Description

Sandridge Energy (“SD”)

This is a reactivation idea. I am recommending a long position in SD. SD does not own world class E&P assets. SD’s production has consistently declined for more than two years with no end in sight. SD’s current board of directors have proven themselves capable of very poor judgment. SD’s CEO, CFO, and Chairman of the Board left the company within the past four months. SD is extremely undervalued.

Current Situation and Timeline:

In October 2016, SD emerged from bankruptcy essentially debt free (0.00% mandatory convertible notes converted to equity in February 2017) and with $100mm in cash. Legacy equity holders were wiped out, and new shares were distributed to the secured and unsecured noteholders. Until the surprise announcement of the BCEI acquisition, management’s stated priorities were to protect the balance sheet and use the Miss Lime free cash flow to drill wells and prove up the NW Stack and North Park (good strategy). The BCEI merger was a serious and unexpected departure from this strategy. After the BCEI merger announcement, Fir Tree and Icahn filed 13D’s opposing the merger, and we started down a path that has seen SD’s CEO, CFO, and Chairman of the Board resign, Icahn propose a full slate of new board members (meeting June 15), MPO propose an at market merger (which was rejected), and SD board’s commence a full strategic alternatives review process. To sum up, SD is a mess with an incredible amount of uncertainty as to what the future looks like. Since the day before the BCEI merger announcement through today, SD stock price has declined 27% while E&P ETF XOP has increased by 14%. SD is now extremely undervalued on a relative and absolute basis, and the risk reward ratio has turned very favorable, especially given the ongoing formal strategic alternatives review and Icahn’s involvement. A more detailed timeline is laid out below, after which I discuss the assets, valuation, and potential outcomes and risks.

September 2016 - court approves bankruptcy plan

November 15, 2017 – SD announces BCEI acquisition

November 20, 2017 - Fir Tree (8.2% owner) files 13D opposing BCEI acquisition

November 22, 2017 - Icahn Files 13D showing 13.5% ownership and opposing BCEI acquisition

November 27, 2017 - SD adopts short-term shareholder rights plan (triggered if "a person or group of persons acting in concert exceeds beneficial ownership of 10% or more of the Company’s common stock")

December 28, 2017 – SD’s board terminates BCEI acquisition due to shareholder opposition

January 23, 2018 - SD amends rights plan trigger level to 15% and eliminates the "acting in concert" language; note: rights plan is structured to automatically expire unless ratified by shareholders at the 2018 annual meeting

February 6, 2018 - Midstates Petroleum (MPO) proposes an at-market combination with SD in all-stock transaction

February 8, 2018 – SD issues letter to shareholders announcing official new strategic direction focused on financial discipline and maximizing asset value and risk adjusted returns as well as targeting a 33% reduction in cash G&A; new capital budget focused on delineating NW STACK and North Park

February 8, 2018 – In light of new strategic direction, SD CEO James Bennet leaves company effective immediately, Bill Griffin (independent board member) made interim CEO; CFO Julian Bott to depart from company after filing 2017 10-K; Sylvia Barnes appointed an independent member of the Board

March 19, 2018 - SD rejects MPO's proposal and announces a formal review of strategic alternatives

April 4, 2018 - Icahn announces intention to nominate a full slate of board candidates to run the strategic alternatives process; Icahn also states willingness to make an all-cash offer (after DD) for 100% of SD equity

April 18, 2018 – Chairman of the Board John Genova retires from the Board; Existing board member Michael Bennet takes Genova’s place as board member; Kenneth beer added as new independent director

April 20, 2018 - Record Date for shareholder vote

May 7, 2018 - SD board recommends that shareholders support the five existing directors plus two of Icahn's nominees and adopts universal proxy card

May 7, 2018 - Fir Tree 13D/A filed showing it has sold ~1.27mm shares (a source of pressure on the stock price)

May 11, 2018 - Icahn expands board slate to 7; continues to press for full removal of current board

May 17, 2018 - Icahn signs CA to participate in strategic review process

May 22, 2018 - Icahn hires Matthew Grubb as consultant (former COO of SD)

May 25, 2018 - Mgmt posted new 3P development plan on 8-K (see Appendix C)

May 25, 2018 – Icahn files presentation laying out his case

May 29, 2018 – SD issues letter to shareholders stating it has signed CA’s with several parties, including Icahn, and will consider divestment or JV opportunities for North Park, corporate and asset combinations, and an outright sale of the Company. SD expects to receive initial indications of interest by the end of June. The letter also urges shareholders (again) to vote for the current 5 directors + 2 of Icahn’s nominees and not to vote for Icahn’s full slate of director nominees. New SD presentation post to SD website laying out SD Board’s case.

June 19, 2018 - Shareholder Meeting

Late June 2018 – Initial indications of interest to be received from process participants

Asset Overview:

Mississippi Lime: SD holds 352k net acres in the Mississippi Lime (“Miss Lime”), which accounted for ~80% of Q118 production. The Miss Lime was a hot basin in the shale boom era (late 2000’s/early 2010’s), but well results proved inconsistent and a lot of capital was vaporized. This left a bad taste in a lot of investor’s mouth’s and probably explains part of the discount in SD’s stock price. SD has not drilled a Miss Lime well since Q117 in order to focus on its two emerging basins with higher oil cuts (NW STACK & North Park). However, there are sweet spots in SD’s vast acreage holdings, and in Q118 SD announced that it would shift some capital to the Miss Lime to highlight the development upside. We will get these well results later in 2018, but the last three-well pad SD completed in the Miss Lime in Q117 cost $1.8mm per lateral (5k ft) and IP’d at an average of 416boe/d (47% oil). Management estimated that pad would earn a 61% IRR at $50 oil and $3 gas. One final note on the Miss Lime, SD owns significant legacy infrastructure in the basin providing it with a relative cost advantage in the basin (and makes it very attractive to a strategic acquiror like MPO).   

NW STACK: Just south of its Mississippi Lime position, SD holds 70k net acres in the NW STACK, which accounted for ~9% of Q118 production. As its name would suggest, SD’s position is northwest of the core STACK where acreage values are hitting $20k/acre. However, the wells in portions of SD’s NW STACK are pretty good and getting better (mostly in Major County). SD is currently targeting the Meramac formation, although the Osage is also prospective but gassier. The area is somewhere in between science and delineation with some great well results (Penelope; 1,314 Boe/d 30d IP; 75% oil) and some poor well results (Morgan; 226 boe/d; 59% oil). In Q217, SD smartly created a DrillCo with an investment fund to delineate a portion of their NW STACK position. It is a $200mm DrillCo (two $100mm tranches) where SD puts up 10% of the capital and receives a 20% up front WI. The investment fund puts up 90% of the capital and receives an 80% up front WI. After the investment fund hits a 10% IRR SD flips into a 65% WI, and after the investment fund hits a 15% IRR, SD flips into an 89% WI. If the wells work, SD does well. If the wells do not work, SD is not risking much of its own capital. DrillCo $ are not cheap $, but the DrillCo capital providers are typically careful not to venture too far afield, as the returns from the good deals are not high enough to offset many bad deals. So far, more recent well results seem to be good but not great. In Q417 the 7 NW STACK wells turned on line had average IP30’s of 623 boe/d (72% oil). Q118 had four 5k ft laterals come online with avg IP 30’s of 675 boe/d (76% oil). Estimated D&C costs for 5k ft laterals and 10k ft laterals are currently $4.4 million and $6.5 million, respectively. Besides delineation, management continues to improve STACK completions. On the Q118 CC we heard that “early-time data that indicates a meaningful uplift with higher-density frac stimulations. We'll be in a position to discuss this in more detail next quarter”.

North Park: SD holds of 122k acres in north central Colorado (Jackson County), west of the DJ Basin. SD purchased North Park in late 2015 from EE3 (private operator) for $190mm. It currently accounts for ~7% of SD’s current production (100% oil). It is a challenging area to operate (8,800 ft altitude) and lacks oil and gas processing and takeaway infrastructure, but the wells are good with a high oil cut (85%). This is where SD is currently spending the majority of its 2018 D&C capital. There were only 16 producing horizontal wells when SD purchased North Park with only the Niobrara D proved commercial. Today, SD has 31 producing horizontal wells and has proved three Niobrara benches (B,C,D) as commercial in portions of their position. SD is drilling 14 additional wells in 2018 testing different well spacings. SD’s North Park type curves imply 40% to 100% IRRs at $50 to $70 oil prices, respectively. There is value in this asset. There are also issues. SD has to truck all of its oil production due to lack of pipeline takeaway. They are contracted to receive a $3.15 discount to WTI until the end of 2018, but it is unclear if that discount will widen after that. In addition, SD is currently flaring all of its gas production as there is no processing or takeaway infrastructure. This is not currently an issue, but it could be. Per management, “we can flare for some longer period of time as long as we have permits in place and a long term development plan”. They are evaluating gas reinjection as well as gas to liquids facilities, refrigeration units, and buying ROW for a pipeline. One GTL facility is currently being built by 3rd party at no cost to SD with more to be evaluated after it is online. In short, despite some remaining hair, SD has created meaningful additional value in this asset since purchasing it in late 2015 for $190mm.

Permian – Central Basin Platform: SD’s Permian CBP accounted for ~4% of its Q118 production. This production mostly consists of SD’s pro rata share of the Sandridge Permian Trust (PER) production. Sandridge owns 25% of PER’s units, which have a market value of ~$30mm. PER’s assets consist of royalty interests in Andrews County (Central Basin Platform). There is no drilling activity in the area.

Valuation:

The numbers I will reference here are laid out in tables in Appendix A. SD has no debt and a $48mm working capital deficit excluding their hedge book. At its current share price, SD’s TEV is slightly less than the PV15 of its PDP reserves at strip pricing (strip through 2022 and $60/bbl thereafter). In other words, if SD fired it’s management team and drilled no new wells you could expect to earn a slightly greater than 15% IRR. Clearly, the market expects SD to allocate capital poorly. Given its recent history (bankruptcy, proposed BCEI merger), this expectation is not unfounded. However, given the formal strategic alternatives process as well as Icahn’s involvement, further capital destruction is no longer a likely outcome.

In addition, SD currently trades at roughly half of its Proved PV10 at strip pricing. Most E&P companies trade at a premium to their Proved PV10 value given the relatively strict rules regarding what wells can be considered “proved”. However, companies with low quality assets can and do trade at discounts to their PV10. MPO, a pure play Miss Lime E&P, currently trades at ~0.65x Proved PV10. First, this is a 30% premium to where SD currently trades (0.5x). Second, MPO does not have assets with the upside potential of SD’s North Park and NW STACK (MPO has acreage it calls NW STACK which has not produced any economic wells I am aware of, unlike SD’s NW STACK assets). SD quantified their NW STACK and North Park asset upside in their most recent reserve report noting Probable reserves PV10 of $248mm for NW STACK and $2.1bn for North Park. I am not saying those assets are worth $2.4bn, but there is upside to the PUD locations included in the “Proved” definition.

Appendix B sensitizes different discount rates and price decks for SD’s proved developed reserve forecast as well as different acreage values for the NW STACK and North Park well inventory. On the downside, if you take the PDP PV20 at $50/bbl and add the low acreage value estimate (see Appendix B) you still get 14% upside to the current share price. At PDP PV20 at strip pricing plus the low acreage value you get 35% upside. At PDP PV15 at strip pricing you get 52% to 110% upside at my estimated low and high acreage values, respectively.

While its fairly simple to get your arms around PDP present values, acreage valuations are a little less straightforward. The question is how much land cost can the well economics bear and how much potential upside will a buyer pay for? NW STACK and North Park are emerging plays with proven commerciality (well level IRRs >30%) and both have meaningful upside from additional delineation and zones. As an example of one simplistic way to look at how acreage values affect your economics, at $10k per acre (high end of my North Park range), you are paying $12.8mm for a 1,280 acre drilling unit. At 12 wells per drilling unit that implies ~$1.1mm per 10k foot lateral. By my numbers, adding $1.1mm to the North Park D&C costs decreases the IRR from >60% at strip to >40%. This methodology is useful but imperfect as it does not take into account the time value of the up front land cost and also allocates no value to upside optionality (there will be upside optionality value in high rate of change emerging plays such as North Park and NW STACK).

I am only attributing value to the ~1/3 of the North Park and NW STACK acreage that I estimate SD has delineated. There is also option value in the remainder of the acreage positions. I am also attributing no value to the Miss Lime undeveloped acreage.

Catalyst / Potential Outcomes

I expect the strategic review process to result in the sale of all or a material piece of the company. The three major assets (North Park, NW STACK, Miss Lime) do not need to be held under one roof.

North Park needs either a larger E&P with deep pockets or a PE backed team with a large equity commitment to fully develop the area and the required associated infrastructure. The North Park well level returns are solid, oil driven, and will likely attract interest.

There are several pure play STACK companies with significant expertise in the area that would likely be interested in the NW STACK acreage.

The Miss Lime asset will not command a premium valuation, but in order for an SD common equity investment to work out, it does not need to. And while there are not many, there are a few natural buyers for it. MPO would love to own it and would have significant synergies. In addition, Tom Ward has a new vehicle that is active in the Miss Lime and would likely see value in the asset.

Icahn (or other financial players) could make a cash bid for the whole company at a reasonable premium to current market. This would not result in maximum value, but I would note that Icahn’s average cost basis for existing position is $17.16/share, which is more than 20% higher than the current share price.

Risks:

• Strategic alternatives process does not result in a meaningful transaction

• In this case, SD will have the ability to make poor capital allocation decisions again; however, given that Icahn will have at least two board representatives after June 19, and the board has explicitly committed to fiscal discipline, there seems to be a lower probability of a major gaffe. Given where SD currently trades, the downside from here seems limited in this scenario.

• Oil and gas prices decrease materially (could be mitigated by a pair trade shorting MPO against long SD)

• Shareholders approve rights plan limiting major shareholders’ ability to effect change

• Fir Tree is selling shares fairly rapidly; this has pressured the stock price and will continue to pressure the stock price

Appendix A:

Note: Strip pricing used through 2022 and $60/bbl thereafter

Appendix B:

Appendix C (Updated 3P Development Plan filed by SD on 5/25/18):

Catalyst

I expect the strategic review process to result in the sale of all or a material piece of the company.