This week, we uncover a well-run oil and gas producer that has successfully reduced its costs while increasing production. Carrizo Oil and Gas Inc. (CRZO) is an exploration and development company engaged in the production of oil and gas from several oil and gas producing shales in the United States. Due to its vast ownership of tracts within the resource-rich Eagle Ford Shale in Texas, the company has been able to reduce its breakeven price on oil production costs to as low as $33.75 per barrel while increasing its production a whopping 63%. In addition to this, Carrizo’s management has astutely minimized its exposure to recent volatility in oil and gas prices through a very successful hedging strategy. As low oil prices continue to shake out the weaker players in the industry, Carrizo is staying the course, and is poised to ramp up production when oil prices begin to rise again. Consequently, we see these B rated bonds, currently trading just under par and yielding about 8½%, as solid addition for income investors looking to profit from the prevailing fear in the oil markets. With interest rates likely to remain suppressed for an extended period of slow economic recovery, these relatively short 5 year bonds appear to represent superior returns to many other asset classes, including stocks, over the next 4 to 5 years. In light of these considerations, we are targeting these bonds for addition to our fixed income portfolios, FX1 and FX2.
About the Issuer
Based in Houston Texas, Carrizo Oil and Gas is an energy company actively engaged in the exploration, development and production of oil and gas from several resource locations in the United States. Current operations are mainly focused in proven producing oil and gas shale primarily in the Eagle Ford Shale in South Texas, the Utica Shale in Ohio, the Niobrara Formation in Colorado and the Marcellus Shale in Pennsylvania.
In April 2010, the company announced the initiation of oil focused horizontal development programs in the Eagle Ford Shale in South Texas where it has accumulated approximately 82,500 net acres and in the Niobrara Formation in Northeastern Colorado where it has accumulated approximately 34,700 net acres. Carrizo has experienced impressive results in both these areas with 100% drilling success and strong production growth. Recently, the company has built a position in the emerging Utica Shale in Eastern Ohio, where it holds approximately 27,500 net acres, as well as the Wolfcamp Shale in the West Texas Delaware Basin, where it holds approximately 20,000 net acres. Carrizo also maintains an option on natural gas prices through its position in the Marcellus Shale in Appalachia, where it has accumulated roughly 33,200 net acres.
Eagle Ford Shale
The Eagle Ford Shale is possibly the largest single economic development in Texas history and ranks as the largest oil & gas development in the world based on the amount of capital invested. Almost $30 billion was spent developing this resource in 2013. The Eagle Ford is presently the most active shale play in the world with over 100 rigs running. The formation is best known for producing variable amounts of dry gas, wet gas, NGLs, condensate and oil.
Many in the oil and gas industry are indicating this resource will be developed for decades to come. And even with current low crude oil prices, the energy industry is still expected to pour $20 billion into the Eagle Ford Shale in 2015. Wood Mackenzie, an energy consultancy group, expects the oil field to reach the 2 million barrel-per-day production mark by 2020, assuming oil trades around the $55-per-barrel level. Currently, the field produces approximately 1.6 million daily barrels, according to a recent report from Bentek Energy.
Carrizo has also benefitted from the abundant oil and gas reserves in Eagle Ford Shale, with nearly 70% of its current production volume coming from its Eagle Ford Shale wells. In fact, this formation was key to propelling Carrizo to a massive increase in oil production in 2014, registering a 63% increase over the previous year. And in Q2 2015, the company had record oil production of 22,284 Bbls/day, 21% above the levels for Q2 2014.
The company has smartly focused its operations on this rich resource also due to the lower oil production costs. The current jewel in Carrizo’s crown, Eagle Ford Shale is the company’s most economical play at present with an average breakeven cost of $41 / barrel in over 80% of its Eagle Ford locations with some assets in the Gardendale / La Salle County area of Eagle Ford boasting a stunningly low breakeven cost of $33.75 / barrel.
For bondholders, Carrizo’s ownership of vast tracts of land within Eagle Ford Shale represents an additional asset that could be liquidated if needed. In the oil industry, the drilling rights associated with a specific property have intrinsic value especially properties which are under production and producing monthly revenue.
Decreasing Well Costs
Carrizo has done an excellent job in reducing its well costs over the past year, which is extremely timely given the recent declines in oil prices. In Q2 2015 (ended 6/30/2015), well costs in Eagle Ford Shale for a 6,100 foot lateral well decreased to an average of $4.8 million, down from $5.6 million, a 14% decrease. Furthermore, since late 2014, company well costs in the Eagle Ford Shale have declined an impressive 35% due to drilling efficiencies and service cost reductions. These decreased well costs have helped Carrizo to keep its production cost per barrel low, a huge benefit in the current low price oil environment.
In light of oil’s recent declines, the management at Carrizo has employed an effective hedging strategy to provide a buffer to oil and gas price volatility. These strategies have definitely worked in the company’s favor this year. As of 6/30/2015, Carrizo’s hedging strategies are expected to add an additional $78.9 million of cash flows for the second half of 2015. Carrizo has a majority of its oil and natural gas production covered this year. 70% of crude oil production for the balance of 2015 is hedged with a weighted average floor price of $50 / barrel and a weighted average ceiling price of $67.34 / barrel. In addition, the company also has approximately 60% of its natural gas production hedged for the balance of 2015. Carrizo also has hedging in place for 2016, consisting of collars on 5,500 barrels per day with $51 floors and $75 ceilings.
While Carrizo had a banner year in 2014, with net income up over 400% from 2013 ($226.3 M versus $43.6 M), and adjusted EBITDA up 29% to $533.3 M from $412.2 M, the real question is how is the company faring in 2015 with oil prices less than half of its 2014 peak.
From a bondholder perspective, interest coverage ratio is extremely important. For the six months ended 6/30/2015, Carrizo had EBIT of $229.393 M and interest expense of $35.195 M for a very healthy interest coverage of 6.5x.
Even with oil at its current levels, Carrizo still maintains a decent balance sheet. The company’s long-term debt stands at 1.37 billion, but there are no near-term maturities until 2020. For the first six months of 2015, Carrizo generated discretionary cash flow of $192 M. If oil prices held reasonably close to their performance in the first half of 2015, then Carrizo would generate close to $400 M in discretionary cash flows. Coupled with the company’s current liquidity of $553 million, this is more than enough to cover the 2015 capital budget of $470 to $490 million.
The default risk is Carrizo Oil and Gas’ ability to perform. The company has been extremely shrewd in its hedging strategy in order to provide a level of protection from falling oil prices in 2015. Also, its low-cost production of oil from its Eagle Ford Shale wells has kept the company’s breakeven cost per barrel extremely low and by extension, limited any company losses from prevailing low oil prices
For the six months ended 6/30/2015, 87% of Carrizo’s revenues came from sales of crude oil. Consequently, the company is significantly exposed to price fluctuations in oil, and to a lesser extent, natural gas. Considering the company has hedged 70% of its remaining 2015 oil production and 60% of its remaining 2015 natural gas production, these measures should provide a level of protection against dramatic corrections in the commodities markets.
Summary and Conclusion
It’s difficult for industry pundits to predict oil prices will do next. Carrizo Oil and Gas has done a very intelligent job of reducing well and production costs by focusing on its low-cost production assets in the Eagle Ford Shale, along with employing an effective hedging strategy to even out the bumps in the roller coaster of recent oil prices. Therefore, we believe the company’s relatively short 60-month bonds, currently yielding a healthy 8.5%, provide investors additional diversification in the oil and gas sector with an extremely well-run and well-managed oil producer that is positioned for outstanding growth when oil prices begin their inevitable march upward. While many investors are shying away from oil and gas, we continue to find hidden gems, like Carrizo, and have chosen to its bonds to our Fixed-income1.com and Fixed-income2.com global high yield income portfolios.
Issuer: Carrizo Oil & Gas, Inc.
Yield to Maturity: ~8.5%
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Disclosure: Some Durig Capital clients may currently own Carrizo Oil & Gas 2020 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.
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