The first nine months of 2018 were amazing for Denbury Resources (NYSE:DNR). Fueled by higher oil prices, the company's stock peaked just shy of a 200% gain by early October. However, it was all downhill from there as shares in the oil producer sold off over the final three months of the year, ending 2018 down nearly 23% due to plunging crude prices and a puzzling acquisition. Because of that, investors likely want to erase last year from their memory banks.
A year of steady progress
Two factors fueled Denbury's big run-up through the third quarter. First, the price of oil was up more than 25% by early October. Those higher prices enabled Denbury Resources to earn more money, which had the added benefit of reducing its leverage ratio. Overall, the company generated $100 million in free cash that it used to repay debt, which when combined with higher earnings, pushed the company's leverage ratio down from an alarming 5.3 times debt to EBITDA in 2017 to a more comfortable 2.9 times by the end of the third quarter after adjusting for the company's oil hedges.
Second, Denbury accomplished nearly everything on its checklist for the year. These items included extending its credit facility, completing successful test wells, and making a final investment decision on a new long-term oil project. Those efforts enabled the company to firm up its financial foundation and add a new short-term growth engine while setting it up for more growth over the longer term.
A downbeat ending to the year
The enthusiasm investors had for Denbury through most of the year faded quickly during the fourth quarter as two concerns weighed on their view of the company, causing the stock to nosedive.
One of those factors was the company's decision to buy Eagle Ford shale driller Penn Virginia (NASDAQ:PVAC) for $1.7 billion in cash and stock. Investors and analysts alike questioned the move because it marks a major departure from Denbury's core business of injecting carbon dioxide to coax more oil out of legacy fields. Several large investors are even planning to vote against the deal because they don't think it's a good fit.
The company, however, believes the acquisition of Penn Virginia will enable it to grow faster in both the short and long term since it can drill shale wells that come on line quickly while also applying its enhanced oil recovery (EOR) expertise to a new region. Furthermore, it sees the transaction boosting cash flow per share while reducing its leverage ratio.
While the transaction has the potential to pay big dividends in the coming years, it's risky. For starters, the acquisition of Penn Virginia represents an outsized bet on oil prices because it enhances Denbury's leverage to crude, since 95% of its production will be oil and liquids -- the highest percentage in the sector. That's a concern because crude prices crashed 40% from their peak during the quarter, adding further weight to Denbury's stock slide.
Meanwhile, the company has a lot riding on its ability to successfully apply its EOR expertise to the Eagle Ford. While leading shale driller EOG Resources and others have had success with EOR in the Texas region, they mainly injected natural gas, which differs from Denbury's process of using carbon dioxide. Because of that, it might not work as well as the company anticipates. Finally, while the deal reduces the combined companies' leverage ratio, it will remain elevated compared with its peer group, which could weigh on the stock if oil prices continue to weaken.
2019 could be another bumpy ride
With several major investors planning to vote against the Penn Virginia deal, the transaction isn't a sure thing. Because of that, 2019 could be a very volatile year for the company as it not only works to win those investors over, but now must deal with much lower oil prices. While shares could soar if oil prices rebound, that upside potential doesn't make Denbury's beaten-down stock worth buying in my opinion, because not only does the company still have a weak balance sheet, but there is also too much uncertainty and risk associated with its acquisition of Penn Virginia.