Denbury Resources 2015 Third Quarter Update

Last year’s bounce did not signal a bottom for Denbury Resources (DNR).  The company’s financial and stock price performance this year has been driven by the collapse in the price of oil.  But there is obviously more to the story.  Year-to-date, through Nov. 11, Denbury’s stock is down 53.6%.  By comparison, the price of West Texas Intermediate crude oil is down 19.8%, the S&P 500 Energy Sector Index is down 15.0% and the Dow Jones U.S. Exploration and Production Sector Index is down 11.9%.

The significant underperformance of Denbury’s shares is especially surprising because the company’s financial performance has been pretty good this year, under the circumstances.  Denbury has outperformed the free cash flow target that it set going into the year.  It was one of the first domestic oil & gas producers to announce cuts to its capital spending budget.  Two years ago, it said that it would begin emphasizing cash flow generation over sales and production growth and begin delivering a quarterly dividend to shareholders that would grow over time.

Through the first nine months of 2015, Denbury’s revenues fell 49% to $988 million, but its free cash flow (i.e. cash flow from operating activities less cash used for investing activities) was $272 million, nearly three times the $96 million generated during the comparable period in 2014.  Over that period, EBITDA fell from $1.03 billion to $787 million, but cash flow from operating activities (i.e. after interest, taxes, changes in working capital and other non-cash items) declined only from $885 million to $699 million.  Most of the relatively better performance of CFOA vs. EBITDA was due to lower estimated interest expense and reduced working capital.  Similarly, cash used for investing activities (essentially net capital expenditures) declined sharply from $789 million to $428 million.

Admittedly, the company’s overall performance was aided by the benefits from hedges put in place prior to the start of the year.  That benefit will not be available in 2016, so Denbury will be exposed fully to the low price of oil, should it remain at this level.

To illustrate, the company’s realized price for oil for the first nine months of 2015 was $72.31 per barrel.  Without hedging, it would have realized $49.58.  So the net benefit from hedging was $12.23 per barrel (at a production level around 73,000 barrels per day) over that interim period.

Yet, even without such a benefit in 2016, the company anticipates that it will be cash flow positive as a result of plans to pare further both operating costs and capital expenditures.  Denbury believes that it can achieve this reduction in net spending without hurting production volumes appreciably.

Added support for the company’s ability to weather the storm comes from its relatively strong balance sheet and available liquidity.  At Sept. 30, the company had $3.3 billion of debt outstanding and its ratio of debt-to-capitalization (with equity measured at book value) was 61.1%.  More importantly, Denbury had only $200 million outstanding against its $1.6 billion credit facility (and its borrowing base of $2.6 billion).  Other than this $200 million bank loan, which is up for renewal in 2019, the company faces no major debt maturities until 2021.  I calculate EBITDA coverage of interest expense at 5.8 times on a rolling 12 month basis (as of Sept. 30).  Denbury’s debt is rated B1 by Moody’s (as of July 2015) and BB- by S&P (as of Oct. 2015), which suggests that the threat of default is not imminent.

Yet, as noted in my previous SA article, the sentiment around the stock has been negative for quite some time.  If you listen to management, analyze the cash flow statement and balance sheet and review the sentiment of the credit rating agencies, things do not seem all that bad for Denbury.  In fact, the company’s performance has been surprisingly good.

On the negative side, investors have concerns.  Among them are the significant impairment charges taken by Denbury against the carrying value of its properties and goodwill this year.  With another anticipated charge of $1.8 billion in the fourth quarter, the company will have written down its properties by $6.7 billion or about 65% this year.  That is on top of a $1.3 billion charge to write off the carrying value of goodwill (associated with Denbury’s purchase of Encore Acquisition in 2010.

The property impairment charges were precipitated by the reduction in the price of oil.  Denbury accounts for its properties on a “full cost” basis, under which all development costs are capitalized and later expensed.  This compares to the “successful efforts” basis, where only the costs associated with the development of successful producing properties are capitalized.  Thus, when write-downs are taken under full cost accounting, they are almost always greater in magnitude.

Companies taking impairment charges typically point out that these are non-cash in nature, but in fact they do represent cash expenditures that were made in prior years.  It would be more appropriate to average those write-down charges over an appropriate time frame, say 5-10 years, which in Denbury’s case would substantially reduce its reported historical profits.

In fairness to Denbury and others who have taken similar charges, however, these write-downs are based upon the current low price of oil and so they are greater in magnitude than they would be, if oil were at a more sustainable price.  When prices rise, the value of those properties will not be written up.  Instead, Denbury will then realize a higher profit per barrel based upon its now significantly reduced carrying costs and higher realized sales price.

Besides the impairments, there are other factors that contribute to investor concerns and the negative sentiment surrounding the stock.  Indeed, analyzing Denbury is like staring at the two faces of Janus.  On the one hand, the financial statements, management comments and even the current debt ratings suggest that everything is OK and that the company is performing reasonably well in an extremely tough price environment.  On the other hand, the dismal market performance of the stock, and also Denbury’s outstanding bonds, suggests that the company may be in dire shape that is not reflected adequately in its reported financial results.  Thus, its performance may deteriorate by more than expected when those hedges roll off at the end of the year.

Even though the rating agencies kept the ratings of the company’s outstanding debt issues at solid below-investment-grade levels (B1 for Moody’s; BB- for S&P), the bonds are now trading at 65-70 cents on the dollar with yields ranging from 12%-14% and maturities ranging from 8 to 6 years.  Those yields are more than 1,000 basis points above comparable maturity Treasurys, which is typically the demarcation line for distressed securities.  Denbury’s bond yields are also about 100-200 basis points above comparably rated high yield energy credits.

While management says the company is on the right track, I still have questions.  For example, Denbury has decisively pared operating costs by cutting personnel and changing operating practices, even though it says it is still in the midst of a major operational review, conducted by its Innovation and Improvement Teams (IIT), that will not be completed until 2016.  The current focus is on operating expenses.  The IIT effort will address potential changes to the company’s field development practices (and so are concerned more with future capital spending).  However, it is not clear whether another round of significant operational changes will have to be undertaken.  On top of this, there are concerns about whether will prove sustainable.  For example, Denbury has been able to sustain most of its tertiary production this year, despite cutting CO2 injections by 30%.  But the concern is that these cuts will eventually result in lower production levels in subsequent years.  Although I calculate the company’s current all-in production cost (including interest expense) at about $58 per barrel, Moody’s has said that it is around $70.  The impairment charges taken this year will reduce reported production costs (through the income statement), but cash production costs will be a truer indicator of ongoing production cost levels.

I was originally attracted to Denbury because I thought that its focus on tertiary production was a good alternative to hydraulic fracturing in a country whose thirst for oil will likely never be quenched.  I thought that its focus on CO2 injection into old oil wells was a potentially perfect solution, well suited to growing worldwide calls to reduce carbon emissions.  On top of that, the company’s strategic refocusing in favor of generating cash flow, maximizing return on investment and providing regular (and growing) income to shareholders through the initiation of a dividend (which will be suspended after the 2015 third quarter) also fit well with my investment objectives.  At the time (now more than two years ago), I thought that Denbury could be a great long-term investment.

The stock has obviously been a disaster. Perhaps most distressing of all, much of the drop in the share price has been far in excess of what can be explained by the plunge in commodity prices and yet, by all accounts, the company is performing well, according to its own expectations

It is hard to imagine that the stock can go lower from here without filing for bankruptcy and yet there are no outward signs of financial distress.  There is a reasonable chance that the stock can outperform its peer group going forward, even if oil remains stuck in the mid-40s, provided that the company remains cash flow positive.  In that case, the shares would merely be gaining back part of what it lost in its significant underperformance vs. peers over the past year.  However, the real upside will come if and when oil begins to move back to a sustainable level (which I guess to be in the $70s).  Of all the domestic independents, Denbury is arguably the one most levered to the price of oil.

The upside potential on the stock should by all accounts be significant.  At the current price of $3.77, the stock is trading well below its previous multi-year low of $5.32 set during the 2008 financial crisis.  From 2012 until mid-2014, DNR regularly traded around $18.

For a company Denbury’s size and given the magnitude of the write-downs, pre-tax earnings of $15.00 per barrel should be achievable, if and when oil climbs back toward $75 per barrel.  A $15.00 per barrel pre-tax profit would work out to roughly $0.75 per share in earnings (assuming production of 75,000 barrels per day, a tax rate of 35% and 350 million shares outstanding).  At a multiple of 15, that yields a price target of $11.50 for the stock.

Although it can be said that a lot of the risk is out of the stock, given its extremely low current price, I still characterize DNR as highly speculative.  The bonds are much less speculative, although also not without risk, as evidenced by their drop of about 20 points in a year.  If Moody’s and S&P are correct in their assessments, the bonds are attractive (relative to comparably rated bonds) at current levels.  We won’t really know for sure if the market’s apparent negative sentiment is correct unless the price of oil remains in the mid-40s for an extended period of time and until after the hedges roll off.

November 12, 2015

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey  07036
(908) 448-2246

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