UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

 

 

Commission File Number 001-32318

 

Devon Energy Corporation

(Exact name of Registrant as Specified in its Charter)

 

 

Registrant’s telephone number, including area code:

(405) 235-3611

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:
None

 

Indicate by check mark if the registrant is a well-known seasoned issuer (as defined in Rule 405 of the Securities Act).  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

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):

Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o     

 

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 aggregate market value of the voting stock held by non-affiliates of the registrant as of June 30, 2006, was $26,464,653,232.

 

On February 15, 2007, 444,461,491 shares of common stock were outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE
Proxy statement for the 2007 annual meeting of stockholders — Part III

 

 

TABLE OF CONTENTS

 

DEFINITIONS

 

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.

 

“FPSO” means floating, production, storage and offloading facilities.

 

“Btu” means British Thermal units, a measure of heating value.

 

“Inside FERC” refers to the publication Inside F.E.R.C.’s Gas Market Report.

 

“LIBOR” means London Interbank Offered Rate.

 

“MBbls” means thousand barrels.

 

“MMBbls” means million barrels.

 

“MBoe” means thousand Boe.

 

“MMBoe” means million Boe.

 

“MMBtu” means million Btu.

 

“Mcf” means thousand cubic feet.

 

“MMcf” means million cubic feet.

 

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

 

“NYMEX” means New York Mercantile Exchange.

 

“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.

 

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

 

“U.S. 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.

 

DISCLOSURE REGARDING FORWARD-LOOKING STATEMENTS

 

This report includes “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements other than statements of historical facts included or incorporated by reference in this report, including, without limitation, statements regarding our future financial position, business strategy, budgets, projected revenues, projected costs and plans and objectives of management for future operations, are forward-looking statements. Such forward-looking statements are based on our examination of historical operating trends, the information which was used to prepare the December 31, 2006 reserve reports and other data in our possession or available from third parties. In addition, forward-looking statements generally can be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “intend,” “project,” “estimate,” “anticipate,” “believe,” or “continue” or the negative thereof or variations thereon or similar

terminology. Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to have been correct. Important factors that could cause actual results to differ materially from our expectations include, but are not limited to, our assumptions about:

 

 

All subsequent written and oral forward-looking statements attributable to Devon, or persons acting on its behalf, are expressly qualified in their entirety by the cautionary statements. We assume no duty to update or revise our forward-looking statements based on changes in internal estimates or expectations or otherwise.

 

General

 

Devon Energy Corporation, including its subsidiaries, (“Devon”) is an independent energy company engaged primarily in oil and gas exploration, development and production, the transportation of oil, gas, and NGLs and the processing of natural gas. We own oil and gas properties principally in the United States and Canada and, to a lesser degree, various regions located outside North America, including Azerbaijan, Brazil and China. We also own properties in West Africa and Egypt that we intend to sell in 2007. In addition to our oil and gas operations, we have marketing and midstream operations primarily in North America. These include marketing natural gas, crude oil and NGLs, and constructing and operating pipelines, storage and treating facilities and gas processing plants. A detailed description of our significant properties and associated 2006 developments can be found under “Item 2. Properties.”

 

We began operations in 1971 as a privately held company. In 1988, our common stock began trading publicly on the American Stock Exchange under the symbol “DVN.” In October 2004, we transferred our common stock listing to the New York Stock Exchange. Our principal and administrative offices are located at 20 North Broadway, Oklahoma City, OK 73102-8260 (telephone 405/235-3611).

 

Strategy

 

We have a two-pronged operating strategy. First, we invest the vast majority of our capital budget in low-risk exploitation and development projects on our extensive North American property base which provides reliable and repeatable production and reserves additions. To supplement that strategy, we annually invest a measured amount of capital in high-impact, long cycle-time projects to replenish our development inventory for the future. The philosophy that underlies the execution of this strategy is to strive to increase value on a per share basis by:

 

 

Development of Business

 

During 1988, we expanded our capital base with our first issuance of common stock to the public. This transaction began a substantial expansion program that has continued through the subsequent years. This expansion is attributable to both a focused mergers and acquisitions program spanning a number of years and an active ongoing exploration and development drilling program. Total proved reserves increased from 8 MMBoe¹ at year-end 1987 to 2,376 MMBoe² at year-end 2006.

 

During the same time period, we have grown proved reserves from 0.66 Boe¹ per diluted share at the end of 1987 to 5.30 Boe² per diluted share at the end of 2006. This represents a compound annual growth rate of 12%. We have also increased production from 0.09 Boe¹ per diluted share in 1987 to 0.48 Boe² per diluted share in 2006, for a compound annual growth rate of 9%. This per share growth is a direct result of successful execution of our strategic plan and other key transactions and events.

 

 

¹ Excludes the effects of mergers in 1998 and 2000 that were accounted for as poolings of interests.

² Excludes reserves in Egypt that are held for sale and classified as discontinued operations as of December 31, 2006.

 

We achieved a number of significant accomplishments in our operations during 2006, including those discussed below.

 

 

In addition to production growth, our U.S. onshore properties also demonstrated significant growth in proved reserves. U.S onshore production in 2006 of 110 MMBoe was more than offset by 265 MMBoe of additions from extensions and discoveries during the year, as well as 105 MMBoe added through acquisitions, primarily the Chief acquisition. The additional reserves added by drilling and acquisition activities caused our 2006 U.S. onshore proved reserves to increase 21% compared to the end of 2005.

 

 

Specific Gulf of Mexico developments in 2006 included the following:

 

 

 

 

On November 14, 2006, we announced our plans to divest our operations in Egypt. At December 31, 2006, our Egyptian operations had proved reserves of eight million Boe. Subsequently, on January 23, 2007, we announced our plans to divest our operations in West Africa, including Equatorial Guinea, Cote d’Ivoire, and other countries in the region. At December 31, 2006, our West African operations had proved reserves of 90 million Boe. We anticipate completing the sale of our Egyptian operations in the first half of 2007 and our West African operations in the third quarter of 2007. Divesting these properties will allow us to redeploy our financial and intellectual capital to the significant growth opportunities we have developed onshore in North America and in the deepwater Gulf of Mexico. Additionally, we will sharpen our focus in North America and concentrate our international operations in Brazil and China, where we have established competitive advantages.

 

Pursuant to accounting rules for discontinued operations, our Egyptian operations were classified as discontinued operations at the end of 2006. Accordingly, we have classified all amounts related to our operations in Egypt as discontinued. Therefore, all amounts for all periods presented in this document related to our continuing operations exclude Egypt. Our West African operations did not meet the criteria to be considered discontinued operations at the end of 2006. Therefore, all amounts related to our operations in West Africa are still presented in this document as part of our continuing operations. Beginning in 2007, our operations in West Africa will be considered and classified as discontinued.

 

Financial Information about Segments and Geographical Areas

 

Notes 14 and 15 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data” of this report contain information on our segments and geographical areas.

 

Oil and Natural Gas Marketing

 

The spot market for oil and gas is subject to volatility as supply and demand factors fluctuate. We may periodically enter into financial hedging arrangements, fixed-price contracts or firm delivery commitments with a portion of our oil and gas production. These activities are intended to support targeted price levels and to manage our exposure to price fluctuations. See “Item 7A. Quantitative and Qualitative Disclosures About Market Risk.”

 

Oil Marketing

 

Our oil production is sold under both long-term (one year or more) and short-term (less than one year) agreements at prices negotiated with third parties. All of our oil production is sold at variable or market-sensitive prices.

 

Natural Gas Marketing

 

Our gas production is also sold under both long-term and short-term agreements at prices negotiated with third parties. Although exact percentages vary daily, as of February 2007, approximately 75% of our natural gas production was sold under short-term contracts at variable or market-sensitive prices. These market-sensitive sales are referred to as “spot market” sales. Another 23% of our production was committed under various long-term contracts which dedicate the natural gas to a purchaser for an extended period of time but still at market sensitive prices. Our remaining gas production was sold under long-term fixed price contracts.

 

Marketing and Midstream Activities

 

The primary objective of our marketing and midstream operations is to add value to us and other producers to whom we provide such services by gathering, processing and marketing oil and gas production in a timely and efficient manner. Our most significant marketing and midstream asset is the Bridgeport

processing plant and gathering system located in North Texas. These facilities serve not only our gas production from the Barnett Shale but also gas production of other producers in the area.

 

Our marketing and midstream revenues are primarily generated by:

 

 

Our marketing and midstream costs and expenses are primarily incurred from:

 

 

Customers

 

We sell our gas production to a variety of customers including pipelines, utilities, gas marketing firms, industrial users and local distribution companies. Existing gathering systems and interstate and intrastate pipelines are used to consummate gas sales and deliveries.

 

The principal customers for our crude oil production are refiners, remarketers and other companies, some of which have pipeline facilities near the producing properties. In the event pipeline facilities are not conveniently available, crude oil is trucked or shipped to storage, refining or pipeline facilities.

 

During 2006, revenues received from ExxonMobil and its affiliates were $1.1 billion, or 10% of our consolidated revenues. No purchaser accounted for over 10% of our revenues in 2005 or 2004.

 

Seasonal Nature of Business

 

Generally, but not always, the demand for natural gas decreases during the summer months and increases during the winter months. Seasonal anomalies such as mild winters or hot summers sometimes lessen this fluctuation. In addition, pipelines, utilities, local distribution companies and industrial users utilize natural gas storage facilities and purchase some of their anticipated winter requirements during the summer. This can also lessen seasonal demand fluctuations.

 

Government Regulation

 

The oil and gas industry is subject to various types of regulation throughout the world. Legislation affecting the oil and gas industry has been pervasive and is under constant review for amendment or expansion. Pursuant to such legislation, numerous government agencies have issued extensive laws and regulations binding on the oil and gas industry and its individual members, some of which carry substantial penalties for failure to comply. Such laws and regulations have a significant impact on oil and gas exploration, production and marketing and midstream activities. These laws and regulations increase the cost of doing business and, consequently, affect profitability. Inasmuch as new legislation affecting the oil and gas industry is commonplace and existing laws and regulations are frequently amended or reinterpreted, we are unable to predict the future cost or impact of complying with such laws and regulations. However, we do not expect that any of these laws and regulations will affect our operations in a manner materially different than they would affect other oil and gas companies of similar size.

 

The following are significant areas of government control and regulation in the United States, Canada and other international locations in which we operate.

 

Exploration and Production Regulation

 

Our oil and gas operations are subject to various federal, state, provincial, local and international laws and regulations, including regulations related to the acquisition of seismic data; the location of wells; drilling and casing of wells; well production; spill prevention plans; the use, transportation, storage and disposal of fluids and materials incidental to oil and gas operations; surface usage and the restoration of properties upon which wells have been drilled; the calculation and disbursement of royalty payments and production taxes; the plugging and abandoning of wells; the transportation of production; and, in international operations, minimum investments in the country of operations.

 

Our operations are also subject to conservation regulations, including the regulation of the size of drilling and spacing units or proration units; the number of wells which may be drilled in a unit; the rate of production allowable from oil and natural gas wells; and the unitization or pooling of oil and natural gas properties. In the United States, some states allow the forced pooling or integration of tracts to facilitate exploration while other states rely on voluntary pooling of lands and leases, which may make it more difficult to develop oil and gas properties. In addition, state conservation laws generally limit the venting or flaring of natural gas and impose certain requirements regarding the ratable purchase of production. The effect of these regulations is to limit the amounts of oil and natural gas we can produce from our wells and to limit the number of wells or the locations at which we can drill.

 

Certain of our U.S. oil and natural gas leases are granted by the federal government and administered by various federal agencies, including the Bureau of Land Management and the Minerals Management Service (“MMS”) of the Department of the Interior. Such leases require compliance with detailed federal regulations and orders that regulate, among other matters, drilling and operations on lands covered by these leases, and calculation and disbursement of royalty payments to the federal government. The MMS has been particularly active in recent years in evaluating and, in some cases, promulgating new rules and regulations regarding competitive lease bidding and royalty payment obligations for production from federal lands. The Federal Energy Regulatory Commission also has jurisdiction over certain U.S. offshore activities pursuant to the Outer Continental Shelf Lands Act.

 

Royalties and Incentives in Canada

 

The royalty system in Canada is a significant factor in the profitability of oil and natural gas production. Royalties payable on production from lands other than Crown lands are determined by negotiations between the parties. Crown royalties are determined by government regulation and are generally calculated as a percentage of the value of the gross production, with the royalty rate dependent in part upon prescribed reference prices, well productivity, geographical location, field discovery date and the type and quality of the petroleum product produced. From time to time, the federal and provincial governments of Canada have also established incentive programs such as royalty rate reductions, royalty holidays and tax credits for the purpose of encouraging oil and gas exploration or enhanced recovery projects. These incentives generally have the effect of increasing our revenues, earnings and cash flow.

 

Pricing and Marketing in Canada

 

An order from Canada’s National Energy Board (“NEB”) is required for oil and natural gas exports from Canada. Any oil or natural gas export to be made pursuant to an export contract of a certain duration or covering a certain quantity requires an exporter to obtain an export license from the NEB, which requires the approval of the Government of Canada. Exporters are free to negotiate prices and other terms with purchasers, provided that the export contracts meet certain criteria prescribed by the NEB. The governments of Alberta, British Columbia and Saskatchewan also regulate the volume of natural gas that may be removed from those provinces for consumption elsewhere based on such factors as reserve availability, transportation arrangements and market considerations.

 

Investment Canada Act

 

The Investment Canada Act requires Government of Canada approval, in certain cases, of the acquisition of control of a Canadian business by an entity that is not controlled by Canadians. In certain circumstances, the acquisition of natural resource properties may be considered to be a transaction requiring such approval.

 

Production Sharing Contracts

 

Many of our international licenses are governed by Production Sharing Contracts (“PSCs”) between the concessionaires and the granting government agency. PSCs are contracts that define and regulate the framework for investments, revenue sharing, and taxation of mineral interests in foreign countries. Unlike most domestic leases, PSCs have defined production terms and time limits of generally 30 years. PSCs also generally contain sliding scale revenue sharing provisions. As a result, at either higher production rates or higher cumulative rates of return, PSCs generally allow the government partner to retain higher fractions of revenue.

 

Environmental and Occupational Regulations

 

We are subject to various federal, state, provincial, local and international laws and regulations concerning occupational safety and health and the discharge of materials into, and the protection of, the environment. Environmental laws and regulations relate to, among other things, assessing the environmental impact of seismic acquisition, drilling or construction activities; the generation, storage, transportation and disposal of waste materials; the monitoring, abandonment, reclamation and remediation of well and other sites, including sites of former operations; and the development of emergency response and spill contingency plans. The application of worldwide standards, such as ISO 14000 governing Environmental Management Systems, are required to be implemented for some international oil and gas operations.

 

In 1997, numerous countries participated in an international conference under the United Nations Framework Convention on Climate Change and adopted an agreement known as the Kyoto Protocol (the “Protocol”). The Protocol became effective February 14, 2005, and requires reductions of certain emissions that contribute to atmospheric levels of greenhouse gases. Certain countries in which we operate (but not the United States) have ratified the Protocol. Presently, it is not possible to accurately estimate the costs we could incur to comply with any laws or regulations developed to achieve such emissions reductions, but such expenditures could be substantial. In 2006, Devon published its Corporate Climate Change Position and Strategy. Key components of the strategy include initiation of energy conservation measures, tracking emerging climate changes legislation and publication of a corporate greenhouse gas emission inventory by the end of 2007. All provisions of the strategy are in progress.

 

We consider the costs of environmental protection and safety and health compliance necessary and manageable parts of our business. With the efforts of our Environmental, Health and Safety Department, we have been able to plan for and comply with environmental and safety and health initiatives without materially altering our operating strategy. We anticipate making increased expenditures of both a capital and expense nature as a result of the increasingly stringent laws relating to the protection of the environment. While our unreimbursed expenditures in 2006 concerning such matters were immaterial, we cannot predict with any reasonable degree of certainty our future exposure concerning such matters.

 

We maintain levels of insurance customary in the industry to limit our financial exposure in the event of a substantial environmental claim resulting from sudden, unanticipated and accidental discharges of oil, salt water or other substances. However, we do not maintain 100% coverage concerning any environmental claim, and no coverage is maintained with respect to any penalty or fine required to be paid because of a violation of law.

 

Employees

 

As of December 31, 2006, we had approximately 4,600 employees. We consider labor relations with our employees to be satisfactory. We have not had any work stoppages or strikes pertaining to our employees.

 

Competition

 

See “Item 1A. Risk Factors.”

 

Availability of Reports

 

Through our website, http://www.devonenergy.com, we make available electronic copies of the charters of the committees of our Board of Directors, other documents related to Devon’s corporate governance (including our Code of Ethics for the Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer), and documents Devon files or furnishes to the SEC, including our annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, as well as any amendments to these reports. Access to these electronic filings is available free of charge as soon as reasonably practicable after filing or furnishing them to the SEC. Printed copies of our committee charters or other governance documents and filings can be requested by writing to our corporate secretary at the address on the cover of this report.

 

Our business activities, and the oil and gas industry in general, are subject to a variety of risks. Although we have a diversified asset base, a strong balance sheet and a history of generating sufficient cash to fund capital expenditure and investment programs and to pay dividends, if any of the following risk factors should occur, our profitability, financial condition and/or liquidity could be materially impacted. As a result, holders of our securities could lose part or all of their investment in Devon.

 

Oil, Natural Gas and NGL Prices are Volatile

 

Our financial results are highly dependent on the prices of and demand for oil, natural gas and NGLs. A significant downward movement of the prices for these commodities could have a material adverse effect on our estimated proved reserves, revenues and operating cash flows, as well as the level of planned drilling activities. Such a downward price movement could also have a material adverse effect on our profitability, the carrying value of our oil and gas properties and future growth. Historically, prices have been volatile and are likely to continue to be volatile in the future due to numerous factors beyond our control. These factors include, but are not limited to:

 

 

Estimates of Oil, Natural Gas and NGL Reserves are Uncertain

 

The process of estimating oil, gas and NGL reserves is complex and requires significant judgment in the evaluation of available geological, engineering and economic data for each reservoir, particularly for new discoveries. Because of the high degree of judgment involved, different reserve engineers may develop different estimates of reserve quantities and related revenue based on the same data. In addition, the reserve

estimates for a given reservoir may change substantially over time as a result of several factors including additional development activity, the viability of production under varying economic conditions and variations in production levels and associated costs. Consequently, material revisions to existing reserve estimates may occur as a result of changes in any of these factors. Such revisions to proved reserves could have a material adverse effect on our estimates of future net revenue, as well as our financial condition and profitability. Additional discussion of our policies regarding estimating and recording reserves is described in “Item 2. Properties — Proved Reserves and Estimated Future Net Revenue.”

 

Discoveries or Acquisitions of Additional Reserves are Needed to Avoid a Material Decline in Reserves and Production

 

The production rate from oil and gas properties generally declines as reserves are depleted, while related per unit production costs generally increase due to decreasing reservoir pressures and other factors. Therefore, our estimated proved reserves and future oil, gas and NGL production will decline materially as reserves are produced unless we conduct successful exploration and development activities or, through engineering studies, identify additional producing zones in existing wells, secondary recovery reserves or tertiary recovery reserves, or acquire additional properties containing proved reserves. Consequently, our future oil, gas and NGL production and related per unit production costs are highly dependent upon our level of success in finding or acquiring additional reserves.

 

Future Exploration and Drilling Results are Uncertain and Involve Substantial Costs

 

Substantial costs are often required to locate and acquire properties and drill exploratory wells. Such activities are subject to numerous risks, including the risk that we will not encounter commercially productive oil or gas reservoirs. The costs of drilling and completing wells are often uncertain. In addition, oil and gas properties can become damaged or drilling operations may be curtailed, delayed or canceled as a result of a variety of factors including, but not limited to:

 

 

A significant occurrence of one of these factors could result in a partial or total loss of our investment in a particular property. In addition, drilling activities may not be successful in establishing proved reserves. Such a failure could have an adverse effect on our future results of operations and financial condition. While both exploratory and developmental drilling activities involve these risks, exploratory drilling involves greater risks of dry holes or failure to find commercial quantities of hydrocarbons. We are currently performing exploratory drilling activities in certain international countries. We have been granted drilling concessions in these countries that require commitments on our behalf to incur capital expenditures. Even if future drilling activities are unsuccessful in establishing proved reserves, we will likely be required to fulfill our commitments to make such capital expenditures.

 

Industry Competition For Leases, Materials, People and Capital Can Be Significant

 

Strong competition exists in all sectors of the oil and gas industry. We compete with major integrated and other independent oil and gas companies for the acquisition of oil and gas leases and properties. We also compete for the equipment and personnel required to explore, develop and operate properties. Competition is also prevalent in the marketing of oil, gas and NGLs. Higher recent commodity prices have increased drilling and operating costs of existing properties. Higher prices have also increased the costs of properties available for acquisition, and there are a greater number of publicly traded companies and private-equity firms with the financial resources to pursue acquisition opportunities. Certain of our competitors have financial and other resources substantially larger than ours, and they have also established strategic long-term positions and maintain strong governmental relationships in countries in which we may seek new entry. As a consequence, we may be at a competitive disadvantage in bidding for drilling rights. In addition, many of our larger competitors may have a competitive advantage when responding to factors that affect demand for oil and natural gas production, such as changing worldwide prices and levels of production, the cost and availability of alternative fuels and the application of government regulations.

 

International Operations Have Uncertain Political, Economic and Other Risks

 

Our operations outside North America are based primarily in Azerbaijan, Brazil, China and various countries in West Africa. As a result, we face political and economic risks and other uncertainties that are less prevalent for our operations in North America. Such factors include, but are not limited to:

 

 

Foreign countries have occasionally asserted rights to oil and gas properties through border disputes. If a country claims superior rights to oil and gas leases or concessions granted to us by another country, our interests could decrease in value or be lost. Even our smaller international assets may affect our overall business and results of operations by distracting management’s attention from our more significant assets. Various regions of the world have a history of political and economic instability. This instability could result in new governments or the adoption of new policies that might result in a substantially more hostile attitude toward foreign investment. In an extreme case, such a change could result in termination of contract rights and expropriation of foreign-owned assets. This could adversely affect our interests and our future profitability.

 

The impact that future terrorist attacks or regional hostilities may have on the oil and gas industry in general, and on our operations in particular, is not known at this time. Uncertainty surrounding military strikes or a sustained military campaign may affect operations in unpredictable ways, including disruptions of fuel supplies and markets, particularly oil, and the possibility that infrastructure facilities, including pipelines,

production facilities, processing plants and refineries, could be direct targets of, or indirect casualties of, an act of terror or war. We may be required to incur significant costs in the future to safeguard our assets against terrorist activities.

 

Government Laws and Regulations Can Change

 

Our operations are subject to federal laws and regulations in the United States, Canada and the other international countries in which we operate. In addition, we are also subject to the laws and regulations of various states, provinces and local governments. Pursuant to such legislation, numerous government departments and agencies have issued extensive rules and regulations binding on the oil and gas industry and its individual members, some of which carry substantial penalties for failure to comply. Changes in such legislation have affected, and at times in the future could affect, our future operations. Political developments can restrict production levels, enact price controls, change environmental protection requirements, and increase taxes, royalties and other amounts payable to governments or governmental agencies. Although we are unable to predict changes to existing laws and regulations, such changes could significantly impact our profitability. While such legislation can change at any time in the future, those laws and regulations outside North America to which we are subject generally include greater risk of unforeseen change.

 

Environmental Matters and Costs Can Be Significant

 

As an owner or lessee and operator of oil and gas properties, we are subject to various federal, state, provincial, local and international laws and regulations relating to discharge of materials into, and protection of, the environment. These laws and regulations may, among other things, impose liability on us for the cost of pollution clean-up resulting from our operations in affected areas. Any future environmental costs of fulfilling our commitments to the environment are uncertain and will be governed by several factors, including future changes to regulatory requirements. There is no assurance that changes in or additions to laws or regulations regarding the protection of the environment will not have a significant impact on our operations and profitability.

 

Insurance Does Not Cover All Risks

 

Exploration, development, production and processing of oil, natural gas and NGLs can be hazardous and involve unforeseen occurrences such as hurricanes, blowouts, cratering, fires and loss of well control. These occurrences can result in damage to or destruction of wells or production facilities, injury to persons, loss of life, or damage to property or the environment. We maintain insurance against certain losses or liabilities in accordance with customary industry practices and in amounts that management believes to be prudent. However, insurance against all operational risks is not available to us. Due to changes in the marketplace following the 2005 hurricanes in the Gulf of Mexico, we currently have only a de minimis amount of coverage for any damage that may be caused by future named windstorms in the Gulf of Mexico.

 

Not applicable.

 

Substantially all of our properties consist of interests in developed and undeveloped oil and gas leases and mineral acreage located in our core operating areas. These interests entitle us to drill for and produce oil, natural gas and NGLs from specific areas. Our interests are mostly in the form of working interests and, to a lesser extent, overriding royalty, mineral and net profits interests, foreign government concessions and other forms of direct and indirect ownership in oil and gas properties.

 

We also have certain midstream assets, including natural gas and NGL processing plants and pipeline systems. Our most significant midstream assets are our assets serving the Barnett Shale region in North Texas. These assets include approximately 2,700 miles of pipeline, two gas processing plants with 680 MMcf per day of total capacity, and a 15 MBbls per day NGL fractionator.

 

Proved Reserves and Estimated Future Net Revenue

 

The SEC defines proved oil and gas reserves as the estimated quantities of crude oil, natural gas and NGLs which geological and engineering data demonstrate with reasonable certainty to be recoverable in future years from known reservoirs under existing economic and operating conditions, i.e., prices and costs as of the date the estimate is made. Prices include consideration of changes in existing prices provided only by contractual arrangements, but not on escalations based upon future conditions.

 

The process of estimating oil, gas and NGL reserves is complex and requires significant judgment as discussed in “Item 1A. Risk Factors.” As a result, we have developed internal policies for estimating and recording reserves. Our policies regarding booking reserves require proved reserves to be in compliance with the SEC definitions and guidance, and assign responsibilities for reserves bookings to our Reserve Evaluation Group (the “Group”). Our policies also require that reserve estimates be made by qualified reserves estimators (“QREs”), as defined by the Society of Petroleum Engineers’ standards. A list of our QREs is kept by the Senior Advisor — Corporate Reserves. All QREs are required to receive education covering the fundamentals of SEC proved reserves assignments.

 

The Group is responsible for internal reserves evaluation and certification and includes the Manager — E&P Budgets and Reserves and the Senior Advisor — Corporate Reserves. The Group reports independently of any of our operating divisions. The Vice President — Planning and Evaluation is directly responsible for overseeing the Group and reports to the President of Devon. No portion of the Group’s compensation is dependent on the quantity of reserves booked.

 

Throughout the year, the Group performs internal audits of each operating division’s reserves. Selection criteria of reserves that are audited include major fields and major additions and revisions to reserves. In addition, the Group reviews reserve estimates with each of the third-party petroleum consultants discussed below.

 

In addition to internal audits, we engage three independent petroleum consulting firms to both prepare and audit a significant portion of our proved reserves. Ryder Scott Company, L.P. prepared the 2006 reserves estimates for all our offshore Gulf of Mexico properties and for 99% of our International proved reserves. LaRoche Petroleum Consultants, Ltd. audited the 2006 reserves estimates for 87% of our domestic onshore properties. AJM Petroleum Consultants prepared estimates covering 46% of our 2006 Canadian reserves and audited an additional 39% of our Canadian reserves.

 

Set forth below is a summary of the reserves which were evaluated, either by preparation or audit, by independent petroleum consultants for each of the years ended 2006, 2005 and 2004.

 

 

“Prepared” reserves are those quantities of reserves which were prepared by an independent petroleum consultant. “Audited” reserves are those quantities of reserves which were estimated by our employees and audited by an independent petroleum consultant. An audit is an examination of a company’s proved oil and gas reserves and net cash flow by an independent petroleum consultant that is conducted for the purpose of expressing an opinion as to whether such estimates, in aggregate, are reasonable and have been estimated and presented in conformity with generally accepted petroleum engineering and evaluation principles.

 

In addition to internal and external reviews, three independent members of our Board of Directors have been assigned to a Reserves Committee. The Reserves Committee meets at lease twice a year to discuss reserves issues and policies and periodically meets separately with our senior reserves engineering personnel and our independent petroleum consultants. The Reserves Committee assists the Board of Directors with the oversight of the following:

 

 

The following table sets forth our estimated proved reserves and the related estimated pre-tax future net revenues, pre-tax 10% present value and after-tax standardized measure of discounted future net cash flows as of December 31, 2006. These estimates correspond with the method used in presenting the “Supplemental Information on Oil and Gas Operations” in Note 15 to our consolidated financial statements included herein.

 

 

 

 

These amounts were calculated using prices and costs in effect for each individual property as of December 31, 2006. These prices were not changed except where different prices were fixed and determinable from applicable contracts. These assumptions yield average prices over the life of our properties of $46.11 per Bbl of oil, $5.06 per Mcf of natural gas and $27.63 per Bbl of NGLs. These prices compare to the December 31, 2006, NYMEX cash price of $61.05 per Bbl for crude oil and the Henry Hub spot price of $5.64 per MMBtu for natural gas.

 

The present value of after-tax future net revenues discounted at 10% per annum (“standardized measure”) was $16.6 billion at the end of 2006. Included as part of standardized measure were discounted future income taxes of $7.5 billion. Excluding these taxes, the present value of our pre-tax future net revenue (“pre-tax 10% present value”) was $24.1 billion. We believe the pre-tax 10% present value is a useful measure in addition to the after-tax standardized measure. The pre-tax 10% present value assists in both the determination of future cash flows of the current reserves as well as in making relative value comparisons among peer companies. The after-tax standardized measure is dependent on the unique tax situation of each individual company, while the pre-tax 10% present value is based on prices and discount factors which are more consistent from company to company. We also understand that securities analysts use the pre-tax 10% present value measure in similar ways.

 

(3) See Note 15 to the consolidated financial statements included in “Item 8. Financial Statements and Supplementary Data.”

 

As presented in the previous table, we had 1,674 MMBoe of proved developed reserves at December 31, 2006. Proved developed reserves consist of proved developed producing reserves and proved developed non-producing reserves. The following table provides additional information regarding our proved developed reserves at December 31, 2006.

 

 

No estimates of our proved reserves have been filed with or included in reports to any federal or foreign governmental authority or agency since the beginning of the last fiscal year except in filings with the SEC and

the Department of Energy (“DOE”). Reserve estimates filed with the SEC correspond with the estimates of our reserves contained herein. Reserve estimates filed with the DOE are based upon the same underlying technical and economic assumptions as the estimates of our reserves included herein. However, the DOE requires reports to include the interests of all owners in wells that we operate and to exclude all interests in wells that we do not operate.

 

The prices used in calculating the estimated future net revenues attributable to proved reserves do not necessarily reflect market prices for oil, gas and NGL production subsequent to December 31, 2006. There can be no assurance that all of the proved reserves will be produced and sold within the periods indicated, that the assumed prices will be realized or that existing contracts will be honored or judicially enforced.

 

Production, Revenue and Price History

 

Certain information concerning oil, natural gas and NGL production, prices, revenues (net of all royalties, overriding royalties and other third party interests) and operating expenses for the three years ended December 31, 2006, is set forth in “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

 

Drilling Activities

 

The following tables summarize the results of our development and exploratory drilling activity for the past three years. The tables do not include our Egyptian operations that were classified as discontinued at the end of 2006.

 

Development Well Activity

 

 

Exploratory Well Activity

 

 

 

 

For the wells being drilled as of December 31, 2006 presented in the tables above, the following table summarizes the results of such wells as of February 1, 2007.

 

 

Well Statistics

 

The following table sets forth our producing wells as of December 31, 2006. The table does not include our Egyptian operations that were classified as discontinued at the end of 2006.

 

 

 

 

Developed and Undeveloped Acreage

 

The following table sets forth our developed and undeveloped oil and gas lease and mineral acreage as of December 31, 2006. The table does not include our Egyptian operations that were classified as discontinued at the end of 2006.

 

 

 

 

Operation of Properties

 

The day-to-day operations of oil and gas properties are the responsibility of an operator designated under pooling or operating agreements. The operator supervises production, maintains production records, employs field personnel and performs other functions.

 

We are the operator of 22,434 of our wells. As operator, we receive reimbursement for direct expenses incurred in the performance of our duties as well as monthly per-well producing and drilling overhead reimbursement at rates customarily charged in the area. In presenting our financial data, we record the monthly overhead reimbursements as a reduction of general and administrative expense, which is a common industry practice.

 

Organization Structure and Property Profiles

 

Our properties are located within the U.S. onshore and offshore regions, Canada, and certain locations outside North America. The following table presents proved reserve information for our significant properties as of December 31, 2006, along with their production volumes for the year 2006. Included in the table are certain U.S. offshore properties which currently have no proved reserves or production. Such properties are considered significant because they may be the source of significant growth in proved reserves and production in the future. Also included in the table are properties located in West Africa that we intend to sale in 2007. The table does not include our Egyptian operations that were classified as discontinued at the end of 2006. Additional summary profile information for our significant properties is provided following the table.

 

 

 

U.S. Onshore

 

Barnett Shale — The Barnett Shale, located in north central Texas, is our largest property both in terms of production and proved reserves. Our leases include approximately 725,000 net acres located primarily in Denton, Johnson, Parker, Tarrant and Wise counties. The Barnett Shale is a non-conventional reservoir and it produces natural gas and natural gas liquids. We have an average working interest in the Barnett Shale of greater than 90%.

 

During 2006, we acquired additional Barnett Shale assets from Chief. The Chief acquisition added approximately 100 MMBoe of proved reserves, 169,000 net acres and some 2,000 additional drilling locations to our Barnett Shale holdings. We drilled 383 gross wells in the Barnett Shale in 2006 and expect to drill 385 gross wells in the area in 2007.

 

Carthage — The Carthage area in east Texas includes primarily Harrison, Marion, Panola and Shelby counties. We hold approximately 126,000 net acres in the area. Our Carthage area wells produce primarily natural gas and natural gas liquids from conventional reservoirs. Our average working interest in this area is about 85%. We drilled 122 gross wells at Carthage in 2006 and plan to drill 150 gross wells in the area in 2007.

 

Permian Basin, Texas — Our oil and gas properties in the Permian Basin of west Texas comprise approximately 1.2 million net acres. Our acreage is located primarily in Andrews, Crane, Martin, Terry, Ward and Yoakum counties. The Permian Basin produces both oil and natural gas from conventional reservoirs. Our average working interest in these properties is about 40%. We drilled 95 gross wells in the Permian Basin of west Texas in 2006, and we plan to drill another 100 gross wells in the area in 2007.

 

Washakie — Our Washakie area leases are concentrated in Carbon and Sweetwater counties in southern Wyoming. We hold about 157,000 net acres in the Washakie area. Washakie produces primarily natural gas from conventional reservoirs. Our average working interest in the Washakie area is about 76%. In 2006, we drilled 137 wells at Washakie, and we plan to drill another 105 wells in the area in 2007.

 

Groesbeck — The Groesbeck area of east Texas includes portions of Freestone, Leon, Limestone and Robertson counties. We hold about 173,000 net acres of land in the Groesbeck area. Groesbeck produces primarily natural gas from conventional reservoirs. Our average working interest in the area is approximately 72%. In 2006, we drilled 31 gross wells in the area. Our plans anticipate drilling 34 additional gross wells in the Groesbeck area in 2007.

 

Permian Basin, New Mexico — We also own oil and gas properties in the Permian Basin in south eastern New Mexico. We hold about 342,000 net acres concentrated in Eddy and Lea counties. We produce conventional oil and natural gas from the Permian Basin in New Mexico, and have an average working interest of about 75% in these properties. In 2006, we drilled 82 gross wells in this area, and we expect to drill another 44 gross wells in 2007.

 

U.S. Offshore

 

Deepwater Producing — Our assets in the Gulf of Mexico include four significant producing properties located in deep water (greater than 600 feet). These properties are Magnolia, Nansen, Red Hawk and Zia. They are all located on federal leases and total approximately 48,000 net acres. The properties produce both crude oil and natural gas. Our working interest is 65% in Zia and 50% in each of the other three properties.

We drilled a total of two gross deepwater producing wells in 2006 and expect to drill four additional gross wells in 2007.

 

Deepwater Development — In addition to our four significant deepwater producing properties, we are in the process of developing two other deepwater projects, Merganser and Cascade. Merganser and Cascade are located on federal leases encompassing a total of approximately 11,500 net acres. We have 50% working interests in both properties.

 

We drilled two producing wells at Merganser in 2006. These wells are expected to commence producing natural gas in mid-2007. No additional drilling is planned at Merganser.

 

We announced in 2006 our plans to develop the 2002 Cascade discovery using an FPSO vessel. Cascade is expected to begin producing primarily oil in late 2009. Additional drilling at Cascade is in the planning stage.

 

Deepwater Exploration — Our exploration program in the Gulf of Mexico is focused primarily on deepwater opportunities. Our deepwater exploratory prospects include Miocene-aged objectives (five million to 24 million years) and older and deeper Lower Tertiary objectives. We hold federal leases comprising approximately 1.2 million net acres in our deepwater exploration inventory.

 

In 2006, various drilling and testing operations provided evidence that our Lower Tertiary properties may be a source of meaningful reserve and production growth in the future. Prior to 2006, we had drilled three discovery wells in the Lower Tertiary. These include Cascade in 2002 (see “Deepwater Development” above), St. Malo in 2003 and Jack in 2004. Operations in 2006 included a successful production test of the Jack No. 2 well and participation in the Kaskida discovery, which is our fourth Lower Tertiary discovery. We currently hold 273 blocks in the Lower Tertiary and have identified 19 additional prospects to date.

 

At St. Malo, in which our working interest is 22.5%, we plan to drill a second delineation well in late 2007 or early 2008. At Jack, where our working interest is 25%, we continue to evaluate with our partners our development options following the successful production test in 2006.

 

In addition to the 2006 Kaskida discovery, a subsequent sidetrack well at Kaskida was drilled in 2006 and another well operation is planned for 2007. Our working interest in Kaskida is 20%, and we believe Kaskida is the largest of our four Lower Tertiary discoveries to date. The Kaskida discovery was our first in the Keathley Canyon deepwater lease area. Twelve of the 19 additional Lower Tertiary exploratory prospects we have identified to date are on our Keathley Canyon acreage.

 

Also in 2006, we participated in a Miocene discovery on the Mission Deep prospect in which we have a 50% working interest. We have fifteen additional prospects in our deepwater Miocene inventory.

 

In total, we drilled three exploratory and delineation wells in the deepwater Gulf of Mexico in 2006, and plan to drill six such wells in 2007. Our working interests in these exploratory opportunities range from 20% to 100%.

 

Canada

 

Jackfish — We are currently developing our 100%-owned Jackfish thermal heavy oil project in the non-conventional oil sands of east central Alberta. We will employ steam-assisted gravity drainage at Jackfish, and we expect to begin steam injection in the second quarter of 2007. Production is expected to eventually reach 35,000 barrels per day by the end of 2008 We drilled 19 pairs of producing and steam-injection wells in 2006, bringing the total number of well-pairs to 24. We hold approximately 80,000 net acres in the entire Jackfish area, which can support expansion of the original project. We requested regulatory approval in late September 2006 to increase the scope and size of the original project. We expect to decide in 2007 whether to proceed with this expansion, which could eventually add an additional 35,000 barrels per day of production.

 

Deep Basin  — Our properties in Canada’s Deep Basin include portions of west central Alberta and east central British Columbia. We hold approximately 646,000 net acres in the Deep Basin. The area produces primarily natural gas and natural gas liquids from conventional reservoirs. Our average working interest in the

Deep Basin is 46%. We drilled 115 gross wells in the Deep Basin in 2006 and plan to drill 57 gross wells in the area in 2007.

 

Lloydminster — Our Lloydminster properties are located to the south and east of Jackfish in eastern Alberta and western Saskatchewan. Lloydminster produces heavy oil by conventional means without steam injection. We hold 2.1 million net acres and have a 97% average working interest in our Lloydminster properties. In 2006, we drilled 397 gross wells in the area and plan to drill 395 gross wells in 2007.

 

Peace River Arch — The Peace River Arch is located in west central Alberta. We hold approximately 476,000 net acres in the area, which produces primarily natural gas and natural gas liquids from conventional reservoirs. Our average working interest in the area is about 69%. We drilled 82 gross wells in the Peace River Arch in 2006, and we expect to drill 62 additional wells here in 2007.

 

Northeast British Columbia — Our Northeast British Columbia properties are located primarily in British Columbia and to a lesser extent in north western Alberta. We hold approximately 1.2 million net acres in the area. These properties produce principally natural gas from conventional reservoirs. We hold a 72% average working interest in these properties. We drilled 64 gross wells in the area in 2006, and we plan to drill 68 wells here in 2007.

 

International

 

Azerbaijan — Outside North America, Devon’s largest international property in terms of proved reserves is the Azeri-Chirag-Gunashli (“ACG”) oil field located offshore Azerbaijan in the Caspian Sea. Our production from ACG increased significantly in late 2006 following the payout of carried interest agreements with various partners in the field. Our production will increase again in 2007 as we benefit from a full year of the higher ownership interest after these payouts. We expect our share of ACG production in 2007 to total approximately 12 MMBoe. ACG produces crude oil from conventional reservoirs. We hold approximately 6,000 net acres in the ACG field and have a 5.6% working interest. In 2006, we participated in drilling 15 gross wells at ACG and expect to drill 13 gross wells in 2007.

 

China — Our production in China is from the Panyu field in the Pearl River Mouth Basin in the South China Sea. Panyu produces oil from conventional reservoirs. In addition to Panyu, which is located on block 15/34, we also hold leases in two exploratory blocks offshore China. In total, we have 4.4 million net acres under lease in China. We have a 24.5% working interest at Panyu and 100% working interests in the exploratory blocks. We drilled six gross wells in China in 2006, all in the Panyu field. In 2007, we expect to drill seven gross wells in the Panyu field.

 

Brazil — We expect to commence oil production in Brazil in 2007 from our Polvo field. Polvo, which we operate with a 60% interest, is located offshore in block BM-C-8. In addition to our development project at Polvo, we also hold acreage in nine exploratory blocks. In aggregate, we have 835,000 net acres in Brazil. Our working interests range from 18% to 100% in these blocks. We drilled three gross wells in Brazil in 2006 and plan to drill 11 gross wells in Brazil in 2007.

 

Equatorial Guinea — All of our oil production from the West African country of Equatorial Guinea is from the offshore Zafiro field in the Gulf of Guinea. Zafiro is located on block B, and we also have interests in three additional exploratory blocks. We hold 518,000 net acres in the four blocks combined. Zafiro produces crude oil from conventional reservoirs. Our working interests (participating interests under the terms of the production sharing contracts) range from 24% to 38% in the four blocks. In 2006, we drilled 10 gross wells in Equatorial Guinea, all in the Zafiro field. In 2007, we plan to drill 10 gross wells in Equatorial Guinea. Equatorial Guinea is included in the West African assets we intend to sell during 2007.

 

Title to Properties

 

Title to properties is subject to contractual arrangements customary in the oil and gas industry, liens for current taxes not yet due and, in some instances, other encumbrances. We believe that such burdens do not materially detract from the value of such properties or from the respective interests therein or materially interfere with their use in the operation of the business.

 

As is customary in the industry, other than a preliminary review of local records, little investigation of record title is made at the time of acquisitions of undeveloped properties. Investigations, generally including a title opinion of outside counsel, are made prior to the consummation of an acquisition of producing properties and before commencement of drilling operations on undeveloped properties.

 

Royalty Matters

 

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. We believe we have acted reasonably, have legitimate and strong defenses to all allegations in the suit, and have paid royalties in good faith. We do not currently believe that we are subject to material exposure in association with this lawsuit and no related liability has been recorded in our consolidated financial statements.

 

Equatorial Guinea Investigation

 

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, we received a subpoena issued by the SEC pursuant to a formal order of investigation. We have cooperated fully with the SEC’s requests for information in this inquiry. After responding in 2005 to such requests for information, we have not been contacted by the SEC. In the event that we receive any further inquiries, we will work with the SEC in connection with its investigation.

 

Other Matters

 

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

 

There were no matters submitted to a vote of security holders during the fourth quarter of 2006.

 

Our common stock is traded on the New York Stock Exchange (the “NYSE”). On February 15, 2007, there were 16,228 holders of record of our common stock. The following table sets forth the quarterly high and low sales prices for our common stock as reported by the NYSE and dividends paid per share.

 

 

We began paying regular quarterly cash dividends on our common stock in the second quarter of 1993. We anticipate continuing to pay regular quarterly dividends in the foreseeable future.

 

Issuer Purchases of Equity Securities

 

On August 3, 2005, we announced that our Board of Directors had authorized the repurchase of up to 50 million shares of our common stock. As of the end of the fourth quarter of 2006, 43.5 million shares remain available for purchase under this program. We suspended this stock repurchase program during the second quarter of 2006 in conjunction with our acquisition of Chief. In conjunction with the sales of our Egyptian and West African assets in 2007, we expect to resume this program in late 2007 by using a portion of the sale proceeds to repurchase common stock. Although this program expires at the end of 2007, it could be extended if necessary.

 

The following selected financial information (not covered by the report of independent registered public accounting firm) should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations,” and the consolidated financial statements and the notes thereto included in “Item 8. Financial Statements and Supplementary Data.”

 

 

 

 

 

 

Introduction

 

The following discussion and analysis presents management’s perspective of our business, financial condition and overall performance. This information is intended to provide investors with an understanding of our past performance, current financial condition and outlook for the future. Reference is made to “Item 6. Selected Financial Data” and “Item 8. Financial Statements and Supplementary Data.” Our discussion and analysis will relate to the following subjects:

 

 

Overview of Business

 

Devon is one of the largest U.S. based independent oil and gas producers and processors of natural gas and natural gas liquids in North America. Our portfolio of oil and gas properties provides stable production and a platform for future growth. About 90 percent of our production is from North America. We also operate in selected international areas, including Azerbaijan, Brazil and China. Our production mix is about 65 percent natural gas and 35 percent oil and natural gas liquids such as propane, butane and ethane. We are currently producing about 2.3 billion cubic feet of natural gas each day, or about 3 percent of all the gas consumed in North America.

 

In managing our global operations, we have an operating strategy that is focused on creating and increasing value per share. Key elements of this strategy are replacing oil and gas reserves, growing production and exercising capital discipline. We must also control operating costs and manage commodity pricing risks to achieve long-term success. The discussion and analysis of our results of operations and other related information will refer to these factors.

 

 

 

Overview of 2006 Results and Outlook

 

2006 was one of the best years in Devon’s history. We achieved key operational successes and continued to execute our strategy to increase value per share. As a result, we delivered record amounts for earnings per share and operating cash flow and grew proved reserves to a new all-time high. Key measures of our financial and operating performance for 2006, as well as certain operational developments, are summarized below:

 

 

We produced 214 million Boe in 2006, representing a 4% decrease compared to 2005. Excluding the effects of production lost due to the sale of non-core properties in the first half of 2005, our year-over-year production remained constant. Operating costs increased due to inflationary pressure driven by the effects of

higher commodity prices and due to the weakened U.S. dollar compared to the Canadian dollar. Per unit lease operating expenses increased 17% to $6.95 per Boe.

 

During 2006, we utilized cash on hand, cash flow from operations, and $1.8 billion of commercial paper borrowings to fund our capital expenditures, repay $862 million in debt and repurchase $253 million of our common stock. We ended the year with $1.3 billion of cash and short-term investments.

 

From an operational perspective, our deepwater Gulf of Mexico exploration program has reached several important milestones related to the Lower Tertiary trend. To date, we have drilled four discovery wells in the Lower Tertiary — Cascade in 2002, St. Malo in 2003, Jack in 2004 and Kaskida in the third quarter of 2006. Also in the third quarter of 2006, we announced the successful production test of the Jack No. 2 well in the Lower Tertiary. We currently hold 273 blocks in the Lower Tertiary and have identified 19 additional exploratory prospects within these blocks to date. These achievements support our positive view of the Lower Tertiary and demonstrate the growth potential of our high-impact exploration strategy on long-term production, reserves and value.

 

On June 29, 2006, we acquired Chief’s oil and gas assets located in the Barnett Shale area of Texas for $2.2 billion. This transaction added 99.7 million Boe of proved reserves and 169,000 net acres to our Barnett Shale assets. This acquisition combined with our organic growth continues to extend our leadership position in the Barnett Shale and provides years of additional drilling inventory.

 

On November 14, 2006, we announced our plans to divest our operations in Egypt. At December 31, 2006, Egypt had proved reserves of eight million Boe. Subsequently, on January 23, 2007, we announced our plans to divest our operations in West Africa, including Equatorial Guinea, Cote d’Ivoire, and other countries in the region. At December 31, 2006, our West Africa operations had proved reserves of 90 million Boe, or 4% of total proved reserves. We anticipate completing the sale of our Egyptian assets in the first half of 2007 and our West African assets in the third quarter of 2007. Divesting these properties will allow us to redeploy our financial and intellectual capital to the significant growth opportunities we have developed onshore in North America and in the deepwater Gulf of Mexico. Additionally, we will sharpen our focus in North America and concentrate our international operations in Brazil and China, where we have established competitive advantages.

 

Looking to 2007, we intend to use the proceeds from the sales of our operations in Egypt and West Africa to repay our outstanding commercial paper and resume common stock repurchases. In addition, our operational accomplishments to date have laid the foundation for continued growth in future years, at competitive unit costs, that we expect will continue to create additional value for our investors. In 2007, we expect to deliver reserve additions of 350 to 370 million Boe with related capital expenditures in the range of $5.3 to $5.7 billion. We expect production related to our continuing operations to increase approximately 10% from 2006 to 2007, which reflects the significant reserve additions in 2005 and 2006, and those expected in 2007.

 

Results of Operations

 

Revenues

 

Changes in oil, gas and NGL production, prices and revenues from 2004 to 2006 are shown in the following tables. The amounts for all periods presented exclude our Egyptian operations. Unless otherwise stated, all dollar amounts are expressed in U.S. dollars.