Denbury Resources: Investing in American Energy Independence
James is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When oil prices fluctuate with the vicissitudes of the market, talking heads will note that a drop in oil prices is a sign that the economy is bad; but when those prices recover you will also hear that the rise in oil prices will hurt the economy. Violent fluctuations in price are often speculation about the direction of global growth, but long-term oil prices eventually form an equilibrium. Overreactions to market moves occur in either direction, but fear often creates investing opportunities in the energy space.
Volatility in NYMEX oil prices is not unique to the commodity itself, but also to companies where the price of a barrel of oil affects the value of their assets. Short-term negative market sentiment should be taken advantage of by those with long-term vision. In a series of articles, I will explore companies with strong American energy assets (natural gas and oil), strong competitive positions, and outsized future growth, including EOG Resources (NYSE: EOG), Range Resources (NYSE: RRC), and Denbury Resources (NYSE: DNR). EOG has been one of the leaders in horizontal drilling in the abundant U.S shale formations and has displayed incredible recent growth. Range Resources focuses on natural gas, one of the key fuels tied to future economic growth in the U.S., making it a key component in realizing the potential for domestic energy independence. However, my focus today is on the the unique strategy utilized by Denbury and why it represents a smart long-term investment.
Denbury’s stock has dropped along with recent volatility in oil prices, but has yet to rebound. Q2 2012 earnings were released this morning, and while lower oil prices did have a negative effect on revenues, stronger production helped to offset lower prices and help the company beat on EPS. Short-term thinking has caused Denbury Resources to drop to an attractive entry point for the long-term investor who recognizes the value of the company’s long-term strategy and their undervalued assets.
Denbury’s Competitive Advantage
Denbury Resources focuses on enhanced oil recovery (EOR), a practice that the oil & gas industry has employed since the 1970s. The carbon dioxide injections act as a solvent, mixing with oil, releasing it from the bedrock, while also trapping the majority of the carbon dioxide. Conventional drilling yields 40% of the potential oil, while EOR can increase recovery to approximately 50-60%.
Denbury competes with oil drillers domestically and abroad for U.S. marketshare. While there are other companies that utilize EOR, it is Denbury's core competency. They are unique in that they own two low-cost sustainable sources of carbon dioxide in wells both in the Gulf (the only significant local source) and the Rockies, and deploy it via a pipeline infrastructure. Many of their current assets are yet untapped as they continue an aggressive build out of their pipelines with 1,000 miles currently operated or under construction.
Denbury’s expertise, assets, and infrastructure are a sustainable competitive advantage, and have resulted in a process that has lower risk than many conventional drillers because the trial and error of finding the oil is removed. They have limited direct EOR competition in the areas they operate given their access to low-cost carbon dioxide, which combined with the means to deliver it has resulted in strong operating results and a relatively low cost per barrel of oil. The company can be strongly profitable even with fluctuations in oil prices.
Underappreciated Assets
From 2009 to 2011, Denbury increased their proven reserves from 14.6 (nat gas) and 192.9 (oil) million barrels of oil equivalent (MMBOE) to 104.2 to and 357.7 (MMBOE), respectively. At the end of 2011, Denbury had 462 million barrels in total proven reserves (nat gas and oil), and the company estimates that their current asset base includes the potential for 800 million barrels of yet untapped reserves. Furthermore, they believe they can expand their record tertiary oil production of just over 33,000 barrels a day today in Q1 2012 to over 100,000 barrels a day by 2020. Due to their Encore acquisition in 2009, they also have conventional reserves in Bakken Shale that grew 164% in Q1 2012 (YOY) with 200,000 net acres that are prospective.
The Valuation
The market not only undervalues Denbury’s proven reserves and the potential of their unexplored assets, but also does not seem to appreciate the company’s aggressive growth or their operational efficiency.
The company had record-breaking production in Q1 & Q2 2012 (16% increase over Q2 2011), continued their expansion plan by increasing capital spending on their pipeline infrastructure, and strengthening their balance sheet by selling non-core assets. They reported 25% growth in Q1 revenues (YOY) and flat Q2 (YOY) revenues due to a drop in oil prices during the quarter, but they continued to execute with record production. While they do have a considerable amount of debt, they have a strong cash flow and excellent operating margins.
At an intraday per share price of $14.50, the company has a P/E (TTW) of 8.69 (historic P/E 5-year average of 32), a .49 PEG ratio, trades at a price/book of 1.2, and operates with incredible efficiency. Denbury earns $535,000 per employee on revenues of $1,850,000. When one considers their operating metrics along with the value of their assets, Denbury represents a rare opportunity to buy a growing company at a remarkable valuation.
The Risks
The risks include Denbury’s ability to continue to execute in their EOR program, expand their pipeline, and manage expenses. Pipeline expansion has some risk of regulatory hurdles and is a major expense. Increases in capital expenditures has also been seen as a negative, but investments like pipeline expansion are an important focus of their growth strategy.
Oil price is completely out of the company’s control, but represents the biggest perceived risk. If oil prices crater for a sustained period so will Denbury’s profitability. However, in Q1 2012 with $26.74 in operating expenses per barrel of equivalent oil (BOE), and $5.62 in general expenses (BOE), and overall interest expense of $36 million their margins allow a significant cushion. Furthermore, while growth in the global economy and oil prices will fluctuate, oil is a finite resource and the long-term need for energy will not abate, which should sustain above-average oil prices for the foreseeable future.
The Bottom Line
Energy independence is an important opportunity for the future of the U.S. economy and our domestic security. Part of that equation will inevitably include domestic oil and natural gas exploration. To that end, Denbury extracts significants amount of oil from wells that other companies no longer have interest, they are investing in local economies, and have plans to sequester man-made carbon dioxide waste to utilize in their pipelines in an effort to lesson their carbon footprint.
The market has undervalued this company because of pessimism about the economy and oil prices, which has created a great opportunity for you as an investor. I think this company has an exciting future and it represents a compelling opportunity to invest in a company that will help to change our domestic energy landscape for years to come.
James Fantaci owns shares of Denbury Resources, Range Resources, and EOG Resources. The Motley Fool owns shares of Denbury Resources. Motley Fool newsletter services recommend Range Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.
