Battling Fears of an Oil Glut

 | Jan 02, 2014 | 11:00 AM EST  | Comments
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eog

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sn

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mpc

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clra

This week WTI oil recovered to $100 per barrel, but that has not seemed to have allayed fears of a future glut in capacity in the United States. Shares of many of the biggest domestic oil producers are still lagging behind the broader market, and that has affected oil stocks.

Because shale oil is harder to get at and generally requires higher oil prices to be produced profitably, shale producers have been hit hardest on concerns of future overcapacity in oil. EOG Resources (EOG), for example, is down 9.2% since October and Pioneer Resources is down 10.2% since the same month.

Paul Sankey of Deutsche Bank, in his upgrade of Marathon Petroleum (MPC), said he believed that WTI could get as low as $75 per barrel before some of the more marginal drilling stops. Shale economics vary quite a bit. Some of the core shale drillers can continue to produce profitably at these levels while many peripheral wells may not be worth drilling.

Sanchez Energy (SN) is one of those producers which should be able to weather through lower oil. Sanchez operates mostly in the Eagle Ford shale of South Texas. Among oil shale plays, the economics of the Eagle Ford are second only to that of the Bakken. Much of Sanchez's operations are in Palmetto County, which is the core area and which yields the highest returns. However, Sanchez is enthusiastically developing and acquiring in the western portion of the Eagle Ford, where it still expects very profitable production, even at a lower price.

$80 oil scenario

 At $80 oil, Sanchez's better core wells will fetch an 86% internal rate of return, with the lesser wells still getting 19%. Its next closest acreage will get a 38% return on 550 thousand barrels of oil equivalent (MBOE) wells and 21% on those set to produce 450 MBOE.  

Moving west, Sanchez's most recently acquired "Wycross" acreage will yield a 53% return on 550 MBOE wells and a still respectable 30% on its 450 MBOE wells, even at $80 oil. Not bad. Finally, Sanchez's western most acreage near Laredo will yield a 24% rate of return on its 500 MBOE wells and 11% on its 400 MBOE wells, all at $80 oil.

Of all of Sanchez's Eagle Ford wells, only the lower production wells in the western most part of the play will yield significantly below 20% at $80 oil. And this is all hypothetical. Remember, WTI oil is now just above $100. Oil would have to drop $20 for returns to get even this low. Sanchez will be just fine.

Before we go into valuation, here are some other operational tidbits. Sanchez's margins in 2013 have thus far been great. At $58.93 earnings before interest, taxes, depreciation and amortization per barrel equivalent, Sanchez has margins that rival even some of the more conventional oil producers. The company has done a great job in reducing operating costs. Since 2011, cash operating costs per barrel have declined from about $45 per barrel down to $22.89 per barrel in the third quarter.

We don't yet have guidance for 2014 production growth, although in 2013 Sanchez grew production by the triple digits. Nearly all of that was oil, not lower-priced gas. In 2014 the company will drill 79 new wells compared to just 40 in 2013.

 Valuation

 Sanchez shares have been beaten up, it's that simple. Since late October, shares are down a whopping 18%, and Sanchez was never all that expensive to begin with. Trading at just 1.33x book value, Sanchez is cheaper than the shale heavyweights: EOG sits at 3.11x, Pioneer is at 3.43x, and Continental Resources (CLR) is up there at 5.34x book. Only a small handful of established shale producers trade at Sanchez's level. Given the company's operational excellence, high margins and bright production growth prospects, I believe that Sanchez Energy is a great value right here.

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