The End of Easy Oil?

By Michael Finarelli - January 27, 2012 | Tickers: DNR | 0 Comments

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Scientific news publisher The Scientific American recently put out an article titled “Has Petroleum Production Peaked: Ending the Era of Easy Oil.” The article suggests that easily extracted oil peaked in 2005 and as a result we now find ourselves globally in the midst of a so-called production plateau. The author argues that from here on the recovery of additional barrels of oil will be much more difficult and costly in the future.

Enter Enhanced Oil Recovery

Although the argument seems quite rational, the author pays far too little attention to the increasing use of technologies that are designed to recover additional amounts of petroleum from existing wells. It has long been known that traditional recovery methods (which we will refer to as primary and secondary) only capture roughly 40% of the oil trapped underground.

However, tertiary methods, such as enhanced oil recovery (EOR) employed by several industry producers has the potential to increase the overall capture to upwards of 60%. Although not new, this technology injects CO2 directly into wells and reduces the surface tension of the oil, thereby aiding further extraction.  A key player in the arena, Denbury Resources (NYSE: DNR), has been successfully using this technology in its Gulf Coast fields over the past decade.

The Power of Competitive Advantage

Since this process is highly dependent upon access to rich sources of CO2, those producers who have the most abundant supply, whether it’s natural or manmade, have a built-in moat protecting their business. According to their most recent investor presentation, Denbury has approximately 16 trillion cubic feet of CO2 in proven reserves.  A good portion of this resides in their Jackson Dome reserve in Mississippi, which fuels their tertiary operations in the Gulf Coast region where they enjoy a dominant market position.

What’s even more interesting for investors is that with the company’s 2010 acquisition of Encore, Denbury has acquired significant assets in the Rocky Mountain region where they hope to replicate their core tertiary recovery strategy with similar competitive advantages enjoyed in their Gulf Coast fields. This is why the company is targeting 13%-15% CAGR in EOR production over the next 10 years.

The Economics of EOR

Now that we have some idea of future demand potential of tertiary recovery techniques, the question for Denbury is whether they can turn their competitive advantage into shareholder value.  Obviously there’s a host of criteria that will ultimately govern the eventual returns earned by the company’s equity-holders, but today let’s focus on the economics behind EOR. The first step if you will. The following cost breakdown on a Barrel of Equivalent basis reflects 2010 per unit results of operations.

Of course since Denbury is predominantly an oil producer, the price of oil as well as the company’s hedging strategies play a crucial role on Denbury’s profitability. Although this sneak peek into the company’s cost structure is interesting, a more robust analysis would be to examine margins over time as well as against Denbury’s peers. This in particular would shed light on Denbury’s business model relative to other E&P companies.

On a final note, whether or not you firmly believe 2005 marked the end of easy or cheap oil, one thing is certain: oil is a finite resource, and at some point the cost to extract what remains will increase. I for one believe that this is a tailwind that will bode very well for the futures of companies like Denbury Resources.

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