Why Did This Eagle Ford Producer Double Down on Gas?

Whoever said land in the Eagle Ford was done changing hands should have informed Sanchez Energy (NYSE: SN). Yesterday Sanchez held a press conference in which it announced an acquisition of over 100,000 contiguous acres in the southwestern corner of the Eagle Ford shale near Laredo. This land, called "West Caterina," was acquired from Royal Dutch Shell (NYSE: RDS-A). With the West Caterina acquisition, Sanchez has doubled its acreage in the Eagle Ford.

Apparently, Shell is vacating its Eagle Ford acreage because the company just isn't able to find the returns it needs from the acreage it has. According to a presentation provided from the press release, Shell was only able to get an internal rate of return somewhere below 20%. With so much other good acreage out there, it's little wonder that Shell wanted to be rid of West Caterina. The deal was a fairly economical one for Sanchez: $639 million, which is an estimated $10.65 per barrel equivalent, according to Ryder-Scott. 

Oil well zippers in the Eagle Ford Shale. Source: Scott Towery

The big question is: Why did Sanchez buy this acreage if Shell could barely turn a profit in it? There are a few reasons. First, Sanchez's specialty is shale drilling. Shell has its eggs in many other baskets, especially offshore drilling. In other words, Sanchez sees opportunities for improvement in West Caterina that Shell would rather not bother with.

For example, Sanchez plans on implementing an artificial lift program, which will reduce back pressure on wells and improve production in the later phases of each well's respective life. In addition, Sanchez will drill a little deeper and thereby reach the 'lower Eagle Ford,' which is a 100 foot interval between 8,600 and 8,700 feet which other drillers, including Shell, have generally ignored.

Sanchez believes that it can capitalize on the lower Eagle Ford because 10 of its 16 lower Eagle Ford test wells are, so far, producing very well. Finally, Sanchez will appraise 37,000 acres in the eastern portion of West Caterina, where management believes it will uncover an additional 400 drilling locations. 

Even without these improvements, Sanchez estimates an internal rate of return of between 35% and 50%. The deal is immediately accretive to cash flow, as well.

Sanchez Energy Investor Relations

Sanchez Energy used to be very oil heavy. After the acquisition, however, Sanchez's production will now be less than half oil. However, as we can see, these assets were acquired on the cheap, and there are several ways in which the company can employ its expertise to make West Catarina work. In addition, Sanchez may yet find more oil in the lower Eagle Ford and in the eastern portion of the new acreage.

Ultimately, what matters most is that Sanchez acquired this acreage at such a price that it will be immediately accretive and will be cash flow positive in 2015. And maybe natural gas isn't so bad anymore. With Henry Hub now between $4 and $5, natural gas is much more profitable than it was just a few years ago. 

Bottom line
Gassy or not, Sanchez's acquisition of West Caterina makes sense just because Sanchez got it at such a good price. In fact, Sanchez Energy is one of the better drillers in the Eagle Ford, and the company's concentration is in the western portion of the shale. I believe that Sanchez will decrease overall well costs, find additional reserves in the lower portion, and perhaps will find more oil and gas in the yet unappraised portion.

If Sanchez is able to do all of these things, internal rates of return should exceed 50%. There's a lot of upside here.

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The article Why Did This Eagle Ford Producer Double Down on Gas? originally appeared on Fool.com.

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