A couple of years ago I fell in love with the idea of investing in energy companies that focus on developing unconventional oil plays. I've focused on oil because I feel much more comfortable with the long-term price of that commodity (over natural gas) because of the long-term supply and demand fundamentals.
As I started focusing on companies that were either pure plays on unconventional production or making a transformation towards a focus on unconventional production I started looking at Sandridge Energy (SD). My attraction to Sandridge was the massive acreage position the company had developed in the emerging Mississippian resource play.
The economics of drilling wells into the play looked outstanding, so did the size of Sandridge's position (7,000 drilling locations) which was quite exciting.
Below is a slide from Sandridge's April 2012 investor presentation pack that details the rates of return from drilling wells in the Mississippian.
I remember looking at this slide and thinking that this must be one of if not the most economic resource plays in North America.
Consider these numbers from that slide:
$60 oil and $2.50 natural gas - A Mississippian well was projected to have an IRR of 30%
$80 oil and $2.50 natural gas - A Mississippian well was projected to have an IRR of 50%
$100 oil and $2.50 natural gas - A Mississippian well was projected to have an IRR of 80%
What really struck me was how profitable a Mississippian well was projected to be with extremely low natural gas prices ($2.50) and quite low oil prices ($60). Most resource plays that I have looked at would not be making any money at those prices. I thought that the Mississippian would be one play that could make money in a low commodity price environment.
Sandridge updated the economics of the Mississippian play in a November 2012 presentation. Below is the slide from this presentation.
The red line represents what Sandridge now believes the economics of a Mississippian well to be. I'd like to compare a couple of them.
- In the November presentation at $60 oil and $4.25 natural gas the IRR is estimated to be 25%. Back in the April presentation the IRR of 30% on a Mississippian well at $60 oil and just $2.50 gas was more than that.
- In the November presentation at $80 oil and $4.25 natural gas the IRR is estimated to be 39%. Back in the April presentation the IRR of 45% on a Mississippian well at $80 oil and just $2.50 gas was more than that.
Even with a 70% increase in the price of natural gas used in the estimate the economics of these wells the IRR has dropped. That makes a big difference for investors wanting to determine how valuable this Mississippian play is to Sandridge. This big change in economics is obviously a red flag and seems to be the result of the play being "gassier" than anticipated.
Previously I wrote an article discussing how it was difficult to want to be a Sandridge shareholder because it was impossible to figure out what the company's long term strategy is. In 2008 it was a natural gas company. Then Sandridge decided to get out of the Gulf of Mexico and sold assets. Then Sandridge wanted to become and oil company and purchased Permian basin assets. Then Sandridge decided to get back into the Gulf of Mexico and acquired Dynamic Offshore. And recently Sandridge has decided to sell its Permian basin oil assets.
What a dizzying collection of changes in strategic direction.
But the big changes in the economics of the Mississippian bother me much more than the seemingly shotgun approach to long-term planning. If the company doesn't really know the economics of its play, how can it possibly be making intelligent capital investment decisions?
I was once quite intrigued by Sandridge's collection of assets and flirted with the idea of owning shares despite the company having a highly leveraged balance sheet. I no longer can justify any reason to own shares because I don't think there is a long-term strategic plan and I don't really trust management's guidance on what the assets might be worth.
After all, if I can't value the main asset of a company how can I possibly know if the company is a good investment?