Sandridge Energy (NYSE:SD) has been in the news recently because of activist involvement in the company, which culminated with new board members being added and the founder and CEO Tom Ward's employment under review. However, the headlines and articles around the management and direction of Sandridge may have missed a more fundamental issue, which may lead to further underperformance of Sandridge stock.
The underlying issue at Sandridge is that well performance has been substantially worse than expected. This is not obvious from the company's investment presentation, but is possible to infer by reading through results from Sandridge's drilling trusts.
By way of background, in April 2011 Sandridge IPOd its first drilling trust, Sandridge Mississippian Trust I (NYSE:SDT). It then proceeded to IPO a second trust in August 2011, Sandridge Permian Trust I (NYSE:PER), and Sandridge Mississippian Trust II (NYSE:SDR) in April 2012. These trusts performed very well at first, with SDT spiking beyond the IPO price on its first day of trading and trading as high as a 50% premium to the IPO price. Since then, the trusts have fallen off substantially, now trading at 30%+ discounts to their IPO prices.
The trusts were designed to let individual investors get exposure to the cash flows from wells Sandridge was drilling in the Permian and Mississippian. Sandridge retained ~50% ownership in the trusts, through a combination of common and subordinated units, and has proceeded to sell down much of its common unit ownership. The subordinated unit structure helps "guarantee" a certain level of distribution to investors in the units, until a year after the trust has completed its drilling program. Sandridge also typically retained 10-50% ownership of each well drilled in conjunction with the trusts.
Here is where it gets interesting. The Permian Trust, just announced results, and they were well below expectations - despite drilling numerous additional wells, PER's production was down 8%! Results were so bad that cash was pulled away from the subordinated unit distributions to fund the minimum distribution level for the common units. This should be concerning to holders of PER units, but even more concerning for investors in Sandridge common stock, SD.
It should be concerning for PER holders because it means that once the subordination period ends, distributions could substantially disappoint, and that Sandridge now has a powerful incentive to finish the drilling program up as soon as possible to end the subordination period convert the now-subordinated units to common units.
And it should be concerning for SD investors because the subordination of cash flows means that Sandridge will get less cash from its sub units than projected. But that's not the only problem - missing the subordination threshold means the assets are underperforming, which means Sandridge's direct interest in the asset is generating less cash flow than expected may be worth less money.
This is less of a problem for Sandridge in the Permian, where it has recently sold most of its interests, but is more of a problem in the Mississippian, which is the company's new focus area, and the source of most of its internally estimated NAV. While SDT and SDR have not yet had subordination issues, production there has disappointed too. Approximately twice as many wells as initially projected were drilled for SDR, in the past year, for example, to achieve projected production rates. (translation, it looks like the wells are producing half as much as expected - not good!).
SD, PER, SDT and SDR have all underperformed in the past year, likely as a result of these performance issues. However, investors in SD may be unaware of how much the underperformance at the trust level may affect the cash flow net to SD, which could potentially further negatively impact the stock as these results flow through SD's financials in upcoming quarters.
A similar problem may affect Chesapeake (NYSE:CHK) through potential underperformance at its Granite Wash Drilling trust (NYSE:CHKR). However, that trust is smaller compared to Chesapeake than Sandridge's trusts are to Sandridge, so Chesapeake may at least be dodging this bullet as it continues its de-leverging process.