CREDO Petroleum's Competitive Advantage

Aug.26.08 | About: Forestar Group (FOR)

Singular Research is initiating coverage on CREDO Petroleum Corporation (NYSEARCA:CRED), citing that the oil and gas exploration company's complementary business lines reduce risk yet generate double digit EPS growth. Key excerpts follow.

Investment Thesis

Headquartered in Denver, Colorado, CREDO is involved in two business lines: one locates and drills new gas and oil wells, and one uses its patented Calliope Gas Recovery System to extract the hard to reach remnants of older wells. The company operates primarily in the Mid-Continent and Rocky Mountains of the U.S. Recently, the company has expanded its 3-D seismic operations into south Texas and north-central Kansas.

As of fiscal 2007, CREDO owns working interests in 282 producing wells and overriding royalty interests in 1,163 wells, and acts as “operator” of approximately 115 wells pursuant to standard industry operating agreements. Natural gas accounts for about 77% of the company’s total production. The company sells its products to crude oil and gas purchasing companies. 

The company's two business lines complement each other in terms of replacing and growing gas and oil reserves. CREDO’s first business segment locates and drills new gas and oil wells. For the industry, gas and oil exploration is very expensive and highly risky. On average, only one in every three to four trial wells finds gas and oil. The company’s first business segment faces high exploration costs and the risk of drilling dry gas and oil wells. However, successful gas and oil wells are highly profitable. The exploration and production segment helps ensure the company replaces and grows its gas and oil reserves.

By contrast, the company’s second business line uses the Calliope system to recover gas from older or depleted wells at a relatively lower cost and risk. For most Calliope applications, the gas reserve addition costs are $0.50 or less per thousand cubic feet, which is about half of the gas reserve addition costs for new wells. But the production volume per day of a Calliope well is substantially lower than the production volume for a new successful gas well since Calliope is installed on mature or depleted gas wells.

Collectively, these two business segments complement each other in terms of replacing and growing reserves. The first business line is more profitable but volatile; and the second business line produces less gas but is more of a sure thing. The combination of these two business lines can hence reduce business risk significantly. It also gives the company a competitive advantage over other gas and oil explorers.

The company reported impressive financial results in fiscal 2004 and so far in fiscal 2005. FY:04 revenue growth was 21.5%. Q2:05 earnings and EPS were up 50%, hitting an all-time quarterly high. Operating margin was 47.2% and 49.1% in Q1:05 and Q2:05 respectively, much higher than the industry average operating margin of 26.4%.

The company’s balance sheet is in the best shape in years with no long-term debt financing. The company has no defined benefit pension plans and no obligations for post retirement employee benefits.

Risks

Oil price fluctuations can be extremely volatile and is hard to predict.