Oil producers Denbury Resources (NYSE: DNR) and Penn Virginia (NASDAQ: PVAC) have mutually agreed to terminate their proposed merger agreement. Denbury initially offered to pay $1.7 billion in cash and stock for Penn Virginia in a deal that would improve its financial profile, boost its growth prospects, and diversify its operations. Investors, however, didn't like the combination because of a suspect strategic fit as well as the fact that volatility has returned to the oil market over the past few months.
While Denbury spent the past few months trying to convince investors that this was the right transaction, they remained firm in their opposition. Because of that, both companies will go their separate ways.
Image source: Getty Images.
A marriage that never made complete sense
While both Denbury and Penn Virginia primarily produce oil, they do so in very different ways. Denbury's core business uses enhanced oil recovery (EOR) techniques such as injecting carbon dioxide into legacy fields to coax out more oil. Penn Virginia, on the other hand, drills unconventional wells by using a combination of horizontal drilling and hydraulic fracturing to extract oil and gas from tight rock formations like shale. These companies also operate in different regions. Penn Virginia solely focuses on the Eagle Ford shale in South Texas while Denbury operates along the Gulf Coast and in the Rockies.
Denbury, however, had hoped to leverage its EOR expertise to tap into the vast potential it saw in the Eagle Ford shale. Companies like EOG Resources (NYSE: EOG) had already started using EOR techniques such as injecting rich hydrocarbon gas into the Eagle Ford to boost the output of older wells. Those projects by EOG Resources and others have proven to be very successful as they've increased oil recoveries by 30% to 70% while generating strong returns on the incremental capital spending. Denbury believed it could do even better by injecting carbon dioxide, which is why it wanted to acquire an Eagle Ford shale-focused company.
Investors, however, questioned that strategic rationale. They worried that the company was making an outsized bet on an unproven process. Furthermore, they were also concerned with the company's lack of experience drilling unconventional wells, which could yield lackluster drilling result in the future. On top of that, while the combination would improve Denbury's credit metrics, its balance sheet would remain an area of weakness, especially given the plunge in crude prices at the end of last year.
Image source: Getty Images.
Where does Denbury go from here?
In walking away from this deal, Denbury will return its focus to developing its existing assets to generate as much free cash as possible. That will give it the money to invest in expansion projects and to pay down debt.
The company currently expects to invest between $270 million to $300 million on capital projects this year, which is a 20%-25% decrease from 2018's level. This investment level will enable the company to produce between 56,000 to 60,000 barrels of oil equivalent per day this year, about 4% lower than last year's average. That will allow the company to generate between $50 million to $100 million in excess cash, assuming oil averages $50 a barrel. It intends on using the money to chip away at its debt level, which stood at $2.5 billion at the end of 2018. Though with oil recently near $60 a barrel, it's on track to produce more than $150 million in free cash this year.
While production is set to decline this year, the company sanctioned a major EOR project in the Rockies last year that should boost output in the future. The company plans to invest $250 million to build a 110-mile carbon dioxide pipeline as well as the infrastructure to inject it into the oil field. These investments should start paying off by late 2021 to early 2022. The first phase of this project should increase output from this field by 7,500 to 12,500 barrels of oil per day. Meanwhile, the company has the potential to complete several more phases in the coming decade.
Denbury is also testing several other development opportunities across its acreage position, including drilling horizontal wells in some new areas. Initial tests have proven to be very promising, which could yield additional high-return growth opportunities.
Walking away was a wise decision
While Denbury's proposed combination with Penn Virginia might have looked good on paper, it came with significant operational risks. That's why I believe the company made the right decision by abandoning the deal. Now, it can focus solely on improving its financial profile so that it's in a better position to take calculated risks in the future.
More From The Motley Fool
- 10 Best Stocks to Buy Today
- 3 Stocks That Are Absurdly Cheap Right Now
- 5 Warren Buffett Principles to Remember in a Volatile Stock Market
- The $16,728 Social Security Bonus You Cannot Afford to Miss
- The Must-Read Trump Quote on Social Security
- 10 Reasons Why I'm Selling All of My Apple Stock