1.     Summary of Significant Accounting Policies 

The accompanying unaudited consolidated financial statements and notes of Devon Energy Corporation (“Devon”) have been prepared pursuant to the rules and regulations of the United States Securities and Exchange Commission. Pursuant to such rules and regulations, 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 should be read in conjunction with the consolidated financial statements and notes included in Devon's 2008 Annual Report on Form 10-K. 

The unaudited interim consolidated financial statements furnished in this report reflect all adjustments that are, in the opinion of management, necessary to a fair statement of Devon's financial position as of September 30, 2009 and Devon's results of operations and cash flows for the three-month and nine-month periods ended September 30, 2009 and 2008. To prepare the accompanying financial statements and notes, Devon's management evaluated events or transactions that occurred subsequent to September 30, 2009 and before November 5, 2009, which was the date these financial statements were issued.

Recently Issued Accounting Standards Not Yet Adopted

In December 2008, the Financial Accounting Standards Board ("FASB") updated Accounting Standards Codification ("ASC") Topic 715 Compensation – Retirement Benefits, regarding employers' disclosures about postretirement benefit plan assets. This ASC update requires additional disclosures about the types of assets and associated risks in an employer's defined benefit pension or other postretirement plan. It is effective for fiscal years ending after December 15, 2009. Devon is evaluating the impact the adoption of this ASC update will have on its financial statement disclosures. However, Devon's adoption of this ASC update will not affect its current accounting for its pension and postretirement plans.  

Modernization of Oil and Gas Reporting

In December 2008, the SEC adopted revisions to its required oil and gas reporting disclosures. Additionally, on two separate occasions in October 2009, the SEC issued certain compliance and disclosure interpretations of its oil and gas rules. The disclosure revisions are intended to provide investors with a more meaningful and comprehensive understanding of oil and gas reserves. In the three decades that have passed since adoption of these disclosure items, there have been significant changes in the oil and gas industry. The amendments are designed to modernize and update the oil and gas disclosure requirements to align them with current practices and changes in technology. In addition, the amendments concurrently align the SEC's full cost accounting rules with the revised disclosures. The revised disclosure requirements must be incorporated in registration statements filed on or after January 1, 2010, and annual reports on Form 10-K for fiscal years ending on or after December 31, 2009. A company may not apply the new rules to disclosures in quarterly reports prior to the first annual report in which the revised disclosures are required.

The following amendments have the greatest likelihood of affecting Devon's reserve disclosures, including the comparability of its reserves disclosures with those of its peer companies:

·         Pricing mechanism for oil and gas reserves estimation – The SEC's current rules require proved reserve estimates to be calculated using prices as of the end of the period and held constant over the life of the reserves. Price changes can be made only to the extent provided by contractual arrangements. The revised rules require reserve estimates to be calculated using a 12-month average price. The 12-month average price will also be used for purposes of calculating the full cost ceiling limitations. Price changes can still be incorporated to the extent defined by contractual arrangements. The use of a 12-month average price rather than a single-day price is expected to reduce the impact on reserve estimates and the full cost ceiling limitations due to short-term volatility and seasonality of prices.

·         Reasonable certainty – The SEC's current definition of "proved oil and gas reserves" incorporate certain specific concepts such as "lowest known hydrocarbons," which limits the ability to claim proved reserves in the absence of information on fluid contacts in a well penetration, notwithstanding the existence of other engineering and geoscientific evidence. The revised rules amend the definition to permit the use of new reliable technologies to establish the reasonable certainty of proved reserves. This revision also includes provisions for establishing levels of lowest known hydrocarbons and highest known oil through reliable technology other than well penetrations.

The revised rules also amend the definition of proved oil and gas reserves to include reserves located beyond development spacing areas that are immediately adjacent to developed spacing areas if economic producibility can be established with reasonable certainty. These revisions are designed to permit the use of reliable technologies to establish proved reserves in lieu of requiring companies to use specific tests. In addition, they establish a uniform standard of reasonable certainty that applies to all proved reserves, regardless of location or distance from producing wells.

Because the revised rules generally expand the definition of proved reserves, Devon expects its proved reserve estimates will increase upon adoption of the revised rules. However, Devon is not able to estimate the magnitude of the potential increase at this time.

·         Unproved reserves – The SEC's current rules prohibit disclosure of reserve estimates other than proved in documents filed with the SEC. The revised rules permit disclosure of probable and possible reserves and provide definitions of probable reserves and possible reserves. Disclosure of probable and possible reserves is optional. However, such disclosures must meet specific requirements. Disclosures of probable or possible reserves must provide the same level of geographic detail as proved reserves and must state whether the reserves are developed or undeveloped. Probable and possible reserve disclosures must also provide the relative uncertainty associated with these classifications of reserves estimations. Devon has not yet determined whether it will disclose its probable and possible reserves in documents filed with the SEC.

2.  Accounts Receivable

The components of accounts receivable include the following:

3.  Derivative Financial Instruments

Devonperiodically enters into commodity and interest rate derivative financial instruments. These instruments are used to manage the inherent uncertainty of future revenues due to oil and gas price volatility and to manage Devon's exposure to interest rate volatility. Also, during the first eight months of 2008, Devon was subject to an embedded option derivative related to the fair value of its debentures exchangeable into shares of Chevron common stock.

The following table presents the fair values of derivative assets and liabilities included in the accompanying balance sheets. None of Devon's derivative instruments included in the table have been designated as hedging instruments.

The following table presents the cash settlements and unrealized gains and losses on fair value changes included in the accompanying statements of operations associated with these derivative financial instruments. None of Devon's derivative instruments included in the table have been designated as hedging instruments.

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(1)   Cash settlements and unrealized gains and losses on fair value changes associated with Devon’s gas price collars, gas price swaps and oil price collars have been recorded in the “Net gain (loss) on oil and gas derivative financial instruments” line item in the accompanying statements of operations. 

(2)   Cash settlements and unrealized gains and losses on fair value changes associated with Devon’s interest rate swaps and embedded option have been recorded in the “Change in fair value of other financial instruments” line item in the accompanying statements of operations. 

4.     Other Current Assets

  The components of other current assets include the following: 

5.     Property and Equipment

In the first quarter of 2009, Devon reduced the carrying values of certain of its oil and gas properties due to full cost ceiling limitations. These reductions are discussed in Note 14.

6.     Goodwill

During the first nine months of 2009, Devon's goodwill increased $350 million. This increase related to Devon's Canadian goodwill and was entirely due to foreign currency translation.

7.     Debt

5.625% Senior Notes Due January 15, 2014 and 6.30% Senior Notes Due January 15, 2019

In January 2009, Devon issued $500 million of 5.625% senior unsecured notes due January 15, 2014 and $700 million of 6.30% senior unsecured notes due January 15, 2019. The net proceeds received of $1.187 billion, after discounts and issuance costs, were used primarily to repay Devon's $1.0 billion of outstanding commercial paper as of December 31, 2008.

Credit Lines

Devon has two syndicated, unsecured revolving lines of credit that can be accessed to provide liquidity as needed. The following schedule summarizes the capacity of Devon's credit facilities by maturity date, as well as its available capacity as of September 30, 2009.

On November 3, 2009 Devon’s unused $700 million short-term facility matured. On November 3, 2009, Devon established a new $700 million 364-day, syndicated, unsecured revolving senior credit facility (the “Short-Term Facility”). The Short-Term Facility matures on November 2, 2010. On the maturity date, all amounts outstanding will be due and payable at that time. Amounts borrowed under the Short-Term Facility bear interest at various fixed rate options for periods of up to 12 months. Such rates are generally based on LIBOR or the prime rate. The Short-Term Facility provides for an annual facility fee of approximately $1.75 million that is payable quarterly in arrears.

The credit facilities contain only one material financial covenant. This covenant requires Devon’s ratio of total funded debt to total capitalization to be less than 65%. The credit agreement contains definitions of total funded debt and total capitalization that include adjustments to the respective amounts reported in the consolidated financial statements. Also, total capitalization is adjusted to add back noncash financial writedowns such as full cost ceiling impairments or goodwill impairments. As of September 30, 2009, Devon was in compliance with this covenant. Devon’s debt-to-capitalization ratio at September 30, 2009, as calculated pursuant to the terms of the agreement, was 21.3%. 

Commercial Paper

Subsequent to the $1.0 billion commercial paper repayment in January 2009, Devon utilized additional net commercial paper borrowings of $1.4 billion to fund capital expenditure payments in excess of cash generated by operating activities during the first nine months of 2009. As of September 30, 2009, Devon’s average borrowing rate on its $1.4 billion of commercial paper debt was 0.32%.

8.     Asset Retirement Obligations  

The following is a summary of the changes in Devon’s asset retirement obligations (“ARO”) for the first nine months of 2009 and 2008.

9.     Retirement Plans

Net Periodic Benefit Cost and Other Comprehensive Income

The following table presents the components of net periodic benefit cost and other comprehensive income for Devon’s pension and other post retirement benefit plans for the three-month and nine-month periods ended September 30, 2009 and 2008.

Devon previously disclosed in its 2008 Annual Report on Form 10-K that it expected to contribute up to approximately $183 million to its defined benefit pension plans in 2009 and $5 million to its defined benefit postretirement plans in 2009. Devon has revised its estimate of 2009 defined benefit pension plan contributions to $55 million. As of September 30, 2009, Devon has contributed $42 million to its defined benefit pension plans and $3 million to its defined benefit postretirement plans.

10.  Stockholders' Equity  

Stock Repurchases

During the first nine months of 2008, Devon repurchased 6.5 million common shares for $665 million, or $102.56 per share, under programs approved by its Board of Directors. The 6.5 million common shares include 4.5 million shares that were repurchased under Devon's 50 million share repurchase program and 2.0 million shares that were repurchased under Devon's ongoing, annual stock repurchase program.  No such repurchases were made during the first nine months of 2009.

Dividends

Devon paid common stock dividends of $213 million and $211 million (quarterly rates of $0.16 per share) in the first nine months of 2009 and 2008, respectively. Devon paid preferred stock dividends of $5 million in 2008. Devon redeemed all 1.5 million outstanding shares of its preferred stock on June 20, 2008.

11.    Commitments and Contingencies

Devon is party to various legal actions arising in the normal course of business. Matters that are probable of unfavorable outcome to Devon and that 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. However, actual amounts could differ materially from management's estimate.

Environmental Matters

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 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 September 30, 2009, Devon's balance sheet included $1 million of accrued liabilities, reflected in other long-term 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.

Royalty Matters

Numerous natural 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 NGLs 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 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 April 12, 2007, the court entered a trial plan and scheduling order in which the case will proceed in phases. Two phases have been scheduled to date. The first phase was scheduled to begin in August 2008, but the defendant settled prior to trial. The second phase was scheduled to begin in February 2009, but the defendants settled prior to trial. Devon was not included in the groups of defendants selected for these first two phases. 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 with respect to this lawsuit. Therefore, no liability related to this lawsuit has been recorded.

In 1995, the United States Congress passed the Deep Water Royalty Relief Act. The intent of this legislation was to encourage deep water exploration in the Gulf of Mexico by providing relief from the obligation to pay royalties on certain federal leases. Deep water leases issued in certain years by the Minerals Management Service (the "MMS") have contained price thresholds, such that if the market prices for oil or gas exceeded the thresholds for a given year, royalty relief would not be granted for that year.

In October 2007, a federal district court ruled in favor of a plaintiff who had challenged the legality of including price thresholds in deep water leases. Additionally, in January 2009 a federal appellate court upheld this district court ruling. This judgment was later appealed to the United States Supreme Court, which, in October 2009, declined to review the appellate court's ruling. The Supreme Court's decision ended the MMS's judicial course to enforce the price thresholds.

Prior to September 30, 2009, Devon had $84 million accrued for potential royalties on various deep water leases. Based upon the Supreme Court's decision, Devon reduced to zero the $84 million loss contingency accrual in the third quarter of 2009. The $84 million expense reduction is included in other income in the accompanying 2009 statements of operations.

Other Matters

Devon is involved in other various routine legal proceedings incidental to its business. However, to Devon's knowledge as of the date these financial statements were issued, neither Devon nor its property is subject to any material pending legal proceedings.

12.  Fair Value Measurements 

Certain of Devon's assets and liabilities are reported at fair value in the accompanying balance sheets. Such assets and liabilities include amounts for both financial and nonfinancial instruments. The following tables provide carrying value and fair value measurement information for such assets and liabilities as of September 30, 2009 and December 31, 2008.

A summary of the changes in Devon's asset retirement obligations during the first nine months of 2009 is included in Note 8. Included below is a summary of the changes in Devon's other Level 3 fair value measurements during the first nine months of 2009 (in millions).

13.  Change in Fair Value of Other Financial Instruments

The components of the change in fair value of other financial instruments are presented in the following table.

14.  Reduction of Carrying Value of Oil and Gas Properties

In the first quarter of 2009, Devon reduced the carrying values of certain of its oil and gas properties due to full cost ceiling limitations. A summary of these reductions and additional discussion is provided below.

The United States reduction resulted primarily from a significant decrease in the full cost ceiling during the first three months of 2009. The lower ceiling value in the United States largely resulted from the continued effects of declining natural gas prices subsequent to December 31, 2008.

Although oil prices improved subsequent to December 31, 2008, Brazil's reduction resulted largely from an exploratory well drilled at the BM-BAR-3 block in the offshore Barreirinhas Basin. After drilling this well in the first quarter of 2009, Devon concluded that the well did not have adequate reserves for commercial viability. As a result, the seismic, leasehold and drilling costs associated with this well contributed to the reduction recognized in the first quarter of 2009.

To demonstrate the changes in the full-cost ceiling for the United States and Brazil, the March 31, 2009 and December 31, 2008 weighted average wellhead prices are presented in the following table.

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N/A – Not applicable.

The March 31, 2009 oil and gas wellhead prices in the table above compare to the NYMEX cash price of $49.66 per Bbl for crude oil and the Henry Hub spot price of $3.63 per MMBtu for gas. The December 31, 2008 oil and gas wellhead prices in the table above compare to the NYMEX cash price of $44.60 per Bbl for crude oil and the Henry Hub spot price of $5.71 per MMBtu for gas.

15.  Other Income

The components of other income are presented in the following table.

16.  Income Taxes

In the third quarter of 2009, Devon recognized $59 million of income tax benefits in conjunction with the filing of its 2008 and certain amended 2005, 2006 and 2007 income tax returns. These tax benefits consist of deferred tax benefits of $50 million and current tax benefits of $9 million. Of the $59 million, $41 million relates to taxation on foreign operations. The remaining $18 million relates to taxation on U.S. federal and state operations.

Also in the third quarter of 2009, Devon recognized a $22 million current tax benefit related to certain unsuccessful international drilling results.