In late March, Denbury Resources (DNR) and Penn Virginia (ROCC 3.29%) terminated their merger agreement. Investors simply didn't like the deal and, in the end, the companies' leaders decided it wasn't worth the fight. That decision, however, has material long-term and short-term implications for Denbury. Here's what to expect from the company over the next year or so.
Scrapping the deal
Denbury and Penn Virginia were an odd pairing because the two energy exploration and production companies operated in different regions and, perhaps more importantly, used entirely different resource extraction techniques. Denbury's belief was that it could mix the two approaches to enhance production, but investors were leery of the idea. In the end, the skeptics prevailed, and the two companies amicably agreed to go their separate ways.
That leaves Denbury in the same position it was before. With a roughly $500 million market cap, it's a small oil driller with operations in the Rocky Mountain and Gulf Coast regions. Its primary approach is to inject carbon dioxide into hydrocarbon formations, which increases the pressure and pushes otherwise unrecoverable oil and natural gas out of wells. (By contrast, Penn Virginia's primary approach is hydraulic fracturing, aka fracking.) Denbury's production is weighted toward oil.
None of that is bad. In fact, in some ways Denbury's operations, heavy on oil, appear well-positioned relative to those of its peers. The fly in the ointment is its balance sheet.
A slow fix
One of the reasons that Penn Virginia was an attractive acquisition target for Denbury was that it's a financially healthier company. Its financial-debt-to-equity ratio of around 0.8 is well below Denbury's, which was nearly 3 at the end of the first quarter. Interestingly, Denbury's debt profile is actually much improved -- it has reduced its total long-term debt by around 25% in the past five years.
With the deal now defunct, Denbury's leverage is again a big issue. Management is aware of that, and part of its long-term plan is to reduce debt. But there is no way for it to deliver a quick fix -- any material improvement will likely be slow and methodical. In other words, a year from now, Denbury will likely remain a heavily indebted oil driller.
That said, the company just worked with lenders on a debt exchange. The upside is that it was able to reduce debt by a little and, more notably, push its maturities out -- buying more time to deal with its balance sheet. The cost, however, could be steep. The new debt has a convertible feature that would add as many as 92 million shares to the company's share count, a roughly 20% increase from current levels. A stock price advance to $2.43 for 10 out of 15 consecutive trading days is all that's needed to trigger a conversion.
The debt exchange, meanwhile, highlights the plight of a debt-heavy company, since all decisions have to be made with the balance sheet in mind. For example, Denbury's 2019 exploration budget will be 20% to 25% below 2018 levels. That could lead to a production decline of as much as 6% this year. That's not usually the type of result investors hope for when they buy an oil stock. That said, the company is attempting to live within its means while it mends its balance sheet. So it's not good, but it's not exactly bad, either.
Basically, without Penn Virginia, Denbury's debt-heavy balance sheet has returned as a leading issue -- and it's one that will persist for at least the next year, and likely longer. Therefore, the driller is going to be financially constrained over the near term as it works to get its fiscal house in order. It is taking steps, but the convertible debt it issued shows that it is being forced to make tradeoffs that may not be great for investors. Significantly higher oil prices would help ease its pain, but a massive oil rally doesn't appear to be in the cards today. There are better options in the energy patch.