Devon Energy - 10-Q quarterly report FY

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

     The number of shares outstanding of Registrant’s common stock, par value $0.10, as of March 31, 2006, was 439,987,000.

     As used in this document:

     “Bbl” or “Bbls” means barrel or barrels.

     “Bcf” means billion cubic feet.

     “Boe” means barrel of oil equivalent, determined by using the ratio of one Bbl of oil or NGLs to six Mcf of gas.

     “MMBbls” means million barrels.

     “MMBoe” means million Boe.

     “Mcf” means thousand cubic feet.

     “NGL” or “NGLs” means natural gas liquids.

     “Oil” includes crude oil and condensate.

     “SEC” means United States Securities and Exchange Commission.

     “Domestic” means the properties of Devon in the onshore continental United States and the offshore Gulf of Mexico.

     “United States Onshore” means the properties of Devon in the continental United States.

     “United States Offshore” means the properties of Devon in the Gulf of Mexico.

     “Canada” means the division of Devon encompassing oil and gas properties located in Canada.

     “International” means the division of Devon encompassing oil and gas properties that lie outside the United States and Canada.

     The accompanying consolidated financial statements and notes thereto of Devon Energy Corporation (“Devon”) have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been omitted. The accompanying consolidated financial statements and notes thereto should be read in conjunction with the consolidated financial statements and notes thereto included in Devon’s 2005 Annual Report on Form 10-K.

     In the opinion of Devon’s management, all adjustments (all of which are normal and recurring) have been made which are necessary to fairly state the consolidated financial position of Devon and its subsidiaries as of March 31, 2006, and the results of their operations and their cash flows for the three-month periods ended March 31, 2006 and 2005. Certain prior period amounts have been reclassified to conform to the current period presentation.

     The following table reconciles the net earnings and common shares outstanding used in the calculations of basic and diluted earnings per share for the three-month periods ended March 31, 2006 and 2005.

     Certain options to purchase shares of Devon’s common stock have been excluded from the dilution calculations because the options are antidilutive. During the first quarter of 2006 and 2005, 2.6 million shares and 35,000 shares, respectively, were excluded from the diluted earnings per share calculations.

     Effective January 1, 2006, Devon adopted Statement of Financial Accounting Standard No. 123(R), Share-Based Payment, (“SFAS No. 123(R)”), using the modified prospective transition method. SFAS No. 123(R) requires equity-classified share-based payments to employees, including grants of employee stock options, to be valued at fair value on the date of grant and to be expensed over the applicable vesting period. Under the modified prospective transition method, share-based awards granted or modified on or after January 1, 2006, are recognized in compensation expense over the applicable vesting period. Also, any previously granted awards that are not fully vested as of January 1, 2006 are recognized as compensation expense over the remaining vesting period. No retroactive or cumulative effect adjustments were required upon Devon’s adoption of SFAS No. 123(R).

     Prior to adopting SFAS No. 123(R), Devon accounted for its fixed-plan employee stock options using the intrinsic-value based method prescribed by Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, (“APB No. 25”) and related interpretations. This method required compensation expense to be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price.

     Had Devon elected the fair value provisions of SFAS No. 123(R), Devon’s 2005 net earnings and net earnings per share would have differed from the amounts actually reported as shown in the following table.

     As a result of adopting SFAS No. 123(R) on January 1, 2006, Devon’s earnings before income tax expense and net earnings for the three-month period ended March 31, 2006 were $6 million and $4 million lower, respectively, than if Devon had continued to account for share-based compensation under APB No. 25. Also, basic and diluted earnings per share were approximately $0.01 per share lower as a result of the adoption. Prior to the adoption of SFAS No. 123(R), Devon presented all tax benefits of deductions resulting from the exercise of stock options as operating cash inflows in the statement of cash flows. SFAS No. 123(R) requires the cash inflows resulting from tax deductions in excess of the compensation expense recognized for those stock options (“excess tax benefits”) to be classified as financing cash inflows. As required by SFAS No. 123(R), Devon recognized $4 million of excess tax benefits as financing cash inflows for the three months ended March 31, 2006.

     Devon’s comprehensive income or loss information is included in the accompanying consolidated statements of stockholders’ equity and comprehensive income. A summary of accumulated other comprehensive income as of March 31, 2006 and 2005, and changes during each of the three months then ended, is presented in the following table.

     Cash payments for interest and income taxes in the first three months of 2006 and 2005 are presented below:

     In April 2006, Devon replaced its existing $1.5 billion five-year unsecured revolving credit facility with a $2.0 billion five-year, syndicated, unsecured revolving line of credit (the “Senior Credit Facility”). The Senior Credit Facility includes a five-year revolving Canadian subfacility in a maximum amount of U.S. $500 million.

     The Senior Credit Facility matures on April 7, 2011, and all amounts outstanding will be due and payable at that time unless the maturity is extended. Prior to each April 7 anniversary date, Devon has the option to extend the maturity of the Senior Credit Facility for one year, subject to the approval of the lenders.

     Devon has the right to increase the aggregate commitment amount under the Senior Credit Facility

from $2.0 billion to $2.5 billion by requesting one or more lenders to increase their respective commitments or adding one or more additional lenders to the syndicate group. Devon expects to work with its lenders to increase the aggregate commitment amount in conjunction with the expected close of the Chief acquisition in the second quarter of this year (see Note 11). However, there is no guarantee that Devon will be successful in increasing the aggregate commitment amount.

     Amounts borrowed under the Senior Credit Facility may, at Devon’s election, bear interest at various fixed rate options for periods of up to twelve months. Such rates are generally less than the prime rate. Devon may also elect to borrow at the prime rate. The Senior Credit Facility currently provides for an annual facility fee of $1.8 million that is payable quarterly in arrears.

     As of April 30, 2006, there were no borrowings under the Senior Credit Facility. The available capacity under the Senior Credit Facility as of April 30, 2006, net of $356 million of outstanding letters of credit, was approximately $1.6 billion.

     The Senior Credit Facility contains only one material financial covenant. This covenant requires Devon to maintain a ratio of total funded debt to total capitalization, as defined in the credit agreement, of no more than 65%.

     The following is a summary of the changes in Devon’s common shares outstanding for the three months ended March 31, 2006 and 2005:

     The shares repurchased in 2006 were repurchased at a cost of $253 million, or $59.61, per share. The shares repurchased in 2005 were repurchased at a cost of $557 million, or $43.78, per share.

     On August 3, 2005, Devon announced that its board of directors had authorized the repurchase of up to 50 million shares of our common stock. As of May 2, 2006, Devon had repurchased 6.5 million shares under this program for $387 million, or $59.80 per share. As a result of the Chief acquisition (see Note 11), this repurchase program has been suspended and will be reevaluated later in 2006.

     As discussed in Note 1, on January 1, 2006, Devon changed its method of accounting for share-based compensation from the APB No. 25 intrinsic value accounting method to the fair value recognition provisions of SFAS No. 123(R). During the first three months of 2006 and 2005, Devon’s stock-based compensation expense was $19 million and $7 million, respectively. The related tax benefit recognized in our statement of operations for such compensation expense was $5 million and $2 million, respectively. During the first three months of 2006, Devon capitalized $5 million of its stock-based compensation pursuant to the full cost method of accounting for oil and gas properties.

     Devon estimates the fair values of stock options granted using a Black-Scholes option valuation model, which requires Devon to make several assumptions. The volatility of Devon’s common stock is based on the historical volatility of the market price of Devon’s common stock over a period of time equal to the expected term of the option and ending on the grant date. The dividend yield is based on Devon’s historical and current yield in effect at the date of grant. The risk-free interest rate is based on the U.S. Treasury yield for the expected term of the option at the date of grant. The expected term of the options is based on historical exercise and termination experience for various groups of employees and directors. Each group is determined based on the similarity of their historical exercise and termination behavior.

     The assumptions presented in the following table represent the weighted-average amounts for the period. The weighted average grant-date fair values of stock options granted during the first three months of 2006 and 2005 were $19.36 and $14.04, respectively.

     A summary of Devon’s outstanding stock options as of March 31, 2006, and changes during the three months then ended, is presented below.

     A summary of Devon’s unvested restricted stock awards as of March 31, 2006, and changes during the three months then ended, is presented below.

     The total intrinsic value of options exercised during the three months ended March 31, 2006 and

2005, was $31 million and $55 million, respectively. The total fair value of shares vested during the three months ended March 31, 2006 and 2005, was $7 million and $4 million, respectively. As of March 31, 2006, Devon’s unrecognized compensation costs related to unvested stock options and restricted stock awards were $62 million and $121 million, respectively. Such costs are expected to be recognized over weighted-average periods of 1.4 years and 1.8 years, respectively.

     The components of other income included the following:

     Devon has various non-contributory defined benefit pension plans, including qualified plans (“Qualified Plans”) and nonqualified plans (“Supplemental Plans”). The Qualified Plans provide retirement benefits for U.S. and Canadian employees meeting certain age and service requirements. The Supplemental Plans provide retirement benefits for certain employees whose benefits under the Qualified Plans are limited by income tax regulations. Devon also has defined benefit postretirement plans (“Postretirement Plans”) which provide benefits for substantially all employees. The Postretirement Plans provide medical and, in some cases, life insurance benefits and are, depending on the type of plan, either contributory or non-contributory.

     The following table presents the plans’ net periodic benefit cost for the quarters ended March 31, 2006 and 2005.

     Devon previously disclosed in its financial statements for the year ended December 31, 2005, that it expected to contribute $7 million to the Qualified and Supplemental Plans in 2006 and $5 million to the

Postretirement Plans in 2006. As of March 31, 2006, Devon has contributed $1 million to the Qualified and Supplemental Plans and $2 million to the Postretirement Plans.

     Devon is party to various legal actions arising in the normal course of business. Matters that are probable of unfavorable outcome to Devon and which can be reasonably estimated are accrued. Such accruals are based on information known about the matters, Devon’s estimates of the outcomes of such matters and its experience in contesting, litigating and settling similar matters. None of the actions are believed by management to involve future amounts that would be material to Devon’s financial position or results of operations after consideration of recorded accruals although actual amounts could differ materially from management’s estimate.

     Devon is subject to certain laws and regulations relating to environmental remediation activities associated with past operations, such as the Comprehensive Environmental Response, Compensation, and Liability Act (“CERCLA”) and similar state statutes. In response to liabilities associated with these activities, accruals have been established when reasonable estimates are possible. Such accruals primarily include estimated costs associated with remediation. Devon has not used discounting in determining its accrued liabilities for environmental remediation, and no material claims for possible recovery from third party insurers or other parties related to environmental costs have been recognized in Devon’s consolidated financial statements. Devon adjusts the accruals when new remediation responsibilities are discovered and probable costs become estimable, or when current remediation estimates must be adjusted to reflect new information.

     Certain of Devon’s subsidiaries acquired in past mergers are involved in matters in which it has been alleged that such subsidiaries are potentially responsible parties (“PRPs”) under CERCLA or similar state legislation with respect to various waste disposal areas owned or operated by third parties. As of March 31, 2006, Devon’s consolidated balance sheet included $4 million of non-current accrued liabilities, reflected in “Other liabilities,” related to these and other environmental remediation liabilities. Devon does not currently believe there is a reasonable possibility of incurring additional material costs in excess of the current accruals recognized for such environmental remediation activities. With respect to the sites in which Devon subsidiaries are PRPs, Devon’s conclusion is based in large part on (i) Devon’s participation in consent decrees with both other PRPs and the Environmental Protection Agency, which provide for performing the scope of work required for remediation and contain covenants not to sue as protection to the PRPs, (ii) participation in groups as a de minimis PRP, and (iii) the availability of other defenses to liability. As a result, Devon’s monetary exposure is not expected to be material.

     Numerous gas producers and related parties, including Devon, have been named in various lawsuits alleging violation of the federal False Claims Act. The suits allege that the producers and related parties used below-market prices, improper deductions, improper measurement techniques and transactions with affiliates which resulted in underpayment of royalties in connection with natural gas and natural gas liquids produced and sold from federal and Indian owned or controlled lands. The principal suit in which Devon is a defendant is United States ex rel. Wright v. Chevron USA, Inc. et al. (the “Wright case”). The suit was originally filed in August 1996 in the United States District Court for the Eastern District of Texas, but was consolidated in October 2000 with the other suits for pre-trial proceedings in the United States District Court for the District of Wyoming. On July 10, 2003, the District of Wyoming remanded

the Wright case back to the Eastern District of Texas to resume proceedings. On February 1, 2006, the Court entered a scheduling order in which trial is set for November 2007 if the suit continues to advance. Devon believes that it has acted reasonably, has legitimate and strong defenses to all allegations in the suit, and has paid royalties in good faith. Devon does not currently believe that it is subject to material exposure in association with this lawsuit and no liability has been recorded in connection therewith.

     In 1995, the United States Congress passed the Deep Water Royalty Relief Act (the “DWRRA”). The intent of the DWRRA was to encourage deep water exploration in the Gulf of Mexico by providing relief from the obligation to pay royalties on certain federal leases. The DWRRA granted royalty relief, without regard to the market prices of oil or natural gas, with respect to leases issued between November 28, 1995 and November 28, 2000. However, in regulations promulgated by the Minerals Management Service (the “MMS”) subsequent to the passage of the DWRRA, the MMS imposed price thresholds on these deep water leases such that if the market prices for oil or natural gas exceeded the thresholds, royalty relief would not be granted.

     The MMS has issued an order to Devon and other oil and gas producers to pay royalties on these deep water leases due to market prices exceeding the price thresholds in recent years. Devon and certain other oil and gas producers have filed Administrative Appeals with the MMS contesting the MMS’ orders. One oil and gas producer has filed suit in Federal court against the Department of Interior challenging the MMS’ authority to suspend royalty relief on the subject leases.

     Devon does not believe that the MMS has the legal authority to suspend the royalty relief granted by the DWRRA. This is based in part on prior successful litigation against the Department of Interior and the MMS involving similar issues related to the DWRRA. Accordingly, Devon has not accrued for any such royalties in its consolidated financial statements. If it were to be found that the MMS’ regulations are valid, Devon estimates that as of March 31, 2006, it would owe royalties and interest totaling $133 million.

     The SEC has been conducting an inquiry into payments made to the government of Equatorial Guinea, and to officials and persons affiliated with officials of the government of Equatorial Guinea. On August 9, 2005, Devon received a subpoena issued by the SEC pursuant to a formal order of investigation. Devon has cooperated fully with the SEC’s previous requests for information in this inquiry and plans to continue to work with the SEC in connection with its formal investigation.

     Devon maintains a comprehensive insurance program that includes coverage for physical damage to its offshore facilities caused by hurricanes. Devon’s insurance program also includes substantial business interruption coverage which Devon expects to utilize to recover costs associated with the suspended production related to hurricanes that struck the Gulf of Mexico in the third quarter of 2005. Under the terms of the insurance program, Devon is entitled to be reimbursed for the portion of production suspended longer than forty-five days, subject to upper limits to oil and natural gas prices. Also, the terms of the insurance include a standard, per-event deductible of $1 million for offshore losses as well as a $15 million aggregate annual deductible. Based on current estimates of physical damage and the anticipated length of time Devon will have production suspended, Devon expects its policy settlements will exceed repair costs and deductible amounts. This expectation is based upon several variables, including the actual amount of time that production is suspended, the actual prices in effect while production is suspended and the timing of collections of insurance proceeds. Should Devon’s policy

settlements exceed repair costs and deductible amounts, the excess will be recognized as other income in the statement of operations.

     Devon is involved in other various routine legal proceedings incidental to its business. However, to Devon’s knowledge as of the date of this report, there were no other material pending legal proceedings to which Devon is a party or to which any of its property is subject.

     Currently, Devon has commitments to drill four wells in Nigeria. The first two wells were unsuccessful. After drilling the second unsuccessful well in the first quarter of 2006, Devon determined that the capitalized costs related to these two wells should be impaired. Therefore, in the first quarter of 2006, Devon recognized an $85 million impairment of its investment in Nigeria equal to the costs to drill the two dry holes and a proportionate share of block-related costs. There is no tax benefit related to this impairment.

     Following is certain financial information regarding Devon’s reporting segments. The revenues reported are all from external customers.

     On May 2, 2006, Devon announced that it will acquire the oil and gas properties of privately-owned Chief Holdings LLC (“Chief”) for $2.2 billion in cash, including assumed liabilities. Devon expects to fund the acquisition with approximately $900 million of cash on hand and approximately $1.3 billion of short-term borrowings under its commercial paper program. Devon estimates that the acquired properties include proved reserves of 617 billion cubic feet of natural gas equivalent and leasehold totaling 169,000 net acres located in the Barnett Shale area of Texas. Devon expects to allocate approximately $1.0 billion of the purchase price to proved reserves and approximately $1.2 billion to unproved properties. The acquisition is expected to close near the end of the second quarter of 2006.

     The transaction is subject to expiration of the Hart-Scott-Rodino waiting period. It is also subject to other customary closing conditions.

     The following discussion addresses material changes in results of operations for the three months ended March 31, 2006, compared to the three months ended March 31, 2005, and in financial condition since December 31, 2005. It is presumed that readers have read or have access to Devon’s 2005 Annual Report on Form 10-K which includes disclosures regarding critical accounting policies as part of Management’s Discussion and Analysis of Financial Condition and Results of Operations. Unless otherwise stated, all dollar amounts are expressed in U.S. dollars.

     We continued to execute our strategy to increase value per share. The following summarizes our performance for the first quarter of 2006 compared to the first quarter of 2005:

     In addition, capital expenditures for oil and gas exploration and development activities were $1.4 billion during the first quarter of 2006. During this same period, estimated proved reserves increased 20 million Boe due to drilling discoveries and extensions and performance revisions.

     On May 2, 2006, we announced that we will acquire the oil and gas properties of privately-owned Chief Holdings LLC (“Chief”) for $2.2 billion in cash, including assumed liabilities. We expect to fund the acquisition with approximately $900 million of cash on hand and approximately $1.3 billion of short-term borrowings under our commercial paper program. We estimate that the acquired properties include proved reserves of 617 billion cubic feet of natural gas equivalent and leasehold totaling 169,000 net acres located in the Barnett Shale area of Texas. We expect to allocate approximately $1.0 billion of the purchase price to proved reserves and approximately $1.2 billion to unproved properties. The acquisition is expected to close near the end of the second quarter of 2006.

     A more complete overview and discussion of full-year expectations can be found in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our 2005 Annual Report on Form 10-K.

     Oil, gas and NGL revenues increased $320 million, or 17%, for the first quarter of 2006 compared to the first quarter of 2005. The quarterly comparisons of production and price changes are shown in the following tables.