Bakken Update: Sanchez Has Upside In The Eagle Ford

| About: Sanchez Energy (SN)
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Sanchez Energy (NYSE:SN) has become an interesting investment over the past 12 months. Acreage acquisitions continue to add value as it has created three core areas in the Eagle Ford. One of these core areas is considered to be best in play. It has also acquired acreage in the Tuscaloosa Marine Shale. This is an emerging play with excellent early results. Although it has missed several quarters in a row, I believe things are beginning to turn around at Sanchez.

Sanchez Energy has missed earnings for three straight quarters. In Q2 it missed on both the top and bottom lines. Revenues came in at $59.1 million, which missed analyst estimates by $2.88 million. Q2 EPS was $.17 versus the Street's estimate of $.28. Since then, Sanchez has announced two large acquisitions. I liked both deals. The first was 40000 acres in the Tuscaloosa Shale and the second 3600 gross acres in the Eagle Ford.

In Q2, production was up 100% sequentially and 800% year over year. The average daily rate was 7700 Boe/d. This was an improvement over Q1, which was 3900 Boe/d. In Q2 of 2012, Sanchez produced 859 Boe/d. Revenues grew 90% over Q1 of this year. For the quarter, Sanchez had a realized crude price without the effect of derivatives of $101.42/bbl. NGL pricing was $24.48 and $4.61/Mcf for gas. In Q2, it spud 15 wells and brought 15 on line. Sanchez's production and revenues for Q2 is broken down by prospect in the table below.

Prospect % Of Total Production % of Revenues
Palmetto 50 52
Marquis 28 28
Cotulla 15 14
Maverick 6 7

One of the most important variables to consider when investing in small cap oil and gas is location. No matter the play, one company's acreage may be two to three times better depending where it is. Evaluating acreage is difficult, as the average investor doesn't have access to this type of information. Not only does one need to know the results of a specific company, but also other operator results for comparison. All plays have differing geology and the Eagle Ford is a good example.

The above map provides differences in geology by location. There are three windows in the Eagle Ford. The green denotes oil, yellow is condensate and pink is gas. The low GOR portion of the oil window garners 99% of its revenues from liquids. EURs improve in the high GOR oil window, and is the best in the condensate window. Liquids as a percent of revenues decreases to 88%. IRRs are just 21% in the low GOR oil window on average, but this is much better in the condensate window at 90%. These numbers are based on $85/Bbl WTI, $3.45/Mcf gas and NGLs at $34/bbl so it will vary depending on current price realizations, but this at least gives an idea of economics.

Sanchez's Cotulla area has seen an improvement in drilling times. It now plans to drill 14 net wells in Cotulla this year. That is four more than originally planned. 80 acre spacing has worked in this area, and Sanchez plans to downspace to 40 acres. Two wells are currently being completed. In Palmetto, Sanchez has 50% working interest with Marathon (NYSE:MRO) as the operator. The 30-day IP average for wells completed is 1050 Boe/d. Its 40-acre pilot has produced better than expected. It doesn't need to mobilize a third rig in this area, as drilling times have improved enough to hit its well count with two. Sanchez plans to participate in 30 gross wells this year. There were 12 wells in some form of completion at the end of Q2. In Marquis, Sanchez has recently completed three wells in Q2. These wells have performed at company expectations. It did abandon one well in Marquis due to an oil service error. It is currently seeking compensation. Sanchez has contracted a third rig here to catch up on drilling times. It also added three wells to guidance. It will drill 22 net wells in Marquis this year. At the end of Q2, it had four wells in completion. In Maverick, Sanchez continues to gather data on the Pearsall shale and Buda shales.

Its current 2013 operated cap ex budget is $475 million. Due to lower costs, it plans to drill a total of 7 additional operated wells within the same capex. It now spud a total of 54 net wells and completed 39 net wells. Q3 production guidance is 11000 to 12000 Boe/d. The current 2013 exit rate guidance is 15000 to 17000 Boe/d.

Sanchez has upside in the Tuscaloosa Marine Shale. It has 40000 net acres, and paid $78 million plus a minimum three well carry. The TMS is about the same age as the Eagle Ford. It is almost an extension and runs from the Gulf Coast. It begins in Texas, runs through Louisiana and terminates in Mississippi. Because it shares some of the same geology as the Eagle Ford, Sanchez believes it can use information garnered earlier and use it here. 50% of its acreage is held by production and the rest doesn't expire until 2016. It plans to drill its first three wells over the next 18 months. The Tuscaloosa is an interesting play. Realized crude pricing is based on LLS. Early well results have been good, and are getting better. Current EURs are between 400 MBoe and 800 MBoe. 90% of the resource mix is crude. Because it is so early, there should be significant upside. Well costs are not as bullish. Wells cost between $12 million and $16 million. I would suppose this will improve, but EURs will need to be to the high end of current estimates to provide decent IRRs. Goodrich (NYSEMKT:GDP) has a well that produced over 100000 Boe in the first five months of production.

There has not been a great deal of well results in the Tuscaloosa. The table below provides data to date.

Well Operator Date Lateral Stages Proppant IP 30
Beech Grove 68 H1 Devon (NYSE:DVN) 7/11 3073 12 2130444 85
Soterra 6H-1 DVN 10/11 3929 13 3146208 176
Richland Farms 74H1 DVN 1/12 4020 10 916000 320
Weyerhaeuser 14H-1 DVN 3/12 5670 20 6350000 692
Murphy 63H1 DVN 4/12 5170 19 5241511 506
Thomas 38H1 DVN 5/12 5086 16 4992000 505
Weyerhaeuser 73H1 ECA 8/11 5150 17 4224993 770
Horseshoe Hill 10H1 ECA 11/11 5650 18 6660000 656
Anderson 17 H1 ECA 12/11 7210 30 11286990 933
Anderson 18 H1 ECA 1/12 8575 29 13736662 1072
Crosby Minerals 12-1 H1 GDP 10/12 6681 24 10885344 1137

Dupuy 20 H1

(NYSE:EOG) 9/12 4855 19 9025000 550
Anderson 17 H2 ECA 5195 23 1159
Anderson 17 H3 ECA 7219 32 557
BOE 1H ECA 2924 10 341
Weyerhaeuser 60 H1 ECA 9/12 7500 25 18750000 747
Weyerhaeuser 60 H2 ECA 5/12 5000 15 11250000 251
Ash 31 H2 ECA 11/12 5309 18 18000000 533

As you can see, these results are quite good. Since the play is very deep, well pressures are higher and should produce better IP rates. The Tuscaloosa has also produced better results to the east, but it is difficult to know if this is due to geology or a better well design. Results continue to improve, with production per foot holding up well in longer laterals. Operators have quickly increased lateral feet and tightened up stages. It also continues to increase proppant used per foot. We are just starting to see how these better well designs perform over time. There is obviously limited data, but I have included the cumulative production for several of the better wells to date.

Well Months Producing Cumulative Production Boe
Anderson 17 H1 13 109341
Anderson 18 H1 13 133893
Crosby Minerals 12-1 H1 5 99202
Weyerhaeuser 60 H1 4 50152

As a general rule, better well design will improve initial production, but more importantly it slows depletion. Encana (NYSE:ECA) is a leader in this play and reports a decrease in well costs from $2.8 million per 1000 feet to $2.2 million. Its longest lateral to date is 8800 feet. I would guess operators will continue to work towards the 10000 foot laterals seen in other plays. Encana's current well costs range from $12.5 to $14 million for a 7500 foot lateral. Its EURs range from 700 MBoe to 800 MBoe.

Halcon (NYSE:HK) is also working the TMS. It had drilled a few wells in 2012, but this area is not a focus in favor of the Bakken and Utica. Its well costs were $11 million, but I would guess this is for a 5000 foot lateral. Halcon's EURs are 569 MBoe. Its estimates were much different than the 90% crude estimated by other operators. Of the 569 MBoe, only 249 MBbls are crude. NGLs account for 121 MBbls and the rest is gas. Given the results, the 90% crude is a much better estimate.

Goodrich Petroleum may be the most levered to the TMS. Its results have produced 92% to 96% crude. Goodrich has outperformed for several reasons, as seen in its Crosby well. This well design utilized 5 clusters and 35 holes per stage. It also used a much higher percentage of slickwater. Goodrich's well costs average $13 million, but it estimates costs will decrease to $10 million.

As a general rule, operators believe current TMS wells will model to EURs of 400 MBoe to 800 MBoe. I have provided below how these wells model to fit the above estimated ultimate recoveries.

Well IP 30 Boe/d EUR MBoe
Horseshoe Hill 10H1 656 400
Anderson 17H1 933 600+
Anderson 18H1 1072 800
Crosby 12H1 1137 800+

The above numbers are estimates, but do show how an improving well design has increased production. Keep in mind, IP rates can be skewed due to a differing well design, so we could see some variance in long-term production. Water, proppant, and the size of choke are just a few variables that could alter these results. Current wells have been producing IP rates between 600 MBoe and 800MBoe. Even with higher well costs, this area has attractive economics. These wells are much like those being drilled in northeast McKenzie County, North Dakota. These wells are being drilled and completed for $9 to $10 million and have roughly the same EURs. Once we begin to see pad development, the economics should be similar. Since the TMS is still in its infancy, well results should continue to improve.

Sanchez's core development is in the Eagle Ford. It has 140000 net acres and 90% of its capital will be spent in this play. Almost all of this acreage is in the oil window. Its acreage currently produces 76% crude, 12% NGLs, and 12% natural gas. Its acreage is spread out and very different. Its best acreage is to the northeast in the Marquis, followed by Palmetto and Cotulla-Maverick. The table below provides Sanchez's 2013 capex percentage by area.

Prospect 2013 CapEx
Marquis 37%
Palmetto 24%
Cotulla-Maverick 24%
Wycross 2%
TMS 2%

Marquis receives the most capital, but it is also the largest prospect in net acres. This is a deeper area for the Eagle Ford, so well costs are also higher. In 2014, its capex distribution changes.

Prospect 2014 CapEx
Marquis 28%
Palmetto 18%
Cotulla-Maverick 28%
Wycross 14%
TMS 6%

Next year, Sanchez reduces dollars to Marquis and Palmetto and moves that capital to the other three areas. A larger percent of capex is used on the 2014 D&C capital plan than in 2013. This move has little to do with well economics and more to do with funding the development of its recent acquisitions. I say this because its best area is Palmetto in Gonzales County. This acreage is in a sweet spot, and has had some of the best well results in the Eagle Ford. To compare Sanchez's Eagle Ford acreage, I have provided the table below.

Prospect EUR MBoe D&C Costs MM IRR $90/Bbl NPV MM Payout Years
Marquis 450-550 $9 30%-53% $3.8-$6.8 1.6-2.4
Palmetto 450-750 $9 29%-117% $3.2-$12 0.9-2.3
Cotulla-Maverick 200-500 $5.5-$7.5 18%-34% $1-$3.8 2.2-3.8
Wycross 450-550 $8 43%-75% $4.8-$7.9 1.2-1.8

As I said earlier, Palmetto has the most upside. It also has the widest range of results. I would guess only some of Sanchez's acreage is in the sweet spot. Palmetto is at the same depth as Marquis, which is also a good area. Its Wycross acquisition is a good one. Well costs are a million dollars lower than Sanchez's eastern prospects, and still performs well. Using the low end EUR, Wycross pays back in the shortest time of all four leaseholds. Its Cotulla-Maverick area is in a shallow portion of the play. The lower well pressures produce lower EURs and well costs.

As a comparison to the Palmetto wells, I have included well results of other operators in Gonzales County. Magnum Hunter (MHR) recently sold its acreage to Penn Virginia (PVA). The table below provides the results by Magnum near the Palmetto Prospect.

Well Stages IP 30
Gonzo Hunter 1H 9 391
Shiner Ranch 1H 9 278
Southern Hunter 1H 13-16 909
Gonzo North 1H 13-16 618
Furrh 1H 13-16 698
GeoHunter 1H 13-16 612
Sable Hunter 1H 13-16 690
Oryx Hunter 1H 20 902
Furrh 2H 20 910
Kudu Hunter 1H 20 883
Snipe Hunter 1H 20 886
Leopard Hunter 1H 20 839
Gonzo North 2H 20 841
Hawg Hunter 1H 20 1203
Oryx Hunter 2H 20 908
Southern Hunter 2H 20 1031
Kudu Hunter 2H 20 1019
Leopard Hunter 2H 20 403*
Leopard Hunter 3H 20 638*
Moose Hunter 1H 20 996
Snipe Hunter 2H 20 739
Hippo Hunter 1H 20 692
Hippo Hunter 2H 20 820
Bertha 1H 20 1044
Rhino Hunter 1H 20 1209
Zebra Hunter 1H 20 1084

Magnum Hunter's EURs ranged from 400 MBoe to 470 MBoe in the earlier wells using 13-16 stages. Its most recent wells modeled 500 MBoe. It had well costs of $9 million. Using $90/Bbl, the IRRs for this area are 47%. Penn Virginia's acreage in Gonzales has EURs of 430 MBoe with a $7.4 million well cost. IRRs are 52%. Its acreage in Lavaca is a little deeper and EURs are 530 MBoe. Well costs increase to $8.6 million, with IRRs of 41%. These results back the validity of Sanchez's Palmetto and Marquis prospects.

Sanchez's Cotulla-Maverick Prospect has produced wells although the acreage is not as good a Gonzales County. Below I have provided a list of wells in McMullen, LaSalle, and Atascosa counties.

Well County IP 30 Boe/d
RTH B 1H McMullen 670
Cortez C 1H LaSalle 432
Cortez D 1H LaSalle 416
Swenson A 1H McMullen 980
Gloria Wheeler C 1H McMullen 980
Gloria Wheeler D 1H McMullen 715
Gloria Wheeler E 1H McMullen 603
Forrest Wheeler A 1H McMullen 555
Gloria Wheeler A 3H McMullen 789
Gloria Wheeler B 3H McMullen 734
Cortez E 1H McMullen 516
Cortez F 1H McMullen 493
Cortez F 2H McMullen 572
Cortez G 1H McMullen 731
DVR A 1H Atascosa 357
Forrest Wheeler C 1H McMullen 1059
NWR 2H Atascosa 387
Swenson B 1H McMullen 1053
Swenson B 2H McMullen 946

The wells in McMullen are much better than those in Atascosa and LaSalle counties. These McMullen wells have a larger mix of NGLs and natural gas, which creates higher well pressure. There are several operators in this area, and many have been very successful. I have provided the table below as a comparison to Sanchez's Cotulla-Maverick and Wycross prospects.

Operator EUR MBoe Well Cost $MM IRR%
CRK 500 7.7
GDP 425 7.5 47
Carrizo (NASDAQ:CRZO) 495 8.0 57

In summary, Sanchez offers exposure to the Eagle Ford and TMS. The majority of its Eagle Ford acreage is in the deeper part of the oil window. This geology is some of the best in play. Sanchez's acreage is supported by very good results by other operators. The Eagle Ford continues to provide some of the best IRRs in the US. Its TMS acreage could provide more upside than the Eagle Ford, given its exploratory value. It already has excellent well results, which should continue to improve.

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.

Additional disclosure: This is not a buy recommendation. The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, are not guaranteed for accuracy or completeness, do not reflect actual investment results, do not take into consideration commissions, margin interest and other costs, and are not guarantees of future results. All investments involve risk, losses may exceed the principal invested, and the past performance of a security, industry, sector, market or financial product does not guarantee future results or returns. For more articles like this check out our website at shaleexperts.com. Fracwater Solutions L.L.C. engages in industrial water solutions for oil and gas companies in North Dakota. This includes constructing water depots, pipelines and disposal wells. It also provides contracting services for all types of construction at well sites. Other services include soil remediation. Please contact me via email if you are interested in working with us. For more of my articles and other pertinent information on the oil and gas sector, go to shaleexperts.com.