What is hedging a bet

Why Denbury Resources Is A Good Bet To Benefit From An Oil Recovery

Apr. 25, 2015 3:20 PM • dnr

  • Denbury Resources has a very low operating cost of $22.64 a barrel, and this has allowed the company to remain profitable despite weak energy prices.
  • Denbury's top line has dropped in the past year, but that could change as tensions in the Middle East and increasing oil demand could push prices to $80 a barrel.
  • Denbury has hedged 75% its production for 2015 at $85 a barrel, which will shield the company in case of a drop in oil prices.
  • Denbury's interest coverage has increased significantly and its debt-equity ratio has dropped, signifying that the company is strengthening its balance sheet.

Despite the weakness in oil and natural gas prices, Denbury Resources (NYSE:DNR ) has managed to make a remarkable comeback on the stock market in the last three months, appreciating close to 20%. This might look surprising at first, since Denbury's revenue has declined at a fast clip in the past year. But, at the same time, the company has strengthened its cost profile, which is why its gross margin, EBITDA, and cash flow have improved despite the drop in revenue as shown below:

Low operational costs will help Denbury enhance margins

The primary reason behind Denbury's strong margin and cash flow performance is its acreage in key oil and gas producing areas, which has enabled the company to operate its wells at a low cost. For instance, the company's average operational cost in the fourth quarter was $22.64 per barrel, down 14% as compared to the year-ago period.

More importantly, Denbury does not have any lease expiration concerns like several of its peers in the energy industry. Therefore, its assets are safe even though production has declined. Moreover, investors can expect the company to sustain its cash flow and margin growth this year, as it has slashed its capital expenditure by half to $550 million. But, even at this reduced capital expenditure, Denbury expects to keep its production flat as compared to last year. Hence, the company will be producing an identical amount of oil as compared to last year at a lower expense, and this will lead to an improvement in its margin and cash flow performance this year.

Positive cues are emerging from the oil market

Thus, Denbury is doing the right thing by adopting a cautious approach in the current oil environment. But, the good thing is that positive cues are emerging from the oil market. In fact, Brent crude now trades at over $65 per barrel, the highest in 2015. In the last one month, Brent crude has gained over 13% as shown in the chart below:

Looking ahead, the trend is expected to continue as industry experts are of the opinion that Brent crude might trade at $78-$80 a barrel by the end of the year. This target does not look entirely out of reach, as several factors will support the improvement in oil pricing going forward, namely production cuts in the U.S. and an increase in demand across the globe. More importantly, Saudi Arabia's war on Yemen could disrupt supplies from the region, lending more support

to oil prices.

If Saudi continues to carry on airstrikes against Yemen, crude oil prices can rise further as "the Bab el-Mandeb Strait on Yemen's southern coast controls access to the Red Sea, Suez Canal and the ports of western Saudi Arabia, the world's biggest crude exporter."

Meanwhile, demand for crude oil is also anticipated to increase in the coming months as per OPEC's latest monthly market report. According to a Saudi Gazette report :

"OPEC forecasts demand at an average of 29.27 million barrels per day in the first quarter 2015, a rise of 80,000 bpd from its previous prediction made in its March report. At the same time, it said, OPEC's own total output will increase by only 680,000 barrels per day, less than the previous expectation of 850,000 barrels per day, due to lower US and other non-OPEC production."

Now, an increase in demand, coupled with lower supply, will mitigate the supply glut in the oil industry to some extent. In addition, tensions in the Middle East are another factor that could drive oil prices.

What if oil prices don't improve?

This is exactly what Denbury needs. The company has been able to keep its expenses under control and enhance cash flow, but weak oil prices mean that it has faltered as far as revenue growth is concerned. An improvement in the top line can happen only when oil prices get better, and this seems to be happening now. But, in case oil prices do not improve substantially, Denbury looks like a safe bet due to its hedging moves.

For instance, in the fourth quarter, Denbury's net realized oil price after including hedges dropped only $4.25 per barrel sequentially. If the company hadn't hedged its production, its realized price would have dropped $24 a barrel. As such, the company has done the right thing by hedging 75% of its expected production for 2015, limiting its downside to $85 a barrel.

A highly-levered balance sheet is not a concern

Denbury, however, has a very weak cash position of $23 million. In comparison, the company's debt is huge at $3.57 billion, while its current ratio is also weak at 1.27. But, investors should not ignore the fact that Denbury has been cutting its debt at a steady pace, while its interest coverage ratio has shot up tremendously. This is shown in the chart given below:

Moreover, as discussed earlier, Denbury is cutting its capital expenses and improving cash flow. Hence, despite having a weak cash position, Denbury should not face any liquidity issues since it is reducing debt. In addition, due to its conservative capital allocation, Denbury should be able to pay its proposed dividend of $0.40 per share, translating into a yield of almost 5%. All in all, considering the arguments presented above, Denbury Resources looks like a good bet to benefit from an oil recovery.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: m.seekingalpha.com

Category: Forex

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