Sanchez Energy: 2014 Revenue Will Not Cover Drilling Costs

| About: Sanchez Energy (SN)


Sanchez production outlook for 2014 may be slightly overoptimistic due to large legacy decline rate from adding 158 wells in 2013.

70 new wells which Sanchez plans to drill will cost more than revenue coming for the year.

This is typical situation in shale oil and gas plays. If capital costs will be recovered, it will happen during production decline phase of projects.

Sanchez Energy (NYSE:SN) had an impressive looking year in 2013. Production increased 726% compared with 2012 and revenue increased 629% (link). A big part of this success can be attributed to the $631 million acquisition which came with 74 producing wells, which was in addition to the 84 wells drilled by Sanchez Energy through the course of the year, which made for a total of 158 new wells. Total number of wells in production is 200, from which in the fourth quarter of 2013, Sanchez achieved an average daily production rate of just under 19,000 barrels of oil equivalent.

For 2014 Sanchez plans to spend between $565-615 million on drilling 70 wells (link). It is hard to predict with much accuracy how much of an impact on production the 70 new wells will have. Sanchez gives guidance for 2014 putting average daily production for the year at 21-23,000 barrels of oil equivalent per day. I believe that might be slightly overly optimistic, given that in 2013 based on the addition of 158 new wells the company achieved an increase of 15,000 barrels of oil equivalent per day compared to the fourth quarter of 2012. That is an increase of 95 barrels per each new well, but we have to remember that there was little legacy decline inherited from previous year, given that only 42 wells were in production in 2012. In 2014, there will be two declining wells drilled or acquired in 2013 for every new well. It is therefore to be expected that total net increase in production per well will be significantly smaller than it was in 2013.

Even if the average daily rate of production will be 20,000 barrels of oil equivalent per day, this would still represent an almost doubling of average production compared to 2013, when 10,600 barrels per day were produced. Assuming the oil/wet gas/ dry gas ratios will stay the same and prices similar to 2013, revenue would also almost double to about $577 million compared to $314 million in 2013.

This means that once again Sanchez will fail to catch up in revenue to the yearly costs of drilling, even as it approaches the point of slower production growth at an increasing cost due to the need to compensate for growing legacy production declines. This is important to acknowledge because when it comes to shale oil and gas we can expect relatively high capital demands even as decline sets in due to the very steep initial decline rates experienced in each well. It is therefore important to reach a point of breaking even on drilling expenses as soon as possible in order to then start paying down the expenses incurred in previous years.

Typical situation in shale fracking:

In order for Sanchez to start paying down capital expenses incurred during the early years, it has to catch up to drilling costs and then still make up for operating costs, with money left over. As I pointed out before in situations such as the Eagle Ford, companies are on average just now catching up on their drilling costs, which is the biggest hurdle. Revenue coming in stronger than capital and operation costs is the next hurdle and it is something we will likely only see in the production decline stage of development.

Given that shale oil and gas production through the process of hydraulic fracturing is a new industry, we do not know what to expect on the decline side of the story just yet. We do not know what the relationship between revenue decline and total cost declines will be. We are told that wells will continue to produce for decades after initial completion, but we cannot know that for sure either. Bottom line is that we need to be cautious and avoid getting caught off guard due to the sensational year on year increases in production we are seeing in shale plays as is the case with Sanchez Energy. The net profit on total investment if it will be achieved, will happen during the less than sensational and exciting decline side of the story.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.