Oil Price Weakness Can Clog Carrizo's Growth

NEW YORK (TheStreet) -- Houston-based Carrizo Oil and Gas (CRZO) is a small energy company with a market cap of $1.8 billion in exploration and production of mainly unconventional oil and gas. The company owns acreage in Eagle Ford Shale, the Niobrara Formation, the Marcellus Shale and the Utica Shale. The business has reported impressive growth over the last couple of years due to an increase in oil production, a trend also evident in its previous quarterly results released a week ago.

The company is now eying considerable growth in production volumes in 2014. However, the recent weakness in oil prices can have an adverse impact on Carrizo's ambitions. Investors should look into the oil prices before betting on Carrizo's rally.

During the third quarter, Carrizo's total production rose to record levels of 30,000 barrels of oil equivalents per day, showing a 17% increase from the same quarter last year. This was largely due to a 41% increase in oil production from 2012 to record level of more than 12,200 barrels per day. The company's total oil and gas revenues rose 50% from last year to $144.3 million due to a 53% increase in oil revenues to $117.8 million. As a result, the business ended the quarter with net income of $5.7 million, a significant improvement from a loss of $1.9 million in the comparable quarter last year. In adjusted terms, this translated into a 60% increase in earnings to 72 cents per share, 2 cents above market's expectations.

Some of the growth of crude oil revenues can also be attributed to a 4% increase in average realized prices (including the impact of derivatives) from the same quarter last year. Although Carrizo missed the revenue estimates of $146.5 million, overall this was a strong performance.

Carrizo holds significant acreage in four of America's leading energy plays, particularly the Eagle Ford where it now owns 58,000 net acres. Carrizo has been working on improving its asset portfolio by selling its non-core acreage, such as the Barnett Shale assets, and increasing its focus on its premier oil assets, such as the Eagle Ford. In the previous quarter, Carrizo sold its Barnett assets and acquired additional acreage at Eagle Ford and the liquids rich area of Utica. Carrizo now owns 21,700 net acres at Utica which represents around 120 potential drilling locations.

The investment at Utica will not yield any meaningful impact in the short term, as Carrizo has no prior experience of working in this region, but it goes well with its strategy to significantly increase its oil output in the long run.

The business's capital and acquisition expenditure is being fueled by its asset sale and through a stock offering of 4.5 million shares. The company's priority is to develop its liquids rich assets. Carrizo spends more than 75% of its drilling and completion expenditure on oil assets, such as its Eagle Ford Shale acreage. As a result, the growth of Corizzo's oil output has easily outpaced the growth of gas.

Due to slump in natural gas prices, most of the exploration and production companies operating in the U.S., including the natural gas giant Chesapeake Energy ( CHK), have shifted their focus towards oil from gas and natural gas liquids. This has led towards a turnaround of fortunes of energy firms, particularly those that were previously producing significant quantities of gas. For instance, in its quarterly results announced a few days ago, Chesapeake Energy was able to beat market expectations due to an unexpected increase in its oil output. Similarly, Carrizo also owes its successful growth to the increase in oil production.

Due to this pro-oil strategy, crude is now making a considerably bigger contribution to the company's revenue mix. In the previous quarter, Carrizo earned more than 80% of its revenues from oil, a significant shift from just 10% in FY2010. Similarly, in terms of production volume, crude's contribution to the company's production mix has risen from 34% in Q3 2012 to more than 40% in Q3 2013. With the strong levels of inventory (discussed below), this trend will continue in the future.

The company has amassed impressive inventory, including 552 potential wells at the Eagle Ford. This could power the company's Eagle Ford production for the next 12 years. Carrizo currently has 24 net wells awaiting completion in this region which could increase its output by 8,900 barrels per day. This would be a significant increase for Carrizo, since it produces just around 12,000 barrels per day.

On the contrary, and not surprisingly, Carrizo is limiting its gas output from Marcellus due to the weakness in pricing environment.

Carrizo's shares have been up more than 100% this year. The stock is now slightly expensive as it is trading 34 times its trailing earnings and 4 times trailing sales. However, I believe it can still move higher due to the expected increase in production from its Eagle Ford wells currently awaiting completion. For the current year, Carrizo has targeted a 47% increase in oil production, followed by 40% increase in the next fiscal year. This will translate into top and bottom line growth in the future. However, there is a catch here; the recent drop in oil prices could hit Carrizo's growth momentum.

The domestic oil supplies have been growing for the last six weeks. Total oil supplies now stand at 383.9 million barrels, their highest levels in more than 4 months. The increase in production and soft demand has dragged the oil futures. The speculation related to Federal Reserve's tapering is adding to the volatility in oil prices. If this negative trend continues, then it would be bad news for Carrizo's investors.

To make matters worse, the international oil market could witness an increase in supply from the Middle East due to the improvement in relations with Iran and an uptake in production from Libya. If, and when, that happens, then oil prices could tumble by as much as $15 per barrel.

At the time of publication, the author held no position in any of the stocks mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

Sarfaraz A. Khan is a capital market analyst and finance writer. Khan earned an MBA from the University of Aberdeen, located in the heart of the UK's oil and gas industry. Not surprisingly, his specialty lies in energy stocks. He also covers consumer goods, services sector, technology stocks, emerging markets and ETFs. His work appears on Seeking Alpha, Motley Fool and TheStreet.

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