In late October, Denbury Resources (NYSE:DNR) unveiled that it had agreed to buy fellow oil producer Penn Virginia (NASDAQ:PVAC) for $1.7 billion in cash and stock. Investors immediately voiced their disapproval of the deal, which along with crashing oil prices, has put significant pressure on Denbury's stock price.
CEO Chris Kendall, however, firmly believes that this combination makes sense. He reiterated why on the company's fourth-quarter conference call.
A strong strategic fit
In discussing the pending Penn Virginia transaction, Kendall stated on the call that:
Denbury and Penn Virginia are two complementary businesses, and we think combining the strengths of our respective assets and capabilities creates a unique opportunity to deliver value. For Denbury, adding scale in the Eagle Ford provides a platform for the next generation of enhanced oil recovery [EOR]. At the same time, Penn Virginia will be benefiting from Denbury's industry-leading EOR expertise and access to our extraordinary [carbon dioxide] resource, providing a step change to EOR.
Investors have questioned the strategic fit since the two companies utilize two very different techniques to produce oil. Denbury uses carbon dioxide to enhance the recovery of legacy oil fields, while Penn Virginia employs horizontal drilling and hydraulic fracturing to develop the Eagle Ford Shale.
Kendall, however, sees these businesses as being complementary. That's because Denbury will benefit from the faster growth potential of shale drilling in the near term, while transferring its EOR expertise into the Eagle Ford in the future to coax more oil out of that play as it matures, building on the learning of others that have already started using EOR in the region.
Kendall also noted that Denbury has "a highly resilient set of long-lived low-decline assets, which creates a stable production base with strong cash flow." Meanwhile, the "remaining primary development on Penn Virginia's acreage provides opportunistic high-return, flexible investment optionality."
As such, in combining the two, the operating model for the new Denbury, he said, will be: "flexible, growing, and sustainable. Even before considering incremental EOR production, we expect that the combination will provide 5% to 10% annual production growth, remaining heavily oil weighted, and generating strong operating margins and free cash flow." That's an improvement for Denbury on a stand-alone basis since it's on track for a slight production decline this year without Penn Virginia.
The deal still makes sense at lower oil prices
Kendall also addressed investors' concerns about the deal in light of the sharp decline in oil prices since early October, noting that the company reworked its projections based on lower oil prices. It now assumes oil in the range of $55 to $60 a barrel over the next few years as opposed to its prior projections based on $60 to $70 oil. As a result, Kendall stated that "capital expenditures have been moderated for both stand-alone companies, and the current estimates assume a two-rig program in the Eagle Ford for 2019 and '20, shifting back to a three-rig program in 2021."
Even with that reduced projection, the combined company can still expand production at a 5% to 10% compound annual growth rate over those three years. Further, it can achieve that healthy growth rate while living well below its means. In 2019, for example, Denbury could produce between $100 million to $200 million in free cash flow, which is double what it could do on a stand-alone basis, and that's assuming a slight production decline.
Meanwhile, the combined company would continue generating significant free cash flow in 2020 and 2021, which it could use to pay down debt. That would help reduce Denbury's leverage ratio from 4.2 times at the end of last year to a "very respectable 2.5 times by 2021," which Kendall thinks "is a great place to be, and we believe there will be opportunities to improve upon that and drive it even lower over the longer term."
The combination looks good on paper
As Kendall lays out, there's a lot to like about this combination. Not only will it enhance Denbury's near-term growth prospects, but it also provides long-term EOR upside in the Eagle Ford. Furthermore, the combined company can still generate healthy cash flow at lower oil prices, which will help improve its balance sheet.
However, while the numbers look intriguing, the proof will be whether the company can successfully develop the Eagle Ford shale both through drilling additional horizontal wells and then employing EOR to older locations. That's much harder to quantify since Denbury doesn't have any experience in either area, which is why investors remain skeptical as to whether this deal will deliver the anticipated results.