Description

 Summary

Despite being one of the most attractive crude oil franchises in the United States, DNR trades at an EV / BOE of $3.89 (vs. industry norms of $10.00-$15.00) due to a confluence of events that have engendered negative sentiment towards the stock.  This has created an excellent opportunity to buy one of the few domestic E&P's that is focused on crude oil and has a highly credible, low risk strategy for increasing production over the next several years.

(DNR recently announced a major acquisition.  For simplicity, I'm going to first describe the company as it exists today, and then I'll transition into how it will look after the acquisition.)

Background

Oil fields are usually produced in three stages, with each stage recovering 15-20% of the Original Oil In Place (OOIP).  During primary recovery, oil flows to the surface through natural pressure or mechanical pumping.  After this has been exhausted, operators sometimes undertake secondary recovery projects by flooding the field with water in order to raise the reservoir pressure and sweep the oil to the surface.  Lastly, operators may initiate tertiary recovery by flooding the reservoir with carbon dioxide which both raises the reservoir pressure and acts as a solvent, breaking the oil droplets away from the rock.  Tertiary recovery, however, is contingent on an economic source of relatively pure carbon dioxide, including the pipeline infrastructure required to deliver it to the oil field. 

DNR enjoys a major competitive advantage because it owns the Jackson Dome, the only large supply of carbon dioxide east of the Mississippi river.  In addition, DNR controls all of the CO2 pipeline infrastructure in the Gulf Coast, making it the only company capable of tertiary recovery in the region.  This allows DNR to acquire depleted oil fields at low cost and then use it's proprietary CO2 to coax another 17% of the OOIP out of the ground.  Some of DNR's acquisitions come with modest amounts of existing production while others include wells that have been plugged for decades.  In a typical acquisition, DNR pays the PV10 for the proved reserves and a mere $0.50 per barrel for the tertiary reserves (vs. the $10.00-$15.00 per barrel usually paid for reserves).  Such monopolistic status gives DNR excellent returns on its tertiary projects, and its large and growing CO2 reserves have provided it with several years of highly visible, low risk production growth. 

In 3Q09, tertiary production was 57% of DNR's total production.  26% of the quarter's production came from other oil fields in Mississippi and Texas that will eventually be converted to tertiary programs.  The balance came from the Barnett Shale and other smaller properties.

While tertiary projects offer a low-risk means of production growth, they involve very long lead times and high upfront capital requirements.  DNR has had to develop proved reserves at Jackson Dome, acquire depleted fields, build out CO2 pipeline infrastructure to existing and acquired fields, build CO2 processing facilities at the fields (these facilities recapture produced CO2 so it can be recycled back into the reservoir), and begin injecting CO2.  After many months of "pressuring up" the reservoir, tertiary production commences.  The time and capital associated with this "value chain" have historically throttled DNR's growth.  Today, it has 5.6Tcf of proved reserves at Jackson Dome which is enough to produce the 8 phases of tertiary projects that DNR has announced to date.  These 8 phases will generate tertiary production growth between 10-20% each year through 2015.  (Management has said that it will be closer to the bottom end of this range in 2010 and closer to the top in 2011.  It is my impression that most years will actually be in the 15-20% part of the range.)  This would translate into low double-digit total production growth across this period.

Additional Upside

In addition to DNR's proved reserves of CO2, there are three possible sources of additional CO2 which could greatly extend DNR's opportunity.  The first of these is the probable and possible CO2 reserves at Jackson Dome.  When Shell originally developed the Jackson Dome, they estimated that its ultimate reserves would be around 12Tcf.  DNR has produced 1.0Tcf of these already, and has 5.6Tcf of proved reserves remaining.  The Jackson Dome is also believed to have about 3.0Tcf of probable reserves (some of which will be drilled for in 2010), and 2.0Tcf of possible reserves beyond that.  Additional CO2 would enable additional oil production with 1Tcf of CO2 enabling roughly 100MMBOE of oil production.  (Historically, DNR has required 12Mcf of CO2 to produce 1Bbl of oil, but modeling suggests that some of its newer fields will require 8Mcf of CO2 to produce 1Bbl of oil.  I use a 10Mcf:1Bbl ratio for simplicity.)

The second possible source of CO2 is recycling CO2 out of depleted tertiary fields and into new tertiary fields.  DNR routinely recycles CO2 within a given tertiary field in order to economize its virgin CO2 consumption.  It is also, however, building experience recovering CO2 from a depleted tertiary field and reinjecting this CO2 into a new tertiary field.  To date, DNR has recovered about 30% of the CO2 it had injected into its small Olive field, and this has been transferred to its newer McComb field.  Management believes that 50% of the CO2 injected into a tertiary field can be recovered and recycled into a new field.  Taken to it's extreme, this would double DNR's total CO2 supply.  (i.e. 50% of the original CO2 is recovered, then 50% of that 50% is recovered, etc.)  The company used to explain this in their presentations, but they have since changed to only illustrating the opportunity of a single round of recycling and even then, they only apply this to their proved CO2 reserves.  When I asked management about this change, they acknowledged that the CO2 can probably be recovered serially, but that the incremental PV10 diminishes significantly after the first round of recycling since you can't begin transferring CO2 to a third tertiary field until you've exhausted tertiary recovery at the second.  Consequently, they only discuss the potential for a single round of recycling.  (While the serial rounds of recycling may not add much PV, it is still conceptually encouraging to know that recycling will probably help extend DNR's production over the longer term.) 

The last possible source of CO2 is anthropogenic sources (a.k.a. manmade CO2).  In order to prepare for anthropogenic CO2, DNR began building it's "Green Line" PL a few years ago.  The Green Line runs from the end of DNR's existing CO2 pipeline infrastructure in eastern Louisiana down to southeast Texas, near Houston.  DNR had acquired a large tertiary candidate near Houston (the Hastings field) as the "anchor field" to justify building the Green Line, but they chose a route that would take the line within a few miles of several existing emitters of pure CO2, as well as the sites of proposed gasification plants.  Existing emitters generate relatively small amounts of usable CO2, but the proposed gasification projects would generate large supplies of anthropogenic CO2.  DNR recently entered into a contract to acquire CO2 from a Dow facility that generates modest amounts of CO2, and it has signed long-term supply contracts with several proposed gasification projects along the Gulf Coast.  It's important to note that DNR is the only company that is able to capture anthropogenic sources in this region since it's unlikely that anyone else would build a duplicate CO2 pipeline next to the Green Line.  This has allowed DNR to enter supply contracts with these emitters on economic terms which would essentially just reimburse the emitters for compressing their CO2 enough to put it into DNR's pipeline system.  Three of the proposed gasification plants that DNR has contracts with are in the DoE's Loan Guarantee Program, though significant hurdles remain before they would begin construction.  A final source of anthropogenic CO2 would be from emitters such as coal fired power plants that emit "dirty" CO2.  Separating this CO2 from other exhaust gases would be very expensive and probably won't occur without some type of federal legislation.  (I've read that CO2 sequestration equiptment at coal fired power plants would consume 30% of the plants' electricity output.)  DNR's management believes that some of the gasification projects that they have contracts with will eventually be constructed, but I have chosen to treat such supplies as a free option, excluding them from my projections and analysis.  If these anthropogenic sources are realized, however, they could be a game changer because they could be large, and they won't deplete like the Jackson Dome.

Quantifying DNR's Resource Base

In summary, DNR has a highly visible set of projects in hand, and there are likely to be additional sources of CO2, though it is difficult to handicap some of these incremental opportunities.  I believe that the probable reserves at Jackson Dome are very likely to be realized because the company appears to have a good understanding of the seismic signature associated with such reserves, and 10 of the 11 exploration wells drilled at the Jackson Dome over the last few decades have been successful.  In addition, CO2 recycling between fields has already been demonstrated on a small scale, recovering 30% of the originally injected CO2 to date.  This lends credibility to management's claim that 50% of CO2 can be recycled.  (Someone at DNR once told me that 50% is really the minimum amount of CO2 that should be recoverable and that the actual amount could be closer to 60%.)  Below, I have estimated DNR's ultimate resource base of proved and probable oil, as well as the oil equivalent of its CO2 resource.  (Possible anthropogenic sources of CO2 are not included.) 

Using a 12Mcf:1Bbl CO2:Oil exchange ratio still demonstrates enormous value in the stock:

As mentioned before, companies are often acquired for $10.00-$15.00 / BOE of reserves though that multiple naturally increases with expected oil prices and $20.00 / BOE would be a reasonable expectation at $100.00 oil.  Depending on how much credit you give DNR for it's CO2 resources, it is trading as low as $3.89 / BOE.

Recent Developments

While DNR's long-term positioning is excellent, there have been a handful of developments over the last 18 months that have weighed heavily the stock.  I recently attended DNR's analyst day in Jackson, Mississippi, giving me the opportunity to poll a number of shareholders and sell-side analysts about their views of the company.  I heard a chorus of voices acknowledge that DNR is undervalued on a long-term basis, but this was always followed by some recurring negative refrains. 

One of the most common complaints was that DNR is "dead money" in the near term because their organic production growth will be slightly down in 2010.  2009's capital budget was dominated by CO2 pipeline investments, which limited the amount that DNR could spend on drilling and tertiary floods.  This set the company up for a tepid 2010, which is in sharp contrast to prominent natural gas producers who are realizing strong growth from the shale plays.

A related complaint stems from changes management has made to DNR's long-term tertiary production forecasts.  In the past, DNR laid out very specific forecasts for the production from each of its tertiary phases, and rolled these up into a detailed forecast for its tertiary production through 2015.  In 2Q08, management disappointed the analyst community by pushing out the forecasted peak in their tertiary production from 2014 to 2015 (though the absolute level of the peak remained the same).  This change was due to a host of factors, such as gaining more experience in how long it takes to build out tertiary infrastructure, discovering that tertiary fields respond to CO2 injections more slowly in their later years than in their early years, and a general desire to build more cushion into their forecast.  In 2009, management backed away from an explicit year by year forecast altogether, instead saying that their tertiary production would grow somewhere between 10-20% each year through 2015.  Based on the detailed forecasts last given in 2008 and recent guidance about 2010 and 2011, it seems likely that tertiary production will grow about 10% in 2010 and in the high-teens from 2011-2015. 

I'm not surprised that they backed away from their year by year forecasts, because while tertiary production has little exploration risk, it is subject to delays and these have periodically forced DNR to push out it's long-term forecast.  For example, DNR experienced delays installing CO2 compression equipment in 2H06 and 1H09, both of which hampered production growth and placed the company behind schedule.  Given the negative responses to such delays and any changes in DNR's long-term forecast, I can understand why management departed from an explicit forecast.  I believe that changes to the detailed forecasts led some analysts to miss the forest for the trees, focusing on relatively minor delays and forgetting that DNR is arguably the most differentiated E&P in North America.  While delays in DNR's ascent are disappointing, the realization of its goals is not in doubt unless oil returns to $30/Bbl for an extended period.  (DNR's tertiary operating costs are $26/Bbl, and their tertiary F&D costs are $8.50/Bbl, leading to an all-in break even cost of $34.50/Bbl.)

A third common refrain was complaints about recent management decisions.  During the summer of 2009, DNR sold 60% of its Barnett Shale properties for about $1.00 / Mcfe.  DNR had been looking to sell all of its Barnett properties for a while, and chose to sell 60% of them to help prepare for its 2010 capital budget which includes the final part of its large CO2 pipeline investments.  Nevertheless, selling gas properties at the bottom of the market was still a bad decision.  The greatest source of disappointment, however, has been DNR's recently announced acquisition of Encore Acquisition Corporation (EAC), with 70% of the purchase price being paid in stock.  While this acquisition is accretive on a CF / share and a reserves / share basis, it is neutral to slightly dilutive on a NAV / share basis.  (Judging the terms of this deal is somewhat clouded by the high portion of probable reserves at both companies, including EAC's probable tertiary reserves which will not become proven for many years into the future.) 

Management has billed this acquisition as a way to expand beyond their core region in the Gulf Coast which has irritated many investors who view such an expansion as unnecessary given the open ended opportunity that DNR enjoys in its current region.  I felt the same way when the acquisition was first announced, but I've become more comfortable with the deal as I've learned more about the opportunity and had time to examine the numbers more carefully.  It is true that DNR has enormous opportunity in the Gulf Coast, but as one of their executives pointed out to me, DNR has essentially already "captured" all of this opportunity.  Even though there are additional fields to acquire in the Gulf Coast, they control all of the region's existing and proposed CO2 supply and infrastructure.  It's an unassailable footprint that they can continue expanding.  Given the long-term planning that they are accustomed to, they have been looking for areas to expand outside of the Gulf Coast for a while, and they determined that the Rockies are the best alternative.  Tertiary recovery is widely used in West Texas, but it's very competitive there because Kinder Morgan sells CO2 on a merchant basis.  The geology in California is technically conducive to CO2 flooding, but the regulatory hurdles there are probably insurmountable.  Alberta has tertiary potential, but most of its participants expect the government to eventually build out CO2 infrastructure and are thus unwilling to sell their properties.  The last alternative was the Rockies. 

There are a number of existing and proposed anthropogenic CO2 sources in the Rockies which means that it wouldn't be possible to secure a competitive advantage there by controlling the CO2 supply.  Consequently DNR decided to pursue a large property acquisition that would allow it to lock up many of the tertiary candidates in the region, as well as provide the scale required to justify building a CO2 pipeline.  One DNR executive recently told me that they've come to realize that it makes much more sense to pursue large tertiary projects because the infrastructure requirements do not scale proportionally to the field.  The large fields thus enjoy better economics than the small ones, and I suspect that this factored into DNR's thinking with EAC.  EAC had already signed one CO2 supply contract in the Rockies, but they were very early in their tertiary program, having yet to break ground on their pipeline and having only formalized plans to flood one of their three tertiary candidates.  DNR has delayed EAC's tertiary development by a year in order to create a more comprehensive plan, and I suspect that DNR will execute this series of projects more thoughtfully than EAC would have.

EAC also brings a number of other properties, the most attractive of which is their significant acreage in the Bakken Shale.  This will provide near term production growth and CF that can be used to fund tertiary projects.  EAC also brings acreage in the Haynesville Shale, a JV with XOM in the Permian Basin, and a variety of other properties.  DNR has said that it will sell at least $500MM of EAC's properties in order to pay down debt associated with the deal.  Based on the tone of some of management's comments, I wouldn't be surprised to see DNR sell considerably more than $500MM, stripping the acquired properties down to EAC's production in the Rockies and possibly the Haynesville.  The uncertainty surrounding which properties will be sold, and what prices will be realized somewhat clouds the near-term outlook and probably adds to the negative sentiment on the stock.

EAC's executives appear completely disinterested in continuing on with DNR, which some observers have interpreted negatively (i.e. "take the money and run"), but this ignores a critical part of the EAC story.  EAC was founded in 1998 by Jon Brumley who has had a distinguished career, helping to found XTO Energy, as well as the being the CEO of MESA Petroleum leading up to its merger with Parker and Parsley which formed Pioneer Natural Resources.  He is now about 70 years old, and was probably looking towards estate planning when EAC began looking at "strategic alternatives" in 1Q08.  When oil prices dropped in 3Q08, EAC took itself off the market, but the management team knew that Brumley was ultimately looking to sell the business, and they probably never "checked back in" mentally.  Consequently, they've probably been waiting for their big paychecks for 18 months now, and I'm not surprised that they're ready to move on.

The EAC acquisition complicates the analysis because it's impossible to know precisely how many EAC properties will be sold and what prices will be realized.  These divestitures will alter the EV (through debt reductions), reserve base, and growth profile.  It's also difficult to know how to compare DNR's probable reserves to EAC's stated "upside."  Still, I've attempted to determine what the valuation will look like after the acquisition but before any property sales: 

As you can see, the resources are still very undervalued.  In the figures above, I include all of EAC's stated upside (423MMBOE) at face value.  In the lines that include credit for recycled CO2, I have assumed that 50% of the CO2 that will be injected into EAC's fields will be recycled, in order to keep the analysis consistent with the way that I treated DNR on a stand alone basis.  (If you only want to give credit for recycling in the Gulf Coast, use 1,805.6MMBOE instead of 1,937.6MMBOE).

Another method for valuing E&P's is based on cash flow multiples.  Companies with short-lived reserves trade at multiples as low as 2-3 whereas companies like DNR with long-lived reserves have multiples around 5-7.  (DNR's CF multiple has historically averaged 7-8x.)  DNR is currently trading around 7x 2009 CF.  (80% of DNR's 2009 oil production was hedged with a floor at $75.00.)  The EAC divestitures make it difficult to model 2010 CF, but management has said that the acquisition will be about 8% accretive on a CF basis.

I want to emphasize the open ended nature of DNR's production growth.  While Jackson Dome's proved reserves will support low double-digit total production growth through 2015 (on a DNR stand-alone basis), DNR's probable and possible CO2 reserves, the CO2 recycling opportunity, and DNR's long-term purchase contracts with proposed CO2 emitters make it likely that DNR will grow well beyond the current forecast window.  Very few oil companies outside of the Canadian oilsands have this kind of visibility, and I believe that it deserves a premium multiple.

Risks

The greatest near term risk is that the EAC acquisition proves too large for DNR to manage, leading to poor execution at both of the companies' properties.  I'm currently giving management the benefit of the doubt because I've been pleased with most of their decisions in the past.  Because the company is relatively small and management is very forthcoming, their mistakes tend to be more visible than larger E&P's.  Once you get under the hood and start talking to management, however, it appears that they are methodical and think things through. 

Another risk is that DNR is unable to divest non-core EAC properties on attractive terms, and their willingness to sell Barnett Shale properties this past summer is a little troublesome in that regard.  The market for selling properties in the near term is decent because credit is available, the oil strip is good, and the gas strip is reasonable.  I am hopeful that this will persist over the next several months, and I suspect that DNR will have some property sales lined up right out of the box.  (Immediately after the acquisition, TD / TC will be 48%.  $500MM of property sales would allow DNR to reduce this to 44.6%.)

The greatest long term risk is that EAC's "upside" proves to be overstated, especially the upside associated with EAC's properties in the Rockies.  Shell did a very small tertiary pilot on one of these properties in the 1980's which confirmed the viability of CO2 flooding.  (Shell had to bring CO2 to the pilot by truck which limited the pilot's size.)  Anadarko also has a tertiary project in the region, lending further credibility to this part of EAC's upside.

Catalysts

I heard so much negative sentiment at DNR's analyst meeting that I think simply pulling off the acquisition without any major execution issues would be a positive catalyst.  I also think that clarity about what DNR will look like after divesting non-core EAC properties will be a catalyst.  Lastly, I think that sentiment will improve moving into 2011 simply because DNR's organic production growth will be accelerating and it's two big infrastructure projects will be behind it.

Catalyst

Hopefully good execution on EAC acquisition

Dust settling from EAC acquisition

Improving organic production growth moving into 2011.