Adjusted cash flow from operations (cash flow from operations before changes in assets and liabilities, a non-GAAP measure) for the third quarter of 2006 was $119.0 million, a 36% increase over third quarter of 2005 adjusted cash flow from operations of $87.3 million. Net cash flow provided by operations, the GAAP measure, totaled $135.4 million during the third quarter of 2006, a Company quarterly record, as compared to $76.3 million during the third quarter of 2005. The difference between the adjusted cash flow and cash flow from operations is due primarily to the changes in receivables, accounts payable 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).
Third Quarter 2006 Financial Results
Earnings and cash flow from operations were at near-record levels for the third quarter of 2006, primarily as a result of record quarterly production and high commodity prices (although commodity prices were approximately the same on a BOE basis between the respective third quarters). The Company set a new quarterly production level during the third quarter, averaging 37,561 BOE/d, a 37% increase over third quarter 2005 levels. Third quarter of 2005 production was negatively affected by Hurricanes Katrina and Rita, with an estimated 3,800 BOE/d of production deferred during that period. If last year's third quarter production is adjusted to include the estimated deferred production, the production increase between the comparative quarters is reduced to approximately 21%, or an increase of approximately 6,400 BOE/d. Approximately one-third of the production increase was attributable to the acquisition that closed January 31, 2006, which added 2,339 BOE/d to the third quarter average. This was supplemented by higher production in the Company's Barnett Shale area and higher natural gas production in Louisiana following several exploratory successes during 2005.
Oil production from the Company's tertiary operations averaged 10,114 BOE/d in the third quarter of 2006, a 14% increase over third quarter 2005 levels, but approximately the same as second quarter of 2006 tertiary production. The Company does not believe that these temporary fluctuations in tertiary production indicate any issue with the proved and potential oil reserves recoverable with CO2 because the correlation between historical oil production and CO2 injections remains high, as expected. The lag in production is due to a series of different types of delays in obtaining equipment or completing facilities causing the Company's CO2 injections to be below forecasted amounts.
Production from the Barnett Shale increased to 4,952 BOE/d in the third quarter of 2006, a 130% increase from 2,150 BOE/d produced in the third quarter of 2005, and a 7% increase over second quarter 2006 production levels, as a result of the increased drilling activity during late 2005 and 2006. In addition, the Company's onshore Louisiana production for the third quarter of 2006 averaged 8,221 BOE/d, a 59% increase over the 5,169 BOE/d produced in the third quarter of 2005, but slightly less than the second quarter of 2006 peak rate of 8,623 BOE/d, with the most significant production increases at Thornwell and South Chauvin Fields as a result of 2005 drilling activity in those areas.
In addition to the higher production, during the third quarter of 2006 the Company recognized $14.6 million of income associated with non-cash mark-to-market fair value changes on the Company's oil derivative contracts as commodity prices decreased during the quarter. Conversely, during the third quarter of 2005, the Company recognized mark-to-market fair value and other non-cash expenses of $8.1 million associated with derivative contracts in place at that time as commodity prices increased during that period. Average commodity prices on a per BOE basis were approximately the same between the respective third quarters of 2006 and 2005, even though the changes in oil and natural gas commodity prices during the respective quarters were in opposite directions.
Overall industry costs continue to increase, which is the primary reason for continued high operating costs and an increase in the depreciation, depletion and amortization ("DD&A") rate per BOE. DD&A increased to $11.92 per BOE in the third quarter of 2006, as compared to the Company's second quarter DD&A rate of $10.60 per BOE, and a rate of $9.68 per BOE in the third quarter of 2005, with the increase primarily due to rising costs. A downward reserve adjustment associated with the Company's Westervelt well and a loss of reserve quantities associated with declining commodity prices also contributed to the higher DD&A rate in the third quarter of 2006 than earlier in the year.
Lease operating expenses increased between the comparable third quarters on both a per BOE basis and on an absolute dollar basis. Lease operating expenses averaged $12.22 per BOE in the third quarter of 2006, up from $10.33 per BOE in the third quarter of 2005, and about the same per BOE as the $12.24 spent during the second quarter of 2006. The increase over prior year third quarter levels was primarily a result of (i) increasing emphasis on tertiary operations with their inherently higher operating costs, (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.
Administrative expenses increased 18%, primarily due to a 29% increase in the number of employees since September 30, 2005 related to the Company's growth. The Company had two partially offsetting non-recurring administrative expense items in the respective third quarters. During the third quarter of 2006, the Company expensed approximately $750,000 related to the retirement of the Company's Vice President of Marketing, as compared to approximately $1.4 million expensed for food, water, gasoline and other supplies provided as part of the Company's hurricane relief efforts in the third quarter of 2005. The Company adopted SFAS No. 123 as of January 1, 2006, which for the third quarter of 2006 resulted in a non-cash charge related to equity compensation of approximately $1.7 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.
During the third quarter of 2006, the Company capitalized approximately $3.7 million of interest expense primarily related to the unevaluated properties associated with the Company's two 2006 acquisitions. This reduced the overall increase in interest expense to 11%, even though average debt levels were 81% higher in the third quarter of 2006 than in the comparable period of 2005. These higher debt levels were primarily due to the use of debt to partially fund the $250 million acquisition which closed in January 2006 and to fully fund the $50 million Delhi acquisition in the second quarter of 2006, both acquisitions of future tertiary flood properties.
The Company's net effective tax rate increased in the third quarter of 2006 to 37.6%, up from 34.2% in the third 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.
The Company is reviewing the impact that delays have had on its production forecasts and plans to provide an update of such forecasts at its analyst meeting on November 8th and 9th. The presentation for this meeting will be available on the Company's website by November 8th. Currently, the Company anticipates that its overall production guidance for 2006 of 37,000 BOE/d will either remain unchanged or be slightly reduced. These anticipated forecasted amounts would represent total growth of 24% over average 2005 production levels, with approximately 72% of that growth coming from internal organic projects. The Company anticipates that its tertiary production for 2006 will either be at the low end of its previous guidance of 10,500 BOE/d to 11,500 BOE/d, or slightly less than that range. In addition to updating its 2006 guidance at the analyst meeting, the Company plans to provide preliminary 2007 guidance.
Denbury's current 2006 development and exploration budget is 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 October 31, 2006 was approximately $459 million, of which $84 million was bank debt.
Gareth Roberts, Chief Executive Officer, said: "During the last few years it has become more and more difficult in our industry to obtain goods and services on a timely basis, primarily due to escalating commodity prices. Experienced personnel have also been difficult to locate and the inflation rate in our industry has been several times higher than the national average for other industries. As a result, Denbury has experienced both delays and rising costs, most visibly in our tertiary program. We are reviewing our forecasts to determine if they are achievable in light of today's industry conditions, while we continue to look to improve management of our business under these conditions. Our overall production is still generally on target, thanks to strong growth in the Barnett Shale area during the last two years (although this rate of growth is not expected to continue) and our exploratory success last year in Louisiana. We remain confident about our tertiary program and its ability to recover forecasted reserves, as evidenced by the strong correlation between CO2 injections and oil production. We are continuing to expand this program as quickly as our internal resources and the industry's limited supply of equipment and personnel will allow. At our forthcoming analyst conference, we will talk more about 2007 and other future plans. We continue to see a bright future for Denbury."
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