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At Less Than $2 a Share, These Oil Stocks Could Have Explosive Upside (but Also Risk Imploding)

Matthew DiLallo, The Motley Fool

Shares of Denbury Resources (NYSE: DNR) and Chesapeake Energy (NYSE: CHK) have made some big moves over the past year. Denbury Resources' stock, for example, was up a jaw-dropping 199.1% at one point last year, before it crashed back to earth along with oil prices. Chesapeake Energy, meanwhile, was up more than 50% earlier this year before plunging as crude entered another bear market in the past month. With their latest sell-offs, shares of both oil producers now sell for less than $2 apiece.

As their big runs in the past year show, both companies have explosive upside when oil prices are on the upswing. That makes them potentially high-reward opportunities should crude prices rebound again. However, as each has also shown, they can quickly crash when crude prices cool off.

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Denbury desperately needs higher oil prices

Denbury Resources is in a tight spot financially these days. The oil producer has more than $2.5 billion of debt on its balance sheet, which is currently weighing it down. To put that number into perspective, debt accounts for an eye-popping 76% of its $3.3 billion enterprise value and is more than four times its earnings. Those metrics are well above the industry comfort levels of 30% and two times, respectively.

The company is trying to chip away at its debt level by keeping its capital spending level to a minimum. For 2019, Denbury expects to invest only $240 million to $260 million on new oil projects. Not only is that 20% to 25% below last year's level, but it's not enough investment to maintain its production rate, which is on track to decline by about 4% this year.

Denbury cut spending so that it could produce some free cash flow to chip away at its debt level. Thanks to improving oil prices during the first quarter, Denbury was on track to generate more than $150 million in excess cash for debt reduction. However, with crude prices slumping in recent weeks, the company might only produce between $50 million and $100 million in excess cash this year, which would barely put a dent in its debt pile.

If oil prices heat up, shares of Denbury Resources could explode higher since that would give it more money to pay down debt. However, if crude keeps falling, Denbury could eventually collapse.

Chesapeake is working hard to dig out of its hole

Chesapeake Energy is in a similarly tight spot financially. The oil and gas company had nearly $10 billion of debt on its balance sheet as of the end of the first quarter. That worked out to about 70% of its enterprise value and roughly four times its earnings.

However, Chesapeake Energy's finances have come a long way over the past few years. Further, the company is on track for additional improvements over the next two years, thanks to a recent acquisition. That deal has the company on pace to grow its oil production and cash flow at a fast pace through the end of next year. That should push its leverage ratio down to 3.6 times earnings this year and 2.8 times by the end of 2020 -- assuming oil prices cooperate -- putting it much closer to its two times target.

Meanwhile, higher oil prices over that time frame could further accelerate Chesapeake Energy's strategy. That's because it would enable the company to produce excess cash to pay off additional debt. That ability to improve its balance sheet more quickly is why Chesapeake has such explosive upside to higher oil prices. On the other hand, if crude prices weaken further, it would put even more pressure on the company's already fragile financial profile.

These oil stocks are certainly entertaining to watch

Shares of Denbury Resources and Chesapeake Energy have the potential to skyrocket in an improving oil market because that would provide them with more cash to pay down debt. However, their shares could also crater if crude prices take another tumble. While their high upside potential certainly makes them intriguing, investors shouldn't ignore the risk of implosion. That's why they might want to watch these oil stocks from the sidelines so that they don't get burned by all the volatility.

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Matthew DiLallo owns shares of Denbury Resources. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.