Mississippi Lime Play Makes SandRidge a Strong Pick

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After an excellent second quarter earnings report, SandRidge Energy (NYSE: SD) is indicating the possibility of raising its production guidance in the third quarter, in part thanks to an unusually quiet hurricane season that could be a boon to SandRidge’s recent acquisition of Dynamic Offshore Resources. 

There is one thing not to like about SandRidge’s second quarter profit, and that’s the fact that it was driven by gains in derivative contracts as much as by production results. If that story sounds familiar, recall that before it made bad bets on the direction of the market, Chesapeake Energy Corp (NYSE: CHK) frequently counted derivatives gains as a large part of its revenues. Of course, a profit is better than a loss even if the source isn’t sales, but Chesapeake’s story and the relationship between CEOs Tom Ward and Aubrey McClendon is a cause for concern as SandRidge increases its debt load and leans on market plays rather than pure oil and gas plays for income.

 

Leading on the Mississippian Lime 

SandRidge’s excellent second quarter results are attributable to what CEO Tom Ward calls the firm’s “foundation on shallow, conventional, low-risk, well assets.” The example that Ward used to explain this foundation, the Central Basin Platform, may not be the best asset in my opinion, considering that this is one of the lowest producing assets for SandRidge with 53 boe per day per well during peak production. Although SandRidge does not face much risk of drilling dry holes in the Central Basin since the area is well explored, it also cannot anticipate much reward for the same reasons.

SandRidge’s results on the Mississippian play are far more respectable. In the second quarter alone, SandRidge completed five wells on the play that produced over 1,000 boe per day during the first thirty days of flow. With 1.7 million net acres providing space for over 8,000 horizontals on this play, SandRidge has a deep inventory to exploit (about 15 years, according to a recent company estimate). This is especially encouraging considering that the majority of its acreage is in the area where it is seeing the most consistent results, between Comanche County, Kansas and Grant County, Oklahoma. 

SandRidge is setting itself up to ensure that it can continue its exponential growth, focusing in part on infrastructure needs, particularly on the Mississippian where it is building out electrical and water disposal system infrastructure. It is reducing its drilling time to about 19 days to completion, in part by reducing the number of frac stages to between six and ten and spacing fracs more widely, driving down already low per well costs. 

SandRidge Senior Vice President, Business Development, puts SandRidge’s per well costs on the Mississippian at “around $3 million,” with the horizontals beginning between 4,000 and 6,000 feet. Steve Antry, Charmain and CEO of independent SandRidge competitor Eagle Energy Co., recently estimated per well costs on the Mississippian at a comparable $3.5 million, noting that the wells here are “very low pressure and we use low tech equipment.” Eagle presents a serious threat to SandRidge, as its growth is commensurately exponential and it claims the single biggest well on the play, the Longhurst No. 1, which came online at about 3,000 boe per day paying out five times in just over five months.

 

Devon Energy (NYSE: DVN) announced its entry onto the Mississippian earlier this year, disclosing an initial 230,000 net acre position with a first well 30 day IP rate of 590 boe per day. These results were strong enough that Devon plans to drill up to 50 wells on its new acreage by the close of 2012, and with its comfortable financial position Devon could easily begin buying up and bidding up acreage around SandRidge’s positions, putting stress on SandRidge’s low cost per acre track record. 

EOG Resources (NYSE: EOG) is also on the Mississippian and perhaps for the long term, as it continues to focus on oil rich assets. EOG recently held part of its Mississippian acreage out for sale through Meagher Energy Advisors, and a quick look at the production chart for the marketed wells shows why: EOG expects the oil production in these wells to drop to zero by 2015, though the gas production has a less precipitous decline. According to Meagher, the deal on these assets is expected to close soon, and it will be interesting to see which company snaps up these natural gas interests. 

Apache (NYSE: APA) holds acreage roughly following the curve of SandRidge’s acreage, interesting because most operators are concentrating positions either further east or south of where Apache and SandRidge are focusing their efforts. Since Tom Ward and Apache both claim long records of success in departing from the pack, I believe that SandRidge and Apache will see long term gains from this move.

 

Outlook 

To avoid a 2014 cash crunch as its past borrowings come due, SandRidge is offering a cumulative total of $750 million in senior unsecured notes, with $500 million to mature in 2023 and $250 million to mature in 2021. Standard & Poor’s Ratings Services assigned both series a B rating with a 4 recovery rating, meaning that Standard & Poor’s expects that if SandRidge defaults on the notes creditors could expect between 30% and 50% recovery. In its rating Standard & Poor’s noted that SandRidge is a “highly leveraged” financial risk, with about $3.9 billion of funded debt. 

SandRidge is currently trading around $7 per share, giving it a price to book of 1.1 and a forward price to earnings of 31.9. For reference, Chesapeake is trading more cheaply, around $20 per share with a price to book of 0.7 and a forward price to earnings of 15.0. Devon is trading around $61 with a price to book of 1.0 and a forward price to earnings of 11.9, attractive for the value of its assets and its growth track. EOG is trading around $109, with a price to book of 2.1 and a forward price to earnings of 20.8, edging towards overvalued. Apache is trading around $89 with a price to book of 1.1 and a forward price to earnings of 8.0, extremely attractive for this well-diversified stock. 

While I do not like SandRidge’s debt load or its increasingly heavy reliance on derivatives for profit, I think that the firm is on the right track with its Mississippian play and have hopes that it will divert expenditures from less impressive results on plays like the Central Basin as the benefits of the Mississippian become clearer. Though its forward price to earnings is high, its overall value is hard to miss, making SandRidge one energy play to consider.


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