Denbury Resources (DNR) recently surprised its investors by agreeing to acquire Eagle Ford shale driller Penn Virginia (ROCC) for $1.7 billion. While the deal caught investors off guard, the company's management team wanted them to know it was a well-thought-out move. That's why they devoted some time on the third-quarter conference call to discuss the transaction. Here are four things they wanted investors to know about the deal.

1. The acquisition doesn't represent a strategy shift

CEO Chris Kendall led off the discussion on the Penn Virginia deal by addressing questions that have arisen since the company announced the transaction. The first was whether it marked a strategy shift since Denbury primarily uses enhanced oil recovery (EOR) techniques such as injecting carbon dioxide into legacy fields to boost production, while Penn Virginia drills horizontal wells into shale formations. The CEO answered by saying:

This transaction is not a shift in strategy. It is a reinforcement that I see fitting perfectly with Denbury's strategy, and here's why. At our core, we are an oil-focused, enhanced oil recovery specialist, committed to generating more cash than we spend. We've developed conventional EOR projects across the country, and we see the next big opportunity for EOR in the unconventional Eagle Ford. Primary development of Penn Virginia's unconventional position adds significant and flexible short-cycle growth capacity and generates even more free cash flow than Denbury does all on its own, all while providing the foundation to apply Denbury's EOR expertise in this emerging, exciting arena.

In other words, while the deal will provide Denbury with a short-term growth engine as it drills shale wells, the company sees significant long-term upside by applying its EOR expertise to the region.

An oil pump next to some storage tanks.

Image source: Getty Images.

2. Here's why they're confident EOR will work in the Eagle Ford

Kendall then provided investors with four reasons why he believes EOR will work in the Eagle Ford:

  1. EOR in the Eagle Ford is very real, working right now, right with them in Gonzales County.
  2. The EOR upside is significant, extending the life of wells and recovering 30% to 70% more oil.
  3. Denbury will attack the Eagle Ford EOR opportunity immediately, driving it toward commercial development by 2021.
  4. Only Denbury has the capacity to deliver significant quantities of low-cost CO2 for injection, with the potential to recover even more oil.

Kendall noted that other oil companies are already working on EOR projects in the Eagle Ford. One of the early leaders is EOG Resources (EOG -1.44%), which has been testing EOR for years. EOG Resources first detailed its success in 2016 and has continued making progress on its program in the years since. EOG noted that it's earning a more-than-30% return on its EOR investments, which have boosted well recovery rates of 30% to 70%.

Denbury will start working on EOR projects in the region immediately. However, instead of injecting natural gas, it plans to pump carbon dioxide into its wells. If those initial tests prove successful, the company plans to build a pipeline from its EOR properties along the coast, which will enable it to efficiently flood its properties with carbon dioxide by 2021.

3. The deal will accelerate its growth rate

While the long-term potential of applying EOR to the Eagle Ford is what drew Denbury to Penn Virginia, Denbury sees the deal providing an immediate benefit since it plans to continue drilling horizontal wells on the acquired acreage. Because of that, Kendall believes that "the combined company will grow production at a greater than 10% annual rate from 2019 and 2020." That's a notable acceleration for Denbury, which experienced a 4% production decline in 2017 and is on pace to keep its output roughly flat this year. Meanwhile, Kendall noted that "after 2020, we expect sustained production growth, underpinned by continued unconventional Eagle Ford development, coupled with EOR development in the Eagle Ford, and response from our Cedar Creek Anticline (CCA) EOR project." 

Several oil pumps in a field.

Image source: Getty Images.

4. The combined company will become a free cash flow machine

In addition to accelerating its production growth rate, Denbury sees the deal positioning it to generate significant free cash flow. Kendall noted on the call that, based on Denbury's planned spending and production levels, and assuming oil averages between $60 and $70 a barrel, "we expect to generate up to approximately $200 million of free cash flow in 2019 and a range of $300 million to $600 million-plus in 2020." That would enable the company to quickly pay down debt so that it could hit its leverage target by 2020.

However, it's worth noting that oil prices have fallen sharply in the past month and are now closer to $50 a barrel. Because of that, the company might need to readjust its spending plan for 2019 so that it can match capital expenditures with cash flow -- although it does have the potential to generate significant excess cash in the future at lower oil prices once its large-scale EOR projects come online.

The bold bet needs everything to go right to pay off

Denbury Resources believes that its acquisition of Penn Virginia will pay big dividends in the coming years. Not only should it immediately accelerate the company's production growth rate and generate free cash flow, but Denbury sees significant EOR upside as it applies its expertise to Penn Virginia's Eagle Ford acreage. However, for the deal to pay off as well as Denbury hopes, oil prices need to rebound and carbon dioxide has to prove to be just as potent as natural gas in enhancing production from Penn Virginia's wells. If that's not the case, then this transaction could turn out to be a bust.