CAPScall of the Week: Sanchez Energy

For years, satirical late-night TV host Stephen Colbert has been running a series on his show called "Better Know a District," which highlights one of the 435 U.S. congressional districts and its representative. While I am no Stephen Colbert, I am brutally inquisitive when it comes to the 5,000-plus listed companies on the U.S. stock exchanges.

That's why I've made it a weekly tradition to examine one seldom-followed company within the Motley Fool CAPS database, and make a CAPScall of outperform or underperform on that company.

For this week's round of "Better Know a Stock," I'm going to take a closer look at Sanchez Energy (NYSE: SN  ) .

What Sanchez Energy does
Sanchez Energy is an oil and gas exploration and production company. Its primary assets are liquid fuels (e.g., oil and liquid natural gas) in the Eagle Ford Shale region, where it holds approximately 95,000 acres. Sanchez also has undeveloped acreage interests in the Bakken Shale and Haynesville Shale. Sanchez currently has 34 wells in operation with an additional 17 in various stages of drilling or completion.

For 2012, Sanchez Energy reported 468.8 million barrels of oil equivalent production, or MBOE, which was a 170% improvement over its production in 2011. Although production volume surged, average production per well dipped as demand dropped and the company spent heavily in bringing 19 new wells online. Revenue for the year grew 197% to $43.2 million despite a dramatic drop in natural gas prices, although the company produced a loss of $0.56 for the year. 

Whom it competes against
As you might imagine, competition is at a premium for acreage in the Eagle Ford Shale. Although natural gas drilling has abated with prices down in the doldrums, NGL and oil drilling remains as profitable as ever. EOG Resources (NYSE: EOG  ) is the king of the Eagle Ford region, having produced in excess of 29.5 million barrels of oil through the first 11 months of 2012. By comparison, Burlington Resources was a distant second at 16.1 million barrels of oil produced. Sanchez is a relative newcomer, so obtaining additional acreage has been difficult.

Unlike its Eagle Ford Shale acreage, which it nearly owns outright, many of its undeveloped acreage is shared interest. Sanchez has 1,500 net acres in the Haynesville Shale region of Louisiana, which it listed in its S-1 prospectus as operated by Chesapeake Energy (NYSE: CHK  ) and EnCana (NYSE: ECA  ) . Neither of these two natural gas behemoths have been looking to splurge recently with natural gas prices down, so this 1,500 acres, while small, could be a troublesome asset to sell if Sanchez has no plans to utilize it.

In the Palmetto region, which is located in the Eagle Ford Shale, it does share a 50/50 working interest with Marathon Oil (NYSE: MRO  ) . With the Palmetto area more rich in volatile oils, it's not devastating for a company like Sanchez to share its working interests here. The key is that its Maverick region is ripe with black oil, and it owns full right to those wells. 

The call
After carefully reviewing the prospects for Sanchez Energy, I've decided to place a CAPScall of outperform on the company.

Clearly, there are risks involved for a newer company like Sanchez. It runs the risk overexpanding too rapidly and outrunning its cash flow. Sanchez also runs the risk of being caught in the same scenario if oil prices dip dramatically from their current levels. However, Sanchez has an answer for many of these scenarios.

To begin with, Sanchez had about 40% of its 2013 production hedged as of its annual report filing, as well as 15% of its 2014 production. This will still leave the company exposed to the markets movements, but to a far lesser extent than if it didn't have a hedging strategy in place.

I think Sanchez's diverse assets make it an attractive takeover candidate as well. I don't think many companies in the oil and gas exploration and production sector look ripe for a takeover, but liquids-rich Sanchez could be one. With undeveloped assets in the Bakken that could be icing on the cake for a prospective bidder, and 100% working interests in the Maverick region of the Eagle Ford Shale, Sanchez's assets tend to speak for themselves.

Sanchez's balance sheet is another positive talking point. With the company expanding rapidly, big profits aren't expected to begin rolling in until 2014. However, it's worth noting now that the company's cash flow is completely responsible for covering its capital expenditures. Sure, shareholders aren't going to be getting a dividend any time soon, but Sanchez is completely debt-free with $61.9 million in cash. If you're willing to bet on sustained oil prices into 2014, then Sanchez at less than seven times forward earnings is a veritable steal of a deal!

Is this the best value in the energy sector?
Energy investors would be hard-pressed to find another company trading at a deeper discount than Chesapeake Energy. Its share price depreciated after negative news surfaced concerning the company's management and spiraling debt picture. While the debt issues still persist, giant steps have been taken to help mitigate the problems. To learn more about Chesapeake and its enormous potential, you're invited to check out The Motley Fool's brand-new premium report on the company. Simply click here now to access your copy.


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