Sanchez To Develop Western Eagle Ford Shale

This is a time of the year when many oil and gas companies release their capital spending plans. Lately there has been a certain fear amongst shale investors regarding lower domestic oil prices. This has lead to downward pressure on shale stocks and even speculation about whether shale producers will scale back some of the more marginal drilling projects were prices to drop significantly. As more companies come out with their 2014 capital budgets, we should know whether doemstic shale producers will be scaling back or accelerating drilling activity.

Sanchez Energy (SN), a fast-growing, small cap producer in the Eagle Ford Shale, is still going full speed ahead in 2014. In fact, Sanchez is one company that is enthusiastically developing the newer western branch of the Eagle Ford. Like bigger players such as EOG, Sanchez believes it can get great well economics in the western portion of this play, perhaps economics comparable to the eastern portion, where rates of return for many companies are well over 50%. This article will look at Sanchez's plans to develop, through both acquisition and capital expenditure, the western portion of the Eagle Ford shale. In addition, this article will address how Sanchez might perform in a lower price environment. Finally, this article will look closely at Sanchez's valuation, which is right now very reasonable.

Developing The West

The Eagle Ford is the second most economical shale play in the United States, bested only by the Bakken. While Sanchez has spent to acquire some acreage in another shale play, the Tuscaloosa, the company has dedicated most of this year's effort to developing the western portion of the Eagle Ford.

Acquisitions

Sanchez's most recent acquisition was in McMullen County, which is due south of San Antonio and toward the western branch of this play. Dubbed the "Wycross acquisition," this acreage includes 11 million barrels equivalent of oil (nearly all of which is actually oil). Wycross will produce 2,000 barrels of oil equivalent, or BOE, per day. The total cost of this acreage was $230 million. At current prices, Sanchez will break even after 5.7 years, not a bad proposition.

Capital Expenditure

Sanchez is also shifting development capital westward this year. Development capital for the company's western Eagle Ford holdings have gone from $122 million last year to $295 million in 2014. This represents 42% of the company's capital expenditure. Of the 79 wells Sanchez will drill, 37 will be in the western Eagle Ford. While we don't yet know how much Sanchez will grow its production in 2014, last year production grew by triple digits, and Sanchez will complete more wells in this year than in the last. The western portion will be the engine of that continued growth.

Can Weather Lower Oil

(click to enlarge)

Sanchez Energy, December 2013 Corporate Presentation

Sanchez Energy is one of those shale producers which should be able to weather lower oil prices. Much of the company's operations are in Palmetto County, which yields the highest returns in the Eagle Ford play. The chart above shows Sanchez's current EBITDA margin per barrel, which is superior to nearly all of the company's peers.

Even at $80 oil, and with a larger portion of oil coming from the western locations of the Eagle Ford, Sanchez will still get by just fine. Below is a set of charts displaying what Sanchez's internal rates of return would be were WTI to drop to $80 per barrel.

(click to enlarge)

Of the four Eagle Ford regions in which Sanchez drills, two of them, Palmetto and Marquis, are in the eastern portion of the shale. Palmetto, the core of the play, will still yield 86% from its 750 MBOE wells, and a respectable 21% from the 450 MBOE wells. Marquis will yield 33% and 21% respectively at $80 oil.

Moving westward, Sanchez's recently acquired Wycross acreage seems to be fairly low-risk. Lower-producing wells in Wycross will still yield 30% were oil to drop to $80. Its higher-producing wells will yield a very nice 53%. Further west still in Cotulla, which is close to Laredo, wells will yield 24% and 11% in the case of $80 oil.

So, of all Sanchez's Eagle Ford wells, only the 400 MBOE wells in the western most part will yield significantly below 20% at $80 oil. And this is all hypothetical. Remember, West Texas Intermediate oil is now just above $100. It would have to drop $20 for returns to get as low as in the charts shown above. Sanchez will be just fine.

Decreasing Costs

As we can see above, Sanchez has been chipping away at operational costs since 2011. Costs have gone from over $45 per barrel to just $22.89 per barrel as of the third quarter of last year. Factors behind the cost decrease include lower rig utilization times due to more efficient operations and implementation of pad drilling.

Financial

Steadily adding debt to both acquire and develop land, Sanchez now has over $600 million in debt. However, Sanchez also has $330 million in cash and an additional $240 million in additional borrowing capacity on its revolving line of credit. This means that Sanchez has $570 million in liquidity.

Data by Morningstar

A "funding gap" refers to when an oil and gas company's capital expenditures exceed its cash flow. As a young company in its early days, Sanchez is spending well above its cash flow in order to acquire land and drill as many profitable wells as it can. Since the company is increasing its drilling budget and may continue to acquire should it be economical to do so, we should expect this funding gap to continue for the time being. However, Sanchez's production is very profitable, and there will come a time when the company becomes very cash flow positive.

Valuation

Sanchez shares have simply been beaten up. Since late October shares have come down by over 18% while the market drifted higher. And Sanchez was never all that expensive to begin with. Trading at just 1.33 times book value, Sanchez is cheaper than all other shale heavyweights: EOG sits at 3.11 times, Pioneer Resources is at 3.43 times and Continental is up there at 5.34 times book. Only a small handful of established shale producers trade down at Sanchez's level. Given Sanchez's operational excellence, high margins and great production growth prospects, I believe that the company is a great value right here.

Source: Sanchez To Develop Western Eagle Ford Shale

Disclosure: I am long SN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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