Impact of Offshore Sale
On July 20, 2004, the Company closed the sale of Denbury Offshore, Inc., a subsidiary that held Denbury's offshore assets, for $200 million (before adjustments) to Newfield Exploration Company. The sale price was based on the asset value of the offshore assets as of April 1, 2004, which means that the net revenue and expenses from these properties which the Company received between April 1st and closing, as well as expenses of the sale and other contractual adjustments, reduced the purchase price to approximately $187 million. The Company's third quarter results include 1,885 BOE/d of production for the first 19 days of July relating to the offshore properties sold to Newfield, generating approximately $5.3 million of net operating revenue (revenue less operating expenses). During the third quarter, Denbury also recorded approximately $18.0 million of current income taxes relating to the offshore sale, and paid approximately $1.4 million of severance pay related to the sale in addition to approximately $1.0 million paid during the first six months of 2004.
On a pro forma basis, excluding the impact of the offshore operations during the third quarter of 2004 as outlined above, third quarter 2004 net income is estimated to be $15.5 million, with adjusted cash flow from operations of $43.8 million.
Production for the third quarter, excluding the offshore production outlined above, was 27,772 BOE/d, just slightly higher than production during the prior quarter and 7% higher than the average of 25,930 BOE/d produced during the third quarter of 2003 (excluding any offshore production for both comparative periods). Oil production from the Company's tertiary operations increased 6% over levels in the prior quarter and increased 65% when compared to third quarter 2003 tertiary production, averaging 6,967 Bbls/d in the third quarter of 2004, primarily as a result of production increases at Mallalieu and McComb Fields. Natural gas production increased in the Barnett Shale as a result of recent drilling activity, increasing from approximately 1.5 MMcf/d in the third quarter of 2003 to approximately 3.9 MMcf/d in the 2004 quarter. Partially offsetting these increases were declines in onshore Louisiana production resulting from natural field depletion, the single largest factor being expected depletion at Thornwell Field, onshore Louisiana, which declined approximately 1,400 BOE/d from first quarter 2004 production levels.
Third Quarter 2004 Financial Results
The Company's net income declined from second quarter 2004 levels, as higher commodity prices were more than offset by the loss of offshore production and its net operating income. Payments on the Company's commodity hedges continued to be a significant outflow, totaling $22.2 million for the third quarter of 2004, and hedge payments are expected to be even higher in the fourth quarter of 2004, after which time they will drop significantly, as most of the out-of-the-money hedges expire by the end of this year. Depreciation and amortization expense declined approximately $0.84 per BOE from the second quarter of 2004 primarily as a result of proceeds from the offshore sale being credited to the Company's full cost pool. When comparing the respective third quarters of 2003 and 2004, higher commodity prices in the 2004 period more than offset lower production, resulting in a 21% increase in net income in the 2004 period.
Operating expenses decreased slightly to $7.25 per BOE in the third quarter of 2004 as compared to $7.35 per BOE in the third quarter of 2003, primarily because there were no significant or unusual workover expenses in the 2004 period. Expenses remained at relatively high levels because of increased activity and emphasis on tertiary operations (with their higher operating costs), higher energy costs to operate the properties, and general cost inflation in the industry. Production taxes increased in the third quarter of 2004 along with increased commodity prices.
General and administrative expenses increased, averaging $2.27 per BOE in the third quarter of 2004, up from $1.13 per BOE in the prior year's third quarter. Lower production as a result of the offshore sale caused a significant increase in per BOE amounts, as did approximately $1.4 million of severance costs related to the offshore property sale. The Company's general and administrative costs have also risen in order to comply with the requirements of the Sarbanes-Oxley Act.
Interest expense decreased on a gross and per BOE basis as a result of lower overall interest rates, primarily related to the subordinated debt refinancing in 2003, and lower average debt levels as a result of the $50 million reduction in debt during 2003 and $85 million of bank debt paid off in July 2004 with the proceeds from the offshore sale.
Depreciation, depletion and amortization expense ("DD&A") decreased in the third quarter of 2004 to $7.62 per BOE, down from $8.46 per BOE in the prior quarter, as a result of the offshore sale, the proceeds of which were credited to the full cost pool. The DD&A rate in the most recent quarter was still slightly higher than the third quarter of 2003 rate, primarily as a result of the higher percentage of expenditures spent on offshore properties during 2003 and the first half of 2004, which typically have a higher finding and development cost per BOE.
The Company recognized a current income tax expense of $18.9 million in the third quarter of 2004 related to state income taxes and alternative minimum taxes resulting primarily from the offshore sale, which taxes cannot be offset by the Company's regular tax net loss carryforwards or enhanced oil recovery credits, partially offset by a deferred tax benefit of $11.1 million.
Denbury's 2004 development and exploration budget is currently $213 million. Denbury's total current debt is $225 million, with no amounts outstanding under its $200 million bank borrowing base, and with approximately $70 million of cash remaining from the offshore sale. The Company plans to invest this cash over the next one to two years on property acquisitions, particularly properties that have future tertiary potential, some of which could be new core properties for additional phases of tertiary operations. The Company is leaving its earlier 2004 fourth quarter production forecast unchanged, anticipating a quarterly average of between 28,000 and 28,500 BOE/d.
The Company has tentatively set its 2005 development and exploration expenditure budget at $260 million, excluding any potential acquisitions. Approximately 55% to 60% of the budget will be spent on projects relating to the Company's tertiary recovery (CO2) projects, which includes additional drilling and development at the CO2 source fields (Jackson Dome), additional development of the Brookhaven, Mallalieu, McComb and Smithdale Fields in southwestern Mississippi, and the commencement of work on three oil fields in East Mississippi in anticipation of the new CO2 pipeline to East Mississippi scheduled to be completed by mid-2006. The cost of the new CO2 pipeline is not included in the $260 million budget, as the Company currently expects to finance this pipeline through project financing and effectively pay for the pipeline over time. The current estimated cost for the pipeline is approximately $45 million. Approximately 10% of the 2005 budget is being allocated to each of the remaining two core areas of onshore Louisiana and eastern Mississippi and about 10% to 15% to the Barnett Shale. Approximately 10% of the budget relates to exploratory projects, primarily natural gas targets onshore Louisiana.
Based on this capital budget program, the Company anticipates that its production for 2005 will be in the range of 30,500 BOE/d, plus or minus 10% higher than the Company's third quarter 2004 production levels excluding offshore production during the quarter. The Company's production from its tertiary CO2 projects during 2005 is expected to increase between 45% and 50%, from an anticipated 2004 average of approximately 6,800 BOE/d to a projected 2005 average of approximately 10,000 BOE/d. The 2005 production forecast excludes any anticipated production from our successful well at High Island A-6 as this property may be sold.
Gareth Roberts, Chief Executive Officer, said: "We are aggressively expanding our core tertiary operations by accelerating our first two phases of tertiary development in Southwest and East Mississippi and by actively pursuing additional properties for subsequent phases. We plan to continue the expansion and development of our CO2 reserve and production capacity in 2005 by drilling four additional CO2 wells, two of which are expected to add additional CO2 reserves. Next year, we are also stepping up our activity in the Barnett Shale, with 25 horizontal wells scheduled for 2005. The net result is a projected +/- 10% increase in overall production, all from internal organic growth. We believe that we can continue this rate of growth for several years without acquisitions, an enviable position in our industry. In addition, with our strong balance sheet and cash position, we have plenty of capital to pursue acquisitions that could further increase our inventory of projects and growth potential. With current strong oil prices and our strategic position in the Mississippi area with our tertiary operations, we believe we are ideally positioned for the future."
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