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Sanchez Energy (NYSE:SN) is a virtual pure-play Eagle Ford explorer with ~85% oil weighting across 138,000 net acres. Having announced its Cotulla acquisition of 43,000 acres in March, the story is now very much about the drill bit.

Sanchez is currently drilling with 2 rigs in Palmetto, 1 rig in Marquis with a second rig coming to Marquis during Q2 2013. Additionally there is an ongoing 1-rig drilling program in Cotulla.

In late 2012, Sanchez adopted pad drilling, which will lead to wells coming online in lumpy batches during 2013. In the early part of 2013, only 2 small wells were brought on line and these were in Maverick, Sanchez's least favored area where well costs are low and 30-day IPs average 250 Boed. However, the picture is now changing significantly; the period from the end of March through the end of May sees a flurry of activity, with 14 sizable wells coming on line. This extract from the company's March 26th presentation is telling:

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To put this into perspective, we will review typical well performance in each area.

Marquis Area: Sanchez has a 100% working interest here and has only drilled 3 'Prost' wells to date, the first well having a 30-day IP rate of ~500 Boed, the second well ~660 Boed and the third well ~900 Boed. Sanchez is excited about the Prost region, especially now that it has cracked the code, and expects it will be prolific during the next couple of years. Using an average 30-day IP of 800 Boed, the 6 new Prost wells should add initial 30-day production of ~4,800 Boed. Completing the 'Sante' well has been problematic, and I will omit it from calculations.

Palmetto Area: Sanchez has a 50% working interest in this area, with Marathon (NYSE:MRO) owning 50% and being the operator. Several wells have already been drilled in the Barnhart region, all with good results. The average 30-day IP rate for the most recent six wells was 1,169 Boed. Using an average 30-day IP of 1,000 Boed, the 8 new gross wells (4 net) coming online in May should add initial 30-day production of ~4,000 Boed for Sanchez.

Additionally, Sanchez has two other sources of production. The Cotulla acquisition, effective March 1, came with production of 4,500 Boed, which the company is maintaining during the remainder of 2013. And Sanchez also has production from its existing well count, this having average production of 3,800 Boed for the first two months of 2013.

After the current crop of wells come online by May 31, Sanchez should have production of about 13,000 Boed {3,800 Jan-Feb, 4,500 Cotulla, 4,800 April, 4,000 May, total headline 17,100, less fall-off}. Already, it looks assured that the company's 2013 exit guidance of 12,500-14,500 Boed will be exceeded.

It is now just 42 days until May 31 - I would expect that soon afterwards shareholders can anticipate some good news from the company.

Sanchez's full-year 2013 drilling plan is; 19 net wells in Marquis, 12.5 net wells in Palmetto, 2 net wells in Marquis and they also aim to drill an average of 1 well per month in Cotulla to maintain production at 4,500 Boed. Assuming the company exits 2013 with a similar drilling inventory as 2012, this means that there will be a further 13 net wells in Marquis and 8.5 net wells (17 gross) in Palmetto coming online during the remainder of 2013. This approximates to total additional 30-day IPs of 19,750 Boed on top of the 13,000 Boed figure estimated at the end of May. Even allowing for a sharp production fall-off and allowing for a larger drilling pipeline at December 2013, it would now appear that the year-end 2013 target exit rate of 12,500-14,500 Boed is excessively cautious.

Aside from the exciting production ramp taking place at Sanchez, there are big picture items associated with the recent Cotulla acquisition that investors should understand.

New acreage

The overall oil-gas split of the new 43,000 Cotulla acreage is 70% oil, 30% gas. The oil-gas split at Briggs Ranch - the blue contiguous patch at the bottom of Cotulla and located partially in the condensate window on the following map - is 50% oil, 50% gas. Excluding Briggs Ranch, Cotulla has approximately 81-83% oil, similar to Sanchez's existing 85% oil weighting.

The contiguous acreage in the middle of Cotulla is Alexander Ranch. It represents approximately 10% of the total 43,000 net acres acquired. Nearly all of the 13.4 million proved reserves acquired and the 4,500 Boed production acquired comes from Alexander Ranch. This ranch alone almost justifies the entire acquisition value: The PV1-10 of the 13.4 million proved reserves acquired was $294 million. The most recent wells on this ranch had PV-10s of $8 to $9 million.

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Of the 43,000 acres acquired, approx 15,000 is held by production, including all the acreage at Briggs and Alexander ranches. The remaining 28,000 is in the scattering of leases to the north of Alexander Ranch of which about 18,000 acres expires in 2013. A large portion of this 18,000 has 2-year extension options at a reasonably small cost. Sanchez is examining what to extend and what to let expire. Tentatively the company may keep 75%, effectively the most contiguous lots offering the best economic benefit. Generally, there is good shale thickness in this region - refer to north La Salle and south Frio on the map below - and the acreage is also prospective for Pearsall and Buda plays that are actively being drilled by offset operators.

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Production guidance 2013 & 2014

The production guidance provided by Sanchez below starts with the 2012 exit rate of 4,500 Boed before the Cotulla acquisition and has a 2014 exit rate of 16,000-18,000 Boed. The operating plan for Cotulla is to keep one rig drilling to maintain production. At first this will be a single well rig but this will soon change to pad drilling. The company has intimated that the Cotulla 4,500 Boed guidance is conservative and may be increased after the acquisition is bedded-in (closing expected in Q2).

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Earnings per share 2013 & 2014

The analysts' consensus EPS estimates for 2013 and 2014 are $1.60 and $2.80. Backing out the convertible preference dividend of 6.5% and upping the share count by 10.5 million to reflect full conversion, gives fully diluted EPS of $1.45 in 2013 and $2.45 in 2014.

Balance Sheet

Sanchez has an existing capex plan for 2013 of $350 million. Adding $80 million for new wells drilled at Cotulla, the full year total for 2013 becomes $430 million. In 2014 an increase to $450 million is assumed. Based on consensus EPS estimates of $1.60 for 2013 and $2.80 for 2014, and generating cash from operations of $175 million and $300 million, this should lead to net borrowings at year-end 2013 of $230 million and $380 million at y/end 2014. These equate to 35% and 50% of equity, which is comfortably lower than the majority of peers.

Summary

The story now at Sanchez is very much about drilling. Based on a strong pipeline of wells coming online between now and May 31, the company should exit May with production of ~13,000 Boed. Achieving this 13,000 Boed figure would mean that Sanchez has already hit its 2013 exit guidance figure early in the year. Moreover, with potentially a further ~20,000 Boed of production being added through drilling for the rest of the year it seems assured that, even allowing for a sharp production fall-off, Sanchez should comfortable exceed its year-end targets.

Sanchez stock, currently trading at $17.70, is on a fully diluted forward p/e of 7.2 (6.3 p/e undiluted). This is unusually cheap, especially considering the unleveraged balance sheet, the conservative production guidance and the 20+ years drilling inventory at the 2013 drilling rate. In the circumstances, it should come as no surprise if/when positive news on the drilling front provides the stock with strong support in the coming weeks.

Source: Sanchez: 13,000 Boed By May 31