Can Sanchez Energy Really Succeed Where Royal Dutch Shell plc Has Failed?

Sanchez Energy , the Houston-based independent exploration and production company, recently announced that it has agreed to buy 106,000 net acres in the Eagle Ford shale from Royal Dutch Shell plc  -- a move that led to a 9% jump in its share price on Thursday.

But given Shell's dismal returns from its U.S. shale acreage, are the markets right to be so upbeat about Sanchez Energy's purchase? Can the company really succeed where Shell has failed?

Photo credit: Carrizo Oil & Gas

Sanchez doubles down on the Eagle Ford
Sanchez Energy's acquisition includes the purchase of approximately 106,000 net acresin Dimmit, LaSalle, and Webb Counties, Texas, for approximately $639 million in cash. The assets to be acquired have proven reserves of 60 million barrels of oil equivalent and were producing 24,000 barrels of oil equivalent per day in the first quarter.

The move will result in a near doubling of Sanchez' Eagle Ford acreage to 226,000 acres, making the company the fifth-largest public leaseholder in the rapidly growing play. It will also double Sanchez's proved reserves to 119 million barrels of oil equivalent and its production to an estimated 49,000 barrels per day.

Sanchez is clearly very optimistic about the acquisition, which it expects will boost its remaining drilling inventory in the Eagle Ford to nearly 3,000 wells (200 identified drilling locations on the soon-to-be-acquired acreage, plus 800 additional potential locations based on appraisal drilling results). The company expects these wells to generate high rates of return in the range of 35%-50%.

Will Sanchez succeed?
While much remains to be seen, I do think that a smaller, nimbler player like Sanchez can extract greater value from this acreage than a behemoth like Shell, which has a pretty disappointing track record of drilling in the U.S. shale plays. Indeed, U.S. shale drilling has been dominated by smaller, regional players and not by the integrated majors.

That's mainly because the smaller drillers can focus exclusively on a single play, or a couple of plays, which gives them greater focus in learning the play's geology, the location of the most productive wells, and the techniques that work best in different parts of the play, unlike the Big Oil companies, whose operations are spread throughout the world.

Though Sanchez Energy has only been drilling in the Eagle Ford since 2011, it has delivered extremely strong production and reserve growth, while also earning some of the highest margins in the industry. Since 2011, the company's average daily net production has grown at a 259% compound annual rate, while its proved reserves have grown at a similarly impressive 196% compound annual rate.

Over the same period, the company has slashed its cash operating costs by 53% to $21.11 per BOE through an aggressive transition toward multiwell pad drilling. Not surprisingly, Sanchez has one of the highest EBITDA margins in the industry, which stood at $57.01 per BOE as of the fourth quarter of 2013, besting other Eagle Ford-focused peers such as Penn Virginia and EOG Resources .

Sanchez also looks reasonably attractive from a valuation perspective, with shares trading at just under 19x forward earnings and less than 2x book value, as compared to peer EOG Resources , which trades at around 15x earnings and 3.5x book value, and Penn Virginia , which trades at 30x forward earnings and 1.3x book value. Given Sanchez's much stronger production growth prospects and higher margins, it may deserve higher multiples.

Investor takeaway
Given Sanchez Energy's tremendous success in nearby blocks of Eagle Ford acreage and its deep knowledge of the play's geology, it just might have what it takes to succeed where Shell has failed. While investing in Sanchez does carry considerable risk given its singular focus on the Eagle Ford, the company's exceptionally strong margins and prospects for production growth bode well for its future, while its valuation suggests that multiple expansion is quite possible.

Will this stock be your next multi-bagger?
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The article Can Sanchez Energy Really Succeed Where Royal Dutch Shell plc Has Failed? originally appeared on

Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool owns shares of EOG Resources. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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