Should Investors Pay Attention to This Under-the-Radar Oil Play?

Energy investment firm Howard Weil recently upgraded Carrizo Oil & Gas Inc  (NASDAQ: CRZO  ) , setting a price target of $74, which would represent 13% upside from its Friday closing price of $65.58. Wall Street seems to have taken a liking to Carrizo Oil & Gas, with several other investment firms raising their target price on Carrizo. Wall Street is most certainty not always right, but that doesn't mean investors should completely disregard its upgrades or downgrades. With a trailing twelve month P/E over 100 yet a forward P/E of 16, analysts are expecting Carrizo to fire on all cylinders, but are these expectations warranted? 

An oil-weighted strategy
From the first quarter of 2013 to the first quarter of 2014, Carrizo's oil production soared from 9,311 bopd to 15,022 bopd, a 61% increase. To grow its oil production, Carrizo is leaning heavily on the Eagle Ford.

When Carrizo entered the Eagle Ford back in 2010, the Barnett shale encompassed most of its output. A few years and millions of dollars later, the Eagle Ford now accounts for over half its output, with most of its future production growth coming from this play. By increasing its Eagle Ford budget this year by 25% to $465 million, Carrizo will drill 51 net wells with its three rigs in the prolific oil-weighted play.

One of the reasons Carrizo is fetching such a high valuation is due to the high levels of growth from its Eagle Ford operations. Growth has been so strong that management has guided for oil production to jump 15% this quarter to 17,300 bopd. On top of strong oil production growth, Carrizo Oil & Gas recently raised its outlook for 2014, increasing the midpoint of its guidance to 54% oil output growth from 50% previously. This is a strong testament of Carrizo's growth prospects as it means that Carrizo will probably hit or exceed its guidance this year. 

Oil output growth has also steadily increased Carrizo's cash margin per barrel of oil equivalent, from ~$30 a barrel to $43.46 over the past year. This was achieved partly by selling off its Barnett shale assets last year, which is why Carrizo's total production was roughly flat year over year. Factoring out the asset sale, its production grew by 48% year over year. 

Going forward Carrizo will be able to combine production growth with higher margins, maybe allowing it to hit Wall Street's ever growing expectations. But beating expectations is just a short-term catalyst; for a company to be a good investment it needs to have a solid long-term pathway to success.

Utica development
Carrizo owns a 100% working interest in 15,000 net acres in the Utica, with a stake in another 10,700 net acres through its 50/50 joint venture with Avista Capital Partners, which Carrizo operates. This year, Carrizo plans on fracking and drilling seven net wells through its one rig drilling program, as it increases its Utica capex budget five-fold from $18 million last year to $100 this year.

In order for Carrizo to further develop the Utica, there needs to be adequate takeaway capacity. By the fourth quarter of 2014, Carrizo hope to have a firm agreement in place with midstream operators so production growth can ensue as it develops the condensate window of the Utica. Due to the low levels of output Carrizo is currently pumping out of the Utica, there is plenty of upside. 

Additional upside could come from following the leader in the Utica, Chesapeake Energy Corporation (NYSE: CHK  ) . From 2012 to 2013, Chesapeake Energy grew its Utica output by 400%, and is already on its way to grow production by 300% this year. To make things even better, Chesapeake Energy is guiding to grow its Utica output by 30%-60% next year. Now Chesapeake produces 75,000 barrels of oil equivalent a day from the play, half of which is oil and natural gas liquids, up from its average production in the first quarter in 2014 of 50,000 BOE/d. 

Chesapeake Energy's tremendous success in the Utica has been about more than just growing production. it has also been a testament to efficiency. This year, Chesapeake Energy hopes to reduce the drilling time per well from 18 to 13 days. This will help reduce well completion costs (not factoring in reinvested capital) from $6.7 million in 2013 to $5.7 million at the end of this year. As well completion costs go down, Chesapeake Energy was able to boost the return on its wells from 20% last year to 45% this year. Chesapeake's success points toward the enormous amount of upside Carrizo has in the Utica.

Foolish conclusion
By utilizing the oil-heavy Eagle Ford, Carrizo Oil & Gas has been able shift its production base toward oil, causing a surge in its bottom line. This trend will continue as Carrizo spends more on the Eagle Ford this year to keep production growing. If Carrizo follows in Chesapeake Energy's footsteps, the Utica shale will be able to pick up the slack down the road. While Wall Street isn't always right (see 2008), in this case I'm going to have to agree with them.

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