|Shares Out. (in M):||570||P/E||0.0x||0.0x|
|Market Cap (in $M):||4,080||P/FCF||0.0x||0.0x|
|Net Debt (in $M):||3,300||EBIT||0||0|
|TEV (in $M):||7,380||TEV/EBIT||0.0x||0.0x|
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Sandridge (NYSE:SD) is an oil and gas exploration and development company, which is staring down the barrel of a wonderfully high return on capital development backlog. Specifically, the company is focused on oil rich drilling opportunities, where the company has shown it can turn $1 of capital into almost $2-$3 of PV10 value for as much as they can manage to spend for the next decade or so.
Historically, Sandridge was a natural gas focused company that has transitioned its asset base and development to be heavily weighted towards oil. Recently, they announced a deal to buy some offshore Gulf of Mexico assets, which was a deal that came completely out of left field for shareholders. These gunslinger type moves by management has created an unfair discount. However, management has shown that they know what they are doing in previous acquisitions and are performing well drilling up what they bought. In short, a depressed stock price, competent (albeit hated) management, low geological risk, and the opportunity to invest capital for a big bang for the buck make Sandridge a compelling long.
Overview of the business:
Sandridge started as Riata, which was started by Malone Mitchell in 1985. In 2006, the co-founder and then COO of Chesapeake Energy, Tom Ward, left Chesapeake for Sandridge and bought $500 mil worth of shares from Mitchell at $17.25. He joined SandRidge as its new Chairman and CEO and largest individual shareholder.
Having invested heavily in a successful natural gas play in the West Texas Overthrust (Pinon field), the company changed strategies in ’08 by pulling back on drilling and hedging most of ’09 and ’10 production. It was the right move. Then in late ’09, judging the bear market in natural gas to be extended, they started looking for oil. While all the big E&Ps were falling all over themselves to pay up for the next gas shale play, Sandridge moved on oil with the acquisition of Forrest Oil’s Permian Basin, Texas assets. They then merged with Arena in July 2010 to better establish the Permian acreage. Along the way, they’ve been divesting their gas rich assets (except Pinon) and focusing capex on oil plays, and currently investing nearly nothing into the remaining legacy Pinon field.
In the last 2 years, they’ve also quietly acquired an acreage position in the Mississippian-Lime, a carbonate deposit that has a long history of vertical well production. Sandridge is applying new horizontal drilling and fracking technology to this old field, and is achieving powerful results that will drive strong production and reserve growth for the next decade.
I believe that the market isn’t taking into account the potential value of this Missippian acreage, which has been flying under the radar in the oil business due to focus on gas shale and Bakken shale oil. Shareholders are also frustrated with management. The shift from gas to oil focus required Sandridge to divest a series of gas-weighted assets, while acquiring oil rich assets aggressively (but cheaply). Similarly to Ward’s former Chesapeake, the company has amassed a pile of debt and acreage, which has caused some skittishness amongst investors and a cheap stock price.
Permian Basin: Texas
Made up of the historic acreage positions of Forrest and Arena. Permian is a conventional, shallow play. Meaning that wells are drilled vertically and require no special completion. The economics of these wells are great:
200K Net Acres (including Royalty Trust acreage)
$760K Drilling & Completion Cost, $1.0 mil NPV-10
83 Mboe EUR/well (80% Crude)
65 Boepd 30-day IP
F&D $12.30, LOE $12.60
100% IRR at current oil & gas prices.
8K Drilling Locations
Based on these metrics, Sandridge has up to $6 bil of drilling cap-ex ahead, which will produce a field with a PV-10 of $14 bil. Or, an NPV of $8 billion of shareholder value.
The attractiveness in the Permian Basin is the good infrastructure, low cost, shallow depth of the pay window, and overall low geologic risk. The shallow depth allows them to use low-horsepower rigs, which, due to their inability to drill deeply are abundantly available. Industry reports an approx. 65% utilization rate for such old rigs.
Mississippian: Oklahoma & S. Kansas
Sandridge is applying new drilling technology here, specifically horizontal drilling and multi-stage fracking. You may have heard of fracking. It’s a technique where an aqueous solution with beads called “proppant” is pumped down a well that has been drilled horizontally through source rock. Then pulses of pressure along with the proppant cause fractures and cracks in the source rock. This artificially causes higher permeability (stimulation), which allows previously unrecoverable oil and gas to escape into the well bore.
CEO Tom Ward helped pioneer the technique while at Chesapeake, as it was applied to gas shale. Gas shale fracking has been so successful that it currently amounts for 1/3 of US natural gas production, and with the warm winter has placed the natural gas market into the worst oversupply situation in years. For crude, the technique is used successfully in North Dakota’s Bakken shale oil. Brigham Exploration was notable in pioneering ND acreage in 2005. Bakken appears to have the best oil economics onshore right now. But Bakken wells require high horsepower equipment to drill ~20k ft and extraordinarily long horizontals with 20-40 fracking stages. In Bakken, a typical well’s drilling and completion costs run $8-$10 mil. We also aren’t 100% sure of the type curve yet.
For the Mississippian Lime, again, Sandridge will use low horsepower rigs and low-pressure fracking equipment, which takes them out of competition for the high-powered rigs used in Bakken and the gas-shale plays. Their horizontals are shorter, around 4K ft with only 8 fracking stages.
2 Mil Gross Acres, 1.5 mil Net (cost basis of only $350 mil)
$3.2 Mil drilling & Completion Costs, $5.6 mil NPV-10
456 Mboe EUR/well (45% Crude)
275 Boe/d 30-day IP
F&D $8.50, LOE $9.75
96% IRR at current Oil & Gas
9000+ Drilling Locations
Based on the above, Sandridge can invest $1.00 in cap-ex and achieve $2.75 of NAV. With 9000 drilling locations, its about $28 bil of capital ready to be invested, which will yield $80 bil of PV-10 value. Or, an NPV of about $50 billion. You read those number right!
The company also announced yesterday that they’ve honed their fracking and completion a bit, and that they are now 11% above this EUR (but most of the revision is nat gas). Such numbers are really eye popping, and I think in coming years we will all be hearing about how the Mississippian-lime is the new Bakken or Utica.
West Texas Overthrust (WTO):
This is mostly made up of the legacy Pinon field that was well discussed the last time SD was posted to VIC in ’09. Production is down to about 90 Mmcf/day and declining in the low teens. There are essentially no rigs running here, and the company wrote all of their PUDs off long ago. The PUDs come back on the books for gas prices between $4.25 a $5.50/mcf.
Net Acreage: 500,000
Well Cost: 2.9M
Average 30 day IP: 2,900 mmcfe/d
Average locations: 8,600 (net, risked)
Permian and Mississippian Royalty Trust IPOs (NYSE: PER, SDT):
Like T. Boone did in the 80s, rather than do a secondary to raise more drilling capital, Sandridge raised $919 mil by IPOing 2 royalty trusts in 2011 (NYSE:PER, SDT) and plans to do another in 2012. The Royalty Trusts are classified as Variable Interest Entities (VIEs) as per FIN 46 (R). And as far as the financial statements, they are essentially in the netherworld of being neither equity, nor debt.
Simply put, what is actually happening is Sandridge takes some producing wells and some future drilling locations and drops them down into a subsidiary, and then sells a majority of the subsidiary to the public. If that were all that was going on, the firm would book a gain or loss based on the cost basis in the wells and land. The wrinkle here is that Sandridge gives a mild guarantee as to dividends for the public units. This distribution preference is secured by some of Sandridges' retained units (called subordinated units). (Got it?) The subordinated units convert to regular units once the drilling promises (carry) and distribution targets are all hit thru 2015. It is this performance guarantee, along with Sandridge's control of drilling future wells that trips FIN 46 and thus, requires Sandridge to reflect these assets on the balance sheet as if the assets never went anywhere (because they are considered still in control of the assets). Future distributions to public unit holders reduce or augment Sandridge's common net income. Ahh, but how is the $919 mil in proceeds from the "sale" of the assets handled? It’s added to the consolidated equity statement and offsets their cost basis in assets. Future dividends are then subtracted from total equity similar to preferred stock.
Some people might view this as just a form of creative debt. However, due to the low geologic risk and the drilling results thus far, SD is on track to outperform the distribution goals. They retain about 1/3 of each PER and SDT, and they have both appreciated 20-30% including dividends in less than a year. The royalties are based off of net revenues (sales minus taxes and delivery costs). These trusts also come with some neat tax benefits. Sandridge gets cash-money upfront, but doesn’t have to book any ‘gain on sale’ because they remain in control of the assets. They also get great pricing.
The Royalties were both sold for only a slight discount to PV10, and about double their actual cost basis in the wells. Sandridge plans another such trust in the coming quarter for wells that they drilled in the last year in the Mississippian. Due to the premium valuation, these deals work for shareholders, and are getting to be something of a wash, rinse, repeat maneuver to realize the value created through the drill bit. Keep in mind that the previously criticized deal to buy Forrest’s Permian assets for about 2/3s PV-10 was partially placed through the PER royalty trust for nearly 1x PV-10. They took the cash and recycled it into more drilling without having to pay taxes on the gain on sale. As for the Mississippian Royalty (SDT), only half of the anticipated EUR payable to the trust is PDPs, the rest are just PUDs with a promise to drill them by 2015. Yet, yield oriented investors will pay nearly PV-10, with half yet to be drilled! These things are great folks!.
Again, I don’t’ really view these as debt per-say. There is no way to default, and Sandridge maintained enough of an interest in the underlying wells placed in the trust to cover LOE and cap-ex. Sandridge is of course holding 25% of each issue as subordinated units, but they have had no problems covering their target distributions, actually performing above model. Also, all anticipated production is hedged thru 2015 when the drilling will be complete so there is no commodity price risk. Thus the only real risk to the distributions and thus their 25% subordinated interest is execution. Again, this geology is low risk as both regions have a long history of conventional production, and Sandridge only needs to run 6 rigs to fill the schedule (Sandridge owns 32 rigs in house).
Tom the Gunslinger:
Yesterday, the market punished SD shares after they announced a $1.25 bil acquisition of Dynamic Offshore, a shallow water Gulf of Mexico roll-up that was slated to go IPO. The IPO deal was likely to get pulled anyway (see Frac Tech Services). Management defended the wisdom of the deal by pointing out that these are the cheapest barrels of oil that can be found in the US and “probably the world.”
The acquisition wasn’t so bad, and it really represents a way to use stock to buy cash-flow and boost borrowing capacity, but to do so with some built in return. Viewed as such, it compares favorably to Sandridge doing a secondary. I also believe that it represents management’s confidence in the Mississipian acreage. Remember, Dynamic’s PV-10 is $1.9 bil, with PDP’s PV-10 of $1.5 bil. The type curve for these PDP resources have a 25% built in decline, which means that not only is most of this acquisition value based on PDP reserves, but that the payback will be rapid. Management indicated that they intend to be out there on hedging against Brent in connection with the buy. The cap-ex will also include a lot of lower risk recompletions and infill drilling. Tom did not buy into a new basin with a multi-decade drilling inventory like they did in the MIssissipian. The drilling inventory is only 4 to 5 years at $200 mil/year against an LTM EBITDA of $380 mil. This was a creative deleveraging move. In short, Tom saw a way to buy a cheap pool of flowing oil, and use a heavier weighting of equity to do it. The move will give them extra capacity to put to work in Mississippian. This is not a Chesepeake Energy, who never met a shale play they didn’t buy with both hands, creating a drilling inventory of 20+ years across the company.
After the Forrest deal in Dec ’09, Ward told the market that they did not foresee any new major acquisitions. Then in July of ’10 they made a major acquisition of Arena, targeting more acreage in the Permian. Then of course there is this unexpected Dynamic Offshore buy. So the guy doesn’t stick to his word, but they really haven’t been operating outside the company’s vision that Tom’s been laying out over the past few years. They are after oil. Oil, in proven locations with high returns on capital, low geologic risk, and in places where they won’t face competition for services. They are also sticking to the plan to double productions and triple EBITDA from 2011 to 2014. Of course, many thought that meant drilling what they had on their plate. Here, the sell side analysts were right to harp on the company’s “funding gap” created by their hike in cap-ex guidance last summer.
Suffice it to say, you do have to deal with a management team that isn’t afraid to make bold moves and change course and drag shareholders along kicking and screaming. But if you look at the acquisition history, the targets they set in their drilling plans and their drilling results, it’s hard to argue that they’ve made any mistakes. They hedged gas and moved to oil when every one was falling over gas shale, and their acquisitions have outperformed expectations with drilling results.
As a consolation, remember, Tom Ward invested $500 million into Sandridge when he arrived. An amount that has declined quite a bit of late, but he still owns about 20 million shares so his interests are somewhat aligned with shareholders as $150 mil is still quite a slug of cash.
With so many low risk drilling opportunities at such high returns on capital, management views the biggest risk as a decline in oil prices. Thus, Sandridge has hedged substantially all of their ’12 & ’13, most of their ’14 and about half of their ’15 oil production at at around $100/bbl. That’s just over 3 years worth of future oil production locked in. They also have a small amount of nat gas collared with $4 floors in ’12 & ‘13. Sandridge is one of the best-hedged producers out there, which makes a valuation that assumes $100 oil very reasonable.
Permian: On the Dynamic acquisition conference call, Tom mentioned that the most recent PV-10 of the Permian assets was $3.9 bil. Because Permian development is mostly infill vertical wells, we can risk that at 75% and call it worth $3 billion.
WTO: Well the nat-gas market is currently in the toilet. But the good news is that it’s going to bounce back soon. The rig count has dropped substantially and initial decline rates in many shale plays are 60-75%, thus it won’t take long for the market to come back into balance. Sandridge’s PDP reserves in WTO is near 400 bcf. I assign very little value to this asset even though it’s a very good gas field with very competitive F&D costs vis-vie shale. The field has another 400 bcf in PUDs that will come back when gas rises to $5 (as it must to allow for a rate of return on all that gas shale acreage). I assign a value of only $1.50/mcf for the PDP reserves and about $0.25 for the PUDs, which gets us to a value of about $750 mil. Keep in mind that they are almost completely unhedged on nat gas, and this field has a lot of room to grow. It represents a cheap call on higher gas.
Mississippian Lime: Late in 2011, Respol purchased 363,000 acres for $1 billion. The land included NO producing wells, and had a cost basis of <$200/acre. This value’s the 1.5 mil net acres left at $2,750/acre or $4.125 billion. Sandridge is also sitting on about 150 net wells they drilled in 2011 that have yet to be monetized (likely coming in their 2nd Mississippian Royalty trust). The PV-10 is around $1.3 bil, which due to the upcoming monetization, I will value at $1 bil. Altogether we can round off Mississippian-lime at $6 bil.
Dynamic Offshore Assets: I’ll just pencil in $1.1 bil, which is just under the $1.25 bil negotiated price.
Then there are the retained interests in the company’s trusts. I am assuming that Tom’s mention of the PV10 of Permian included their retained interest in PER. The SDT shares, however, are worth $340 mil.
Add it all up and we have an EV of about $11.2 billion. Pro-forma the Dynamic deal, SD will have 570 mil shares (assuming preferreds convert), and about $3.3 bil of net debt. This works out to $14/share for Sandridge.
Keep in mind that in Permian and Mississippian they will be investing future cash flows at 100% IRRs. Placed in this light, I can understand management’s desire to buy some cash-flowing offshore assets cheaply with some stock in order to boost capacity to invest in the onshore plays. That $14/share target valuation will grow quickly over time.
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