(Bloomberg Gadfly) -- It certainly feels like patience is wearing thin in the shale patch.
Carrizo Oil & Gas Inc. is the latest fracker to feel the hot breath of an activist down its neck, in the form of Kimmeridge Energy Management Co. The private equity firm has taken a roughly 8 percent stake in Carrizo and wants it to either merge or sell a large slug of assets.
You can see why investor relations have become a tad fraught in the exploration and production business:
Investors have been backing away from energy stocks, be it majors like Exxon Mobil Corp., minnows like Carrizo and even related sectors like pipeline operators. What links them all is a lack of faith in management to spend money wisely after years of investment that often generated growth but didn't help returns or balance sheets. Hence, we've seen activists crop up at several firms, as well as some companies taking radical action to head off that dreaded schedule 13D filing. The broad message: Show us some money, not just more barrels.
Carrizo, trading at less than 4 times 2019 Ebitda, is in something of a bind. It has decent holdings in the Permian and Eagle Ford basins and its production has risen at a compound average of 18 percent a year since 2013; 31 percent for higher-value crude oil. But cash flow and leverage are a different story.
Negative free cash flow has pushed up Carrizo's leverage; although consensus estimates imply it falling quickly over the next few years:
That projected drop in leverage is less than meets the eye. Ebitda forecasts are, as they say, subject to change. And in any case, leverage of even 2 times Ebitda looks pretty high in Carrizo's peer group these days.
Most of all, though, it misses the point. Ebitda as a proxy for cash flow is all well and good, but it's before capital expenditure -- and Carrizo is forecast to have negative cash flow through the end of the decade, even if the burn is expected to ease. That leaves little flexibility to offer investors payouts in the near term. Essentially, Carrizo is asking them to keep the faith while it develops its assets and brings down its leverage over time, hopefully relieving the burden on its stock along the way. This was the core of its response to Kimmeridge, put out Friday morning:
Carrizo agrees with Kimmeridge’s assessment that its assets are currently undervalued relative to peer companies with similar-quality acreage, but believes that executing on its development programs in the Eagle Ford Shale and Delaware Basin while continuing to strengthen its balance sheet will reduce the current discount valuation in its shares and create significant value for shareholders.
That message is just not very compelling in an energy sector where even top-tier players are working harder to attract scarce incremental investors. It doesn't help that Carrizo delivered a messy operational update and soft guidance with its year-end results in February.
Even without that, Carrizo's appeal for the marginal investment dollar is limited by its scale. It's a relatively small player, both in terms of enterprise value -- $3.2 billion -- and its position in both shale basins. The recently announced acquisition of RSP Permian Inc. by Concho Resources Inc. underlined the potential productivity gains on offer if companies with adjoining acreage pool their assets. Per Magnus Nysveen, head of analysis at Rystad Energy, points out that pad drilling -- a more-efficient method sinking multiple wells from one location -- lags in the Permian basin compared to elsewhere due to fragmented land ownership:
Carrizo holds about 80,000 and 42,000 acres, net, in the Eagle Ford and Permian basins, respectively. To put that in perspective, here's how that stacks up against the 15 largest landholders for the regions, combined:
Little wonder, then, that Kimmeridge is calling for Carrizo to merge or sell a large chunk of its assets. Its Permian acreage sits next to large positions held by the likes of Anadarko Petroleum Corp., Centennial Resource Development Inc. and PDC Energy Inc. The latter two are small-cap E&P companies like Carrizo -- and PDC just happens, y'know, to also be in Kimmeridge's portfolio. Carrizo's larger Eagle Ford position sits hard by acreage held by far bigger companies such as EOG Resources Inc., Chesapeake Energy Corp. and EP Energy Corp.
With many investors simply indifferent to the sector, banking on a few years of blocking and tackling to boost multiples is a long shot. Consolidation in shale is both logical and, at this moment in time, offers comfort for the truly unloved.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.
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