- 56% increase in revenues.
- Production growth of 4%.
- Adjusted Cash Flow from Operations increased 106% year-over-year.
- Q2 interest coverage was 3.4x
This week’s bond review focuses on a company involved in tertiary oil production. Denbury Resources produces oil using carbon dioxide injections to draw more oil out of fields that have exhausted their production from conventional methods. Denbury has had a fantastic year since our last review of the company and has just posted results from the company’s second quarter. Highlights include:
56% increase in revenues.
Production growth of 4%.
Adjusted Cash Flow from Operations increased 106% year-over-year.
Q2 interest coverage was 3.4x
Denbury has also accomplished a mammoth feat – debt reduction of nearly $1 billion since 2014. The company is set to begin a significant project on its lucrative Cedar Creek Anticline field that is estimated to hold 5 billion barrels. And with long-producing assets, Denbury’s production, once established, is more stable than shale oil wells, which have been the main source of the U.S. oil boom in recent years. The company’s 2021 bonds, already a position within Durig Capital’s Fixed Income 2 (FX2) Managed Income Portfolio, are an ideal candidate for additional weighting given Denbury’s excellent performance, the most recent of the FX2 Portfolio is shown below.
Second Quarter Results
Denbury recently reported its results for the three months ending June 30, 2018. Denbury posted some impressive increases both quarter over quarter and year over year.
Revenues increased 56% year-over-year, from $257 million in Q2 2017 to $382 million in Q2 2018. Also, total revenues increased 9.7% over Q1 2018. Revenue increases were tied to increased production as well as increased oil prices.
Production also showed increases as compared to last year and Q1. Year-over-year, production grew nearly 4%, from 59,774 BOE/d in Q2 2017 to 61,994 BOE/d in Q2 2018. Production grew from 60,338 BOE/d in Q1 to 61,994 BOE/d in Q2, up 3%.
Adjusted cash flow from operations was $134 million in Q2 2018, up 7% from Q1 2018 and 106% from Q2 2017.
Adjusted EBITDAX was $153 million in Q2 2018, a hefty year-over-year increase of 78% ($86 million), and an increase of nearly 8% over Q1 ($142 million).
Denbury has done a fantastic job at cost reduction while increasing its production and maximizing its operating margin to nearly $40 per BOE in Q2.
Chris Kendall, Denbury’s President and CEO commented, “We are committed to retaining the focus and discipline put in place when oil was at $50, even with today’s oil prices well above that point. That focus and discipline will make us even more profitable in today’s environment, and well prepared for the long term”.
Cedar Creek Anticline
Denbury’s Cedar Creek Anticline is an extremely valuable asset in the company’s portfolio. Cedar Creek Anticline (CCA) is the largest potential EOR (enhanced oil recovery) property that Denbury owns and it is currently its largest producing property, contributing approximately 24% of the company’s 2017 total production. The field is primarily located in Montana but covers such a large area (approximately 126 miles) that it also extends into North Dakota. CCA is a series of 14 different operating areas, each of which could be considered a field by itself. Denbury’s position in the CCA covers about 175,000 acres and is estimated to hold up to 5 billion bbl of original oil in place. The company also owns large reserves of CO2.
Denbury recently announced it is moving forward with a $400 million EOR project in the CCA. Tertiary oil production should begin sometime in 2021. Chris Kendall, President and CEO indicated just how valuable this resource is to the company. “We expect this project could ultimately produce more than 400 million bbl through CO2 EOR, much greater than Denbury’s entire current proved reserves base.”
Denbury said the first two phases of the project could generate an estimated $3 billion of cumulative net free cash flow, assuming a crude oil price of $60/bbl. (Kendall indicated that the project would still be attractive at $50/bbl). The company also stated that it could fund the estimated $250 million price tag to achieve initial tertiary production within its existing cash flow.
Continued Debt Reduction
Perhaps the most astounding metric from Denbury is the company’s debt reduction over the past several years. Since 2014, the company has eliminated almost $1 billion in debt from its balance sheet. Over the last seven months, Denbury has reduced the outstanding principal on its long-term notes by $329 million through a series of exchange transactions completed in December 2017 and January 2018 as well as related conversions of all of its convertible notes into equity in April and May 2018.
About the Issuer
Headquartered in Plano, Texas, Denbury Resources Inc. is an independent oil and natural gas company with 254.5 MMBOE of estimated proved oil and natural gas reserves as of December 31, 2016, of which 95% is oil. Denbury’s operations are focused in two key operating areas: the Gulf Coast and Rocky Mountain regions. The company’s goal is to increase the value of its properties through a combination of exploitation, drilling and proven engineering extraction practices, with the most significant emphasis relating to CO2 enhanced oil recovery operations.
What is CO2 Enhanced Oil Recovery
With much of the easy-to-produce oil already recovered from U.S. oil fields, producers have attempted several tertiary, or enhanced oil recovery (EOR), techniques that offer prospects for ultimately producing 30 to 60 percent, or more, of the reservoir’s original oil in place. The most promising of these techniques is gas injection, which uses gases such as natural gas, nitrogen, or carbon dioxide (CO2) that expand in a reservoir to push additional oil to a production wellbore. Gas injection accounts for nearly 60 percent of EOR production in the United States. Denbury has been successfully using this type of tertiary oil recovery in its operations.
Low Decline Assets
The explosion in shale oil / fracking in the past 10 years has greatly reduced the amount of oil the United States imports. But what many may not know, is that shale oil wells have a very short life. They produce robustly for a relatively short period of time, then production declines very rapidly. What this means for fracking companies is that they continue to have to put holes in the ground to keep production stable (or even more if they want to increase production). Here is a typical decline curve for a shale oil well.
(Source: David Hughes, AGU presentation, December 2012)
Enhanced oil recovery (EOR) from established oil fields is typically less risky, since the operator (Denbury) is drilling in an area that has had steady primary oil production. Denbury’s assets decline at at a significantly slower rate than shale oil wells, which means less capital for exploration. And while some may think that tertiary (or EOR) production only yields a small amount of oil, the following graphic shows that tertiary production yields almost as much as primary and secondary oil production.
Interest Coverage and Liquidity
For its most recent quarter, Denbury has registered excellent interest coverage as well as liquidity levels. Denbury quoted Income Before Income Taxes of $39.7 million on its most recent Q2 press release. Adding back the net interest expense gives an operating income of $55.9 million. With a net interest expense of $16.2 million, Denbury has an interest coverage ratio of 3.4x.
Liquidity levels also appear to be solid as well. The company’s credit facility was reaffirmed at $1.05 billion in its semi-annual review. With that said, as of June 30, 2018, Denbury had $573 million available on its credit facility.
The risk for bondholders is whether Denbury can continue to increase production, keep costs low and continue to reduce debt. The company has a fantastic opportunity for increased production in its Cedar Creek Anticline property and has the cash flow from operations to fund this expansion. Estimated production numbers for 2018 show production growing over 2017 levels and with oil prices continuing their slow and steady march up, this could again provide revenue increases over last year. Company management is also committed to continued debt reduction. As long as free cash flow continues to grow, Denbury will continue to have the opportunity to improve its balance sheet. With Denbury’s production increasing, costs decreasing and debt coming down, the about 8.0% yield-to-maturity on the company’s 2021 bonds does appear to outweigh the risks identified.
As nearly all of Denbury’s revenues come from the sale of oil, the company is significantly exposed to fluctuations in the price of oil on a daily basis. If the price of oil were to decrease significantly, it could affect the company’s ability to generate enough cash flow for daily operations as well as to pay bondholder interest.
In general, bond prices rise when interest rates fall and vice versa. This effect tends to be more pronounced for lower couponed, longer-term debt instruments. Any fixed income security sold or redeemed prior to maturity may be subject to a gain or loss. Higher yielding bonds typically have lower credit ratings, if any, and therefore involve higher degrees of risk and may not be suitable for all investors.
Summary and Conclusion
Denbury posted a very solid quarter. The company surprised analyst’s in Q2, beating EPS estimates by $0.02 (actual $0.13 vs estimates of $0.11). It had numerous financial metrics that grew not only year-over-year, but also showed consecutive growth over Q1 financials. Debt continues to decrease, making a more attractive balance sheet. If the company can leverage its lucrative Cedar Creek Anticline property in the next few years, and oil prices remain stable, the company could see significant growth in revenues and profits. Durig Capital already holds a position in these 2021 bonds, but given Denbury’s excellent Q2 performance, these bonds make an outstanding candidate for additional weighting in the Fixed Income 2 (FX2) Managed Income Portfolio, the most recent performance of which is shown above.
Issuer: Denbury Resources, Inc.
Ratings: Caa3 / CCC-
Yield to Maturity: ~7.76%
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Disclosure: Durig Capital and certain clients may hold positions in Denbury Resources’ August 2021 bonds.
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