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Want to Bet on Oil Companies? It’s All About the ZIP Code

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For energy investors, it is all about location, location, location.

That is the message that emerges in the prices of bonds of oil-and-gas companies operating across North America.

Bonds of companies with below-investment-grade credit ratings, or junk bonds, have held up best for producers in west Texas, Canada and parts of Oklahoma, as producers in those regions have proven relatively resilient to low commodity prices, according to data from Citi Research, part of Citigroup Inc.

Meanwhile, bond prices of producers operating in east Texas, North Dakota and the Gulf of Mexico have dipped to distressed levels, indicating bond investors—focused on a company’s financial strength—aren’t keen on drilling properties in those areas.

The are a few reasons for the divergence, including terrain and the costs of transporting oil and gas to market. But the biggest factor is simply how much fuel is yielded by wells in certain areas, versus other areas for relatively similar costs. In south Texas, the difference between wells with initial flows greater than the equivalent of 800 barrels of oil a day, compared with those that produce less than 600 barrels a day, is the difference between profits and losses, according to energy consultants RBN Energy LLC.

Until lately, drilling productivity, or lack of it, had been masked by high prices. “When crude was at $100 it didn’t matter,” said RBN President Rusty Braziel. “Everything was good at $100.”

At around $40 a barrel, though, it is a lot harder to cover costs. The sharp decline in prices since mid-2014 has forced producers to drill only their best prospects. With many investors and energy executives expecting prices to remain at these levels for some time, companies that can’t profit drilling their best properties aren’t being given strong odds of survival by debt investors.

Consider east Texas, which Citi defines to include the Haynesville, Bossier and Barnett shales. The unweighted average price for the longest-dated unsecured junk bonds of companies with primary operations there has plummeted to less than 12 cents on the dollar, the bank said.

Goodrich Petroleum Corp., which drills mostly in the region and has bonds that trade at around 1 cent on the dollar, said earlier this month it expects to report a large loss for 2015 after writing down the value of its assets and that its auditors are likely to express substantial doubt about its ability to stay in business.

It is a different story on the other side of the state. Companies drilling in the Permian Basin in west Texas have been among the industry’s best performing, with stocks that have risen in some cases throughout the downturn. Several layers of oil– and gas-bearing rock are stacked in the Permian, giving producers more chances to hit pay dirt from each well. Meanwhile, these producers reap the same savings on drilling and supplies—which have fallen with oil prices—as competitors in other areas.

The low costs, combined with individual wells that produce the equivalent of thousands of barrels of oil a day, result in a profit even at $30 oil for some producers, said Gabriele Sorbara, an analyst with Topeka Capital Markets. Citi’s data peg the Permian as the most-profitable drilling area in North America, and average bond prices have held steady at about 80 cents on the dollar.

To be sure, there is wide variance within the Permian. Diamondback Energy Inc.’s bonds trade at a premium to their issue price, yet debt sold by Approach Resources Inc., which drills one county south of Diamondback, trades at a big discount to face value.

Varied fortunes such as those can be found within many drilling regions, said Citi credit analyst Marisa Moss. “Even in good areas, it’s very county-by-county.”

Mr. Braziel’s RBN Energy studied the Eagle Ford Shale in south Texas—where bond prices average about 50 cents on the dollar by Citi’s methodology—examining production data and financial returns on individual wells. RBN found that a narrow band of land where wells produce initial flows greater than the equivalent of 800 barrels of oil a day are generally profitable at $38 a barrel. But just outside that area, wells likely won’t produce enough to justify drilling at current prices, Mr. Braziel said.

“It’s the difference between having a bond yield of 8% versus 80%,” he said.

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