Included in second quarter 2006 results are several items (discussed below) which were not present in the 2005 period's results, or were higher than a year earlier: (i) a significant change associated with mark-to-market value adjustments related to the Company's oil and natural gas derivative contracts, (ii) stock compensation expense related to the adoption of SFAS No. 123 effective January 1, 2006, (iii) stock compensation expense related to modifications of the vesting terms of certain restricted stock and stock options related to the departure of a senior vice president, partially offset by (iv) interest capitalization on significant unevaluated properties associated with the Company's 2006 acquisitions.
Adjusted cash flow from operations (cash flow from operations before changes in assets and liabilities, a non-GAAP measure) for the second quarter of 2006 was $128.8 million, a 57% increase over second quarter of 2005 adjusted cash flow from operations of $82.0 million. Net cash flow provided by operations, the GAAP measure, totaled $106.4 million during the second quarter of 2006, as compared to $88.4 million during the second quarter of 2005. The difference between the adjusted cash flow and cash flow from operations is due to the changes in receivables, accounts payables and accrued liabilities during the quarter. (Please see the accompanying schedules for a reconciliation of net cash flow provided by operations, as defined by generally accepted accounting principles (GAAP), which is the GAAP measure, as opposed to adjusted cash flow from operations, which is the non-GAAP measure).
Highlights, including non-cash items
Earnings and cash flow from operations were at near-record levels for the first half of 2006, primarily as a result of high commodity prices and record quarterly production. The Company set a new quarterly production level during the second quarter, averaging 37,474 BOE/d, approximately a third of which increase was attributable to the acquisition that closed January 31, 2006, which added 2,199 BOE/d to the second quarter, supplemented by higher production in the Company's tertiary operations, the Barnett Shale area, and higher natural gas production in Louisiana following several exploratory successes during 2005.
Although net income for the second quarter of 2006 was only 9% higher than the net income during the second quarter of 2005, there are several positive and negative factors affecting the comparison of these results. In addition to the high commodity prices and record production, which both contributed to higher net income, the Company capitalized approximately $2.7 million of interest expense in the second quarter of 2006 primarily related to the unevaluated properties associated with its 2006 acquisitions. This reduced the overall increase in interest expense to 33%, even though average debt levels were 87% higher in the second quarter of 2006 than in the comparable period of 2005. Overall industry costs continue to increase, the primary reason for record, or near record, operating costs and depreciation and depletion rates per BOE in the second quarter of 2006. Operating expenses were also impacted by higher energy costs (electrical and fuel charges) and the Company's continuing emphasis on tertiary operations. During the second quarter of 2006, the Company also incurred a $9.3 million ($5.6 million after tax) mark-to-market non-cash charge to earnings as rising oil prices reduced the value of the Company's oil derivative contracts put in place to cover production from the January acquisition. Further, the Company expensed approximately $5.3 million of non-cash charges related to the modification of vesting terms of certain restricted stock and stock options previously awarded to Mr. Worthey, former Senior Vice President of Operations, associated with his departure during the second quarter of 2006. Additionally, the Company booked stock compensation expenses related to the adoption of SFAS No. 123® as of January 1, 2006, which for the second quarter of 2006 resulted in a non-cash charge of approximately $1.8 million to general and administrative expense, approximately $0.3 million to lease operating expense and approximately $0.3 million to capitalized oil and gas properties. Lastly, the Company's income tax expense increased, primarily as a result of high oil prices causing enhanced oil recovery credits to become unavailable during 2006.
Second Quarter 2006 Financial Results
Production for the quarter was 37,474 BOE/d, a quarterly record for the Company. In addition to the incremental production from its January 2006 acquisition, oil production from the Company's tertiary operations increased 6% over first quarter 2006 levels, and 10% when compared to second quarter 2005 tertiary oil production, averaging 10,375 Bbls/d in 2006's second quarter. Natural gas production from the Barnett Shale increased to 4,621 BOE/d in the second quarter of 2006, a 125% increase from 2,052 BOE/d produced in the second quarter of 2005. In addition, the Company's onshore Louisiana production for the second quarter of 2006 averaged 8,623 BOE/d, a 49% increase over 5,791 BOE/d produced in the second quarter of 2005, with the most significant production increases at Thornwell and South Chauvin Fields as a result of recent drilling activity in these areas.
Oil and natural gas revenues, excluding any derivative contracts, increased 51% between the respective second quarters as a result of higher commodity prices and increased production. Cash payments on derivative contracts were $2.2 million in the second quarter of 2006, up slightly from the $1.8 million paid in the second quarter of 2005 as only a small percentage of the Company's total production was covered by derivative contracts in either period. In addition to the cash payments, the Company expensed $9.3 million of mark-to-market and other charges related to derivative contracts in the second quarter of 2006, as compared to a gain of $2.8 million on these contracts in the second quarter of 2005.
Company-wide oil price differentials (Denbury's net oil price received as compared to NYMEX prices) were relatively consistent for the first and second quarters of 2006, but a little worse than oil differentials during the second quarter of 2005, averaging a negative variance of $6.64 per Bbl in the second quarter of 2006, $6.71 per Bbl in the first quarter of 2006 and $5.72 per Bbl in the second quarter of 2005. The Company's average NYMEX natural gas differential improved in the second quarter of 2006 to a positive variance of $0.25 per Mcf, as compared to a negative variance in the second quarter of 2005 of $0.13 per Mcf, although the most recent positive variance was not as good as the first quarter of 2006 positive variance of $0.78 per Mcf. This improved variance is due primarily to decreasing natural gas prices during the quarter. Since most of the Company's natural gas is sold on an index price that is set near the first of each month and fixed for the entire month, variances decrease (improve) if the NYMEX natural gas prices decline throughout the entire quarter.
Lease operating expenses increased between the comparable second quarters on both a per BOE basis and on an absolute dollar basis. Lease operating expenses averaged $12.24 per BOE in the second quarter of 2006, up from $9.65 per BOE in the second quarter of 2005. The increase over prior second quarter levels was primarily a result of (i) increasing emphasis on tertiary operations, (ii) general cost inflation in the industry, (iii) increased personnel and related costs, (iv) higher fuel and energy costs to operate Company properties, and (v) additional lease payments for certain tertiary operating facilities.
Production taxes and marketing expenses generally change in proportion to production and commodity prices and therefore were higher in the second quarter of 2006 than in the comparable quarter of 2005.
General and administrative expenses increased 98% on a BOE basis between the two second quarter periods, averaging $4.27 per BOE in the second quarter of 2006, up from $2.16 per BOE in the prior year's second quarter. The most significant increase was a charge for $5.3 million related to the modification of vesting terms of certain restricted stock and stock options associated with the departure of Mr. Worthey, former Senior Vice President of Operations in June 2006. Additionally, the Company incurred approximately $1.8 million of non-cash charges to expense both previously awarded stock options and newly awarded stock appreciation rights, as a result of the adoption of SFAS No. 123® as of January 1, 2006. The remaining increase is primarily related to higher compensation costs associated with additional personnel hired during the last year.
Interest expenses increased $1.4 million, or 33%, between the second quarters of 2006 and 2005, as debt levels almost doubled, partially offset by the previously noted capitalization of interest. Debt levels were unusually low in the second quarter of 2005 following the sale of the Company's offshore properties in mid-2004. Conversely, debt was used to partially fund the $250 million acquisition closed in January 2006, and to fully fund the $50 million acquisition of the Delhi Field in the second quarter, both future tertiary properties.
Depreciation, depletion and amortization expense ("DD&A") increased to $10.60 per BOE in the second quarter of 2006 from the Company's first quarter DD&A rate of $10.26 per BOE primarily due to rising costs. DD&A for the second quarter of 2005 was $8.80 per BOE.
The Company's net effective tax rate increased in the second quarter of 2006 to 39.9%, up from 32.8% in the second quarter of 2005, primarily because the Company will not earn any enhanced oil recovery credits during 2006, as high oil prices have caused the credits to be unavailable. Nonetheless, the Company will be able to utilize its $42.1 million of enhanced oil recovery credits carried forward from 2005 to help reduce its 2006 cash taxes.
The Company reaffirms its production guidance for 2006 of 37,000 BOE/d which represents total growth of 24% over average 2005 production levels, with approximately 72% of that growth coming from internal organic projects. However, since production from the Company's tertiary operations has been a little behind its original schedule, primarily due to injection delays at McComb Field early in the year and overall industry delays in obtaining goods and services, the Company is adjusting its 2006 tertiary production guidance to a revised forecast of between 10,500 BOE/d to 11,500 BOE/d.
Denbury's 2006 development and exploration budget is currently approximately $550 million. Any acquisitions made by the Company would be in addition to these capital budget amounts. Denbury's total debt (principal amount excluding capital leases) as of July 31, 2006 was approximately $445 million.
Gareth Roberts, Chief Executive Officer, said: "We are pleased with our overall operational results this quarter and believe our future continues to look bright. Overall production is still on target thanks to strong growth in the Barnett Shale area and in Louisiana. Production from our tertiary operations has been a little behind our original production guidance, primarily due to injection delays at McComb Field, but this has not affected reserves at all, and we believe we have resolved this issue as evidenced by production rates that are now responding to our higher injection pressures."
"Operating expenses have increased on a per barrel basis, primarily because of higher commodity prices, but also because we are in the early injection stages of the three new East Mississippi floods which will not be producing oil until late this year. Despite these increases in cost, we have been able to maintain an almost identical gross margin percentage this quarter as compared to the second quarter of 2005."
"We continue to pursue the acquisition of additional potential flood properties to further our extensive project inventory. Our program is working in spite of overall industry cost pressure and ever increasing delays in the procurement of goods and services."
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