The one stock you must own for 2018 is Sanchez Energy (SN) . Sanchez shares had a terrible 2017, falling 40%. The year started with much promise for Sanchez, with the announcement of a purchase (a 50/50 venture with Blackstone) of 318,000 acres in its core Eagle Ford play in South Texas. Sanchez was able to use that optimism to issue 11.5 million shares at $12.50 in late January 2017 -- but then, things turned sour.
Stocks of oil exploration and production companies were taken to the proverbial woodshed just after Sanchez closed its stock offering. Oil prices had been in a weirdly static range of $52-$53 per barrel in the months after the election, but fell on supply worries to a low of $42 per barrel by late June.
In a market where seemingly everything (except Action Alerts PLUS charity portfolio holding General Electric (GE) , which has significant energy exposure) was rising, E&P stocks became convenient whipping boys for the shorts. As of Dec. 15, 2017, more than 22 million of Sanchez's shares were borrowed by short-sellers -- a whopping 30.3% of its float.
Sentiment has changed markedly in the oil pits in recent weeks, however. OPEC's decision to continue with reduced output started crude's upward move on Nov. 29, and lower U.S. inventory levels have contributed to the oil's price gains. There is always a pundit on CNBC saying "yes, but increasing U.S. production will limit oil's upside", but that misses the point of investing in oil stocks.
I want to be exposed to production growth and, aided by the addition of the Comanche acreage, Sanchez's production (see below; measured in barrels of oil equivalent per day) grew through 2017, even as its stock price imploded.
Also, note that Sanchez is not a pure play on oil. As of Sept. 30., Sanchez's production mix was 31% oil, 32% natural gas liquids and 37% natural gas. So, Sanchez has upside if historically cold weather continues to power a natural gas price revival.
I also want a company that is leveraged to rising output not just participating in it, and Sanchez certainly is a leveraged company. As of the end of the third quarter, Sanchez had $1.93 billion in debt compared to its current equity market value of $460 million.
The bond market is sanguine about Sanchez's prospects, even if the shorts are not. Sanchez's debt is composed of two main tranches of senior notes, and as shown below, both are trading at yields that are not out of the ordinary in the high-yield energy debt space:
Coupon Maturity Face Value Price (1/3/18) Yield
7.75% 6/15/21 $600 million 96.83 8.84%
6.125% 1/15/23 $1.15 billion 87.50 9.29%
So, what are SN shares worth? It is not easy to value Sanchez, and I think that helps the shorts. As part of the Comanche transaction, Sanchez created an unconsolidated subsidiary that carries some debt (I include that in the $1.93 billion figure I use to value SN). Sanchez also has 15.6% ownership in a publicly-traded MLP that contains some of its formerly-owned gathering and processing assets, Sanchez Midstream Partners (SNMP).
For the sake of simplicity, I value SN using an old-fashioned energy sector valuation metric: value per flowing barrel. This is based on forward futures pricing (the strip, in financial lingo), and with the strip moving upward, the value per flowing barrel must have increased. That has not been reflected in SN shares.
As of the close of trading on Jan. 2, I calculate an enterprise value for SN of $2.4 billion and a value per flowing barrel of $30,000. This is not only well below the value ascribed by investment bank Cowen to Sanchez's Comanche acquisition ($34,400), but also below a late-December transaction in the Eagle Ford, Penn Virginia's purchase of assets from Hunt Oil, which carried a valuation of $35,000 per flowing barrel.
Sanchez's massive position in Southwest Texas (397,000 mostly contiguous acres) gives it a size premium that has to be included in a fair valuation. Also, my valuation is based on the low end of management's guidance for fourth-quarter 2017-- 80,000-84,000 boepd -- and gives no credit for production increases. Sanchez management has a production target of 100,000 boepd by mid-year 2018, so it clearly is bullish on output.
I value Sanchez today at $40,000 per flowing barrel, or $7.50 per share. That is about 30% upside from the stock's closing price of $5.52 on Jan. 2. That valuation only reflects current production and excludes the value of Sanchez's holding in SNMP, so it could be conservative. Confirmation of that bias was shown when Blackstone BX took 8.5 million warrants on SN at $10 per share as part of the Comanche transaction, at a time when oil prices were lower than they are today.
So, the smartest guys in the room (Blackstone) love Sanchez, the dumbest guys in the room (the shorts) hate it, and the most accurate guys in the room (bond traders) believe it is creditworthy, albeit risky.
Bottom line: SN is a Portfolio Guru stock, and my clients and I own a substantial position.