it can maximize its value and compete with majors while still being nimble enough to enter and exit potential markets with relative ease? Is Devon there?

That is something that we have thought about. We think we are able to do that at the size that Devon is. It is a question of being focused in one business and not allowing yourself to get too diversified in a lot of other businesses. Devon and our peer companies are every year expanding the size that one can become and still be a pure E&P company. But if you are properly organized with the right people, I don’t see any inherent problem in size.

Our goal is not to get bigger, but to become more profitable. And if there are ways to become more profitable by becoming larger, then we will do it. The Chief acquisition was one of those ways that we could increase our value per share and increase our growth potential and be able to produce more gas in the future.

What distinguishes Devon from other independents?

I think we have had a very strong and sound business plan that has taken us from a tiny independent to the size that we are now. When we went public, we thought that there would be a significant consolidation that would take place in the industry. We wanted to buy as much gas and, to a lesser extent, as much oil as we could while we could buy it cheaply. And we realized that if consolidation did start taking place in the industry, then acquisitions would get to be fairly expensive. So we wanted to make sure that we had a quality portfolio of long-term assets that we could grow with the drill bit out into the future. And that is exactly where we think we are today.

We basically have the assets that we want for the long term. We think we have the right balance between oil and gas and between exploration and exploitation, most of it in the relatively politically safe North American area. So we think the evolution of the company has led us to a good position.