We think that SandRidge Energy (SD) common shares are cheap at $6.50. They are trading at that level for macro reasons, not fundamental reasons. Without the overhang of the European debt crisis, we think the shares would recover to the $7 – $8 range where they traded during March and April. Longer term on fundamental valuation, we think the shares can realize from $10 to $13 per share on a holding period to 2013, depending on results from the company’s intensive drilling program in the Mid-Continent Mississippian play in northwestern Oklahoma and western Kansas.
Strategically, SandRidge has become a pure play in the Mississippian, where it has accumulated a dominant 1.7 million net acre position, including 1.2 million acres which it acquired in the past year at $335 per acre. SandRidge also produces from the Central Basin Platform (CBP) area of the Permian Basin, where it has 225 thousand net acres, and the Gulf of Mexico via its purchase of Dynamic Offshore that closed last April. But the CBP and Gulf assets are cash cows whose role is to generate cash flow at attractive rates of return to help fund development in the Mississippian.
The Mid-Continent Mississippian is an shallow carbonate (limestone) formation spanning Oklahoma and Kansas in which completed wells to date, more than 50% of which have been drilled by SandRidge, show extremely promising results. SandRidge’s type curve for Mississippian wells, from a 2011 appraisal by Netherland Sewell, predicts a 204 mboe EUR (expected ultimate recovery) on completion cost of $3.2 – $3.7 million (depending on ratio of producing wells to salt water disposal wells) and an oil to natural gas cut of 45/55. This well profile generates an eye-catching IRR of above 70% (above 90% on a higher oil cut) at $3.50 gas and $90 oil, and supports land values above $3,000 per acre even at wide spacings.
At $3,000 per acre, the value of SandRidge’s 1.7 million net Mississippian acres plus the PV-10 value of its proved reserves would imply an equity valuation of around $16 per share. While this calculation is indicative of the Mississippian’s upside potential, we think $16 per share is unlikely to be realized on in the near term holding because of uncertainty about SandRidge’s unproved Mississippian acreage and a complex capital structure.
• Large-scale Execution on Unproved Mississippian Acreage. Of SandRidge’s 1.7 million net Mississippian acres, roughly 750 thousand are in the company’s designated fairway of northern Oklahoma where drilling activity to date has been exclusively concentrated. The remaining 950 thousand acres are spread over an extension area in west-central Kansas for which we have no horizontal drilling results. In 2012, SandRidge plans to run 29 rigs in the Mississippian to drill 380 horizontal wells, including 50 in the Kansas extension area. This aggressive program will more than double the number of SandRidge’s horizontal wells in its fairway area and will also provide initial results from the extension area. These results will go a long way toward validating or qualifying SandRidge’s projected type curve over its entire acreage holdings.
• Liquidity. SandRidge is guiding to capital expenditure of $1.85 billion in 2012 to support its large scale drilling program in the Mississippian, as well as smaller commitments to the CBP Permian and Gulf. SandRidge projects a similar capital expenditure budget for 2013. Even if Mississippian results conform to its type curve, SandRidge projects to outspend organic cash flow by $1.4 billion in 2012, and by $800 million in 2013. Following the IPO of the Mississippian Trust II (SDR) in April, SandRidge is almost fully funded for 2012. A recent billion dollar high yield issue funds SD cap ex until end of 2013.
• Complex Capital Stucture. SandRidge has a non-standard capital structure with two large JV’s (Atinum at $500 million and Repsol at $1 billion), three royalty trusts (Mississippian I & II, and Permian), and convertible preferred stock. The complex capital structure makes SandRidge a less attractive takeover target, and the royalty trusts in particular make it more difficult to estimate SandRidge’s net enterprise value. With these structural complexities, we think that SandRidge’s equity will trade at a discount to what its price would be under a cleaner capital structure.
In addition to straight debt, SandRidge’s capital structure includes several series of convertible preferred stock and three royalty trusts. These elements complicate the calculation of SandRidge’s enterprise value, and we think have caused confusion in published research of sell-side analysts.
Catalyst
Mississippian Drilling by SD
Acerage Sales/Acquisition in Mississippian play
Funding via high yield issuance of 2012/2013 cap ex