December 29, 2009 - 1:23pm EST by
2009 2010
Price: 9.94 EPS NA NA
Shares Out. (in M): 261 P/E NA NA
Market Cap (in $M): 2,590 P/FCF NA NA
Net Debt (in $M): 2,539 EBIT 377 487
TEV ($): 5,130 TEV/EBIT NA NA

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 SandRidge Energy, Inc.


Investment Summary:


SandRidge Energy is a well-positioned, well-run natural gas-focused exploration and production (E&P) company which is trading at a 70% discount to its net asset value (NAV) based on current oil and gas futures strips. Moreover, there is a reasonable chance that the company makes a significant gas find in its largely unexplored West Texas Overthrust (WTO) acreage, an embedded call option that is also not reflected in the current share price.

Over the past 15 months, SandRidge management has taken a number of steps to improve the company's liquidity and to position the company well for years to come. SandRidge recently acquired Forest Oil's Permian assets, thereby giving the company more oil exposure and providing diversification. It is worth noting that I am not a natural gas bull or bear: the more time I have spent analyzing the supply-demand characteristics of the commodity, the more uncertain I am of future prices. Given the inherent uncertainty of future gas prices, it seems reasonable to use the futures strip as a neutral indicator of future gas prices. Based on the current gas strip, SandRidge is significantly undervalued, and given the company's recent oil diversification, stable balance sheet and oil and gas hedges, investing in SandRidge stock offers a compelling reward with low risk.

The Business and History:

SandRidge is an independent natural gas and oil E&P company that primarily focuses its E&P activities in the WTO, a natural gas prone geological region where the company has operated since 1986. The WTO has four thrusts, the Dugout, Warwick, Frog Creek and Haymond. The Piñon field covers part of two of these thrusts. Piñon is a prolific 50,000 acre gas field. Management intends to add to its existing reserve and production base in this area by increasing its development drilling activities in the Piñon field and its exploration program in other parts of the WTO. Importantly, SandRidge is the largest operator and producer in the WTO and has assembled the largest acreage position in the area with over a 90% working interest. SandRidge is not competing with anyone for acreage in the WTO now. While the company's core asset is its acreage in the WTO, SandRidge also has reserves and production in the Gulf Coast area, Oklahoma and the Piceance Basin of Colorado. In June 2009, the company sold its interest in its East Texas acreage. Most recently, the company acquired Forest Oil's Permian assets (65% oil and NGL reserves) for $800MM.

SandRidge has assembled an extensive natural gas base, and it has identified over 3,000 drilling sites in the WTO. Including the Forest acquisition, SandRidge's proved reserves are ~2.6 Tcfe, of which ~80% are natural gas. The company has over 10 Tcfe of 3P reserves.

SandRidge's current asset portfolio was assembled via a series of acquisitions dating back to the 1990s. Riata, the predecessor company, was originally established by Malone Mitchell in 1985. Riata operated in West Texas among other areas and grew mainly via acquisitions through 2005.

In February of 2006, Tom Ward left Chesapeake Energy, which he co-founded and where he served as President and COO. During Ward's 17-year tenure at Chesapeake, the company became one of the most active onshore drillers in the U.S. Ward has publicly commented that it was his inability to precisely monitor the day-to-day details of such an expansive drilling operation that ultimately led him to step down at Chesapeake. It is worth noting that Ward has sold all of his CHK stock.

Malone Mitchell, the then owner of Riata, solicited Ward's interest in a strategic investment in Riata, which was capital constrained and in need of additional operating leadership. Ward was compelled by the opportunity in the WTO, which has historically been under-explored due to its remoteness as well as past limitations on understanding the geology, which have been overcome with 3D seismic technology. Additionally, the Piñon field produces a significant amount of carbon dioxide, which until recently made drilling uneconomical. Through an agreement with Occidental Petroleum and the construction of the Century Plant, SandRidge has found a profitable solution to deal with the high CO2 wells. Essentially, OXY takes the CO2 and SandRidges takes the methane gas.

In May 2006, Ward purchased approximately 29MM shares from Malone Mitchell at $17.25 for a total investment of $500MM, joining SandRidge (formerly Riata) as its new Chairman and CEO and its largest shareholder. Ward currently owns 9% of the company's equity on a fully diluted basis.

Investment Thesis:

With industry-low finding costs, SandRidge's acreage has some of the most profitable gas in the U.S. The company is led by Ward, who clearly understands the risks and significant potential upside of the WTO and has a proven operational track record. Based on the current oil and gas futures curves, the company has ~$11/share in proved reserves (1P) and ~$35/share in proved, probable and possible reserves (3P). At the current stock price, the company is trading at a 70% discount to 3P NAV. The company's core asset, the Piñon field, has some of the lowest finding costs in the industry at ~$1.00/Mcfe (versus the industry average of ~$3/Mcfe). After adding the production and G&A costs, the all-in cash cost to get the gas out of the WTO is ~$4.50/Mcfe, while the industry average is ~$5-6/Mcfe.

Unlike many new unconventional shale plays, SandRidge does not need to spend a significant amount of capital on infrastructure costs and its conventional wells do not require as much spending on multi-stage re-fracing, so finding costs are a more meaningful metric in the WTO than in newer shale plays such as the Haynesville or Marcellus. Additionally, the decline curves in the Piñon are not nearly as severe as in shale plays - the Warwick thrust has a decline curve of ~13% while shale plays have initial decline curves above 80%, and there remains a lively debate whether shale wells will follow an exponential production profile over many years.

Since the end of 2008, Ward and his team have been actively strengthening SandRidge's balance sheet. SandRidge has ramped down drilling and raised almost $1 billion in new capital excluding the financing required for the Forest acquisition. In September 2009, management announced its intent to purchase Crusader (which was in bankruptcy) for $230 million. Subsequent to this announcement, the Crusader sale went to auction and SandRidge withdrew its bid. While the Crusader purchase proved unsuccessful, we liked management's strategy of picking up distressed assets on the cheap while others are forced to divest due to liquidity concerns. Soon thereafter, SandRidge announced a deal in November to purchase Forest Oil's Permian Basin assets for ~66% of proved NAV based on the then-current futures strip, and the purchase price was approximately 40% of 3P NAV (~$2Bn). While we would have preferred that this oil diversification did not entail issuing any SD shares, we believe the overall risk-reward is roughly equivalent (lower risk and lower reward) to legacy SandRidge pre-Forest. It is worth noting that Ward has stated that he doesn't envision any more material acquisitions in the foreseeable future, which makes sense given the company's opportunities in its existing acreage.

Low gas prices in the near-term will not have a detrimental impact on near-term cash flows since the company is largely hedged through 2010. The company wisely hedged approximately 77% of its 2009 production at $8.59/mcfe, and management has hedged a similar percentage of its 2010 production at $8.79/mcfe. While we wouldn't mind if Ward hedged more of SandRidge's future production, he has been quite good at opportunistically hedging: between 2007 and 2010, he has hedged over 70% of SandRidge's production at above $8.50/mcfe.

SandRidge has grown production and reserves rapidly over the past 5 years, and this strong growth will likely continue with the Century Plant scheduled to come on-line in July 2010. From 2003 to 2008, SandRidge's production and proved reserves grew 28% and 43%, annually. SandRidge is currently forecasting 20% production growth annually through 2012. Before the 3D seismic data came in at the end of June 2008, the company had no reason to believe there would be gas in any part of the WTO outside the Piñon, and there are now no issues that would preclude SandRidge from drilling outside the Piñon. While there is always uncertainty in E&P activities, this data has truly been a game-changer for SandRidge and, importantly, has largely been forgotten given the pull back in exploratory drilling due to weak gas prices. Management has identified 20 Piñon-type structures, so there seems at least a reasonable chance that they could make a material find sometime in the next few years. The company plans to drill 6 exploratory wells in 2010. If the company successfully discovers another prolific field in its largely unexplored acreage, similar to Piñon, the value of its reserves would increase significantly. We are not assuming management makes such a find, but it does provide option value that is not at all reflected in the current stock price.

In summary, given the positive developments - oil diversification and a more secure balance sheet - low all-in cash costs, option-value with a potential 2nd Piñon field, and a significant discount to NAV, we believe an investment in SandRidge stock is an attractive risk-reward. To be clear, we neither anticipate nor need SD to trade up to its full 3P valuation for this investment to work out very well.

The risk associated with the price of natural gas:

Weak gas prices for several years is the primary risk for SandRidge going forward. If the price of natural gas is below $4.50 over the long-term, SandRidge and the U.S. natural gas E&P industry are in trouble. While SandRidge's recent financing activities, Forest acquisition and hedges will protect the company over the medium term, there is no way around the fact that low natural gas prices in the future will be tough for SandRidge. As utah1009 noted in his recent short write-up on CHK, we too worry that natural gas producers may fall all over themselves, producing too much gas too quickly and keeping prices low. Many industry management teams (and investors) incorrectly focus on production growth rather than creating value per share. Ward is quite familiar with this sentiment, as SD traded off after decreasing 3Q09 production below estimates despite the fact that it was the right decision for shareholders. (Gas prices were low and SD didn't produce more gas than they had hedged, which seemed perfectly logical to us.) We continue to believe that longer-term the natural gas price will trend more towards the marginal cost of supply, which currently is somewhere between $5.50-$7.00/mcfe depending on how one believes the shale plays will turn out. However, as we have seen in the last 12 months, in the short-term the price of gas can fluctuate dramatically based on short-term supply-demand imbalances. The price of gas is no doubt a risk and one that we are keenly focused on. However, we believe that the reward is high enough to justify taking on the risk, given the position is sized appropriately.


- Century Plant coming on-line

- Finding another prolific field in the WTO

- Higher gas prices and a shift upward in the curve

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