SandRidge Energy: Attractive Value, Desirable Acquisition Target

Includes: SD, UNG
by: Dan Carroll
On December 14th, Exxon (NYSE:XOM) announced it was buying XTO Energy (XTO), a major Natural Gas supplier, for $31 billion. Was this a big deal? Huge to me. Exxon was betting big on natural gas. Why?
Let’s first take a step back. Circle back to 2008, Boone Pickens trumpeted around the country with his alternative energy plan to rid America’s dependence on foreign oil. Wind and natural gas were huge parts of the Picken’s plan. Oil was trading over $100 and eventually topped out at $150 before tumbling back down. So then died the Pickens plan. Without the price of oil over $100, there wasn’t the political pressure to push hard for alternative energy.
Enter Exxon. Exxon tops the oil & gas industry’s spending in Washington with over $27.4 million spent in lobbying expenditures in 2009. With oil close to $80 a barrel again and the country in dire needs for jobs, the will for support from Washington for natural gas and other alternative energies should rise as an energy revolution could add more than 2 million jobs by some estimates. Add in Exxon’s lobbying prowess to start to push natural gas more favorably with its recent purchase of XTO, and the chances for natural gas fueling stations, natural gas powered cars, etc can only increase.
Why natural gas? Simple answer: we have a lot of it. As of July 2009 according to the Potential Gas Committee, the estimated natural gas reserves in the United States is 2,074 trillion cubic feet. To put that in English, that equates to over a 100 year supply of natural gas at current rates according to the WSJ. As Boone Pickens likes to say, “We have more natural gas than Saudi Arabia has oil.” There have been huge breakthroughs in natural gas exploration in the past four years with huge discoveries in Louisiana, Texas, and Pennsylvania amounting to a 58% increase in natural gas available for production.
Is natural gas economical compared to oil and gasoline? Natural gas is trading roughly $5.5 per million Btu [MMBtu]. After converting the current dollar price of oil and gasoline to MMBtu, they both are more expensive than natural gas. If natural gas is cheaper than oil and gasoline both, why are cars all over the United States not powered by Natural Gas?
The problem lies in converting gasoline powered vehicles to natural gas is expensive and can range from $12.5k- $22.5k and buying a compressed natural gas car you will have to pay a premium close to $9k according to Car and Driver. Why so? Marc Rauch, VP of The Auto Channel explains, “For an individual (or shop) to be licensed to do a conversion, the person must pay $10,000 per year, per engine type, per year of manufacture. So that if a conversion shop wanted to do conversions in 2009 for Camrys for the years 1995 to 2005, the shop owner would have to pay the government $100,000 in licensing fees.” If there were no licensing fees to convert cars to natural gas, experts agree it would cost a couple hundred bucks to convert
Licensing fees charged by the government are protectionism at its finest. With Exxon lobbying for natural gas combined with the massive supply of natural gas in the United States and the continuing ascent of the price of oil, natural gas use should increase over time. In fact, I think we could be at the beginning stages of what could be a secular bull market for natural gas for the next twenty years after some interim expected hiccups. Because of this, companies with large natural gas proven reserves should do extremely well over the long term.
I am finally getting to my leveraged natural gas play SandRidge Energy (NYSE:SD). SandRidge focuses on natural gas exploration / development along the West Texas Overthrust [WTO] and the Permian Basin.
A few things I like about the company:
  • Seasoned CEO- Tom Ward, the current CEO of SandRidge, was also co-founder of natural gas giant Chesapeake Energy (NYSE:CHK) in 1989. From the years of 1989-2006, Ward served as President & COO of Chesapeake before bolting to run SandRidge shortly thereafter. Put simply, the man has natural gas in his veins and knows how build a natural gas company from its beginning stages to a big time conglomerate.
  • Insider buying- Three high level executives of SandRidge in December purchased $855k of stock around $8.50 a share. This can’t be a bad thing.
  • 20% short interest- Close to 20% of shares outstanding are sold short, and the potential for a short squeeze is there. I don’t typically care about short interest when making an investment but it can provide a nice bid similar to when companies do share buy backs.
  • 80% of SandRidge’s 2010 natural gas production is hedged at $7.70/Mmbtu, which should provide for stable cash flows for the next year plus
  • Great acquisition target- SandRidge has over 2,642 Bcfe proven reserves, 78% of which is natural gas; On February 1st, President Obama has asked Congress to end nearly $37 billion in subsidies for oil and gas companies. If approved, it would be effective January 2011. Main tax advantages that would get axed according to Business Insider include: deductions for drilling costs, manufacturing tax deductions for oil and gas companies, and tax credits for low-volume oil and gas wells. What are the effects of this? By eliminating the ability for oil & gas companies to expense intangible drilling costs, it is in effect a tax penalty. According to the New York Times, these intangible drilling costs (labor, supplies, contractors, fuel, etc.) represent about 70 percent of all drilling costs. By forcing oil and gas companies to capitalize these costs, the incentives to invest in new drilling and exploration projects will DECLINE. This will make companies like SandRidge with massive proven reserves very attractive acquisition targets.
Tom Ward has continually said that 2009 was a year to shore up SandRidge’s balance sheet and improve the company’s financial picture to be able to execute on the company’s stated growth plan “Road to 2012.” The company is starting to go on the offensive, recently acquiring the Permian Basin properties from Forest Oil for $800 million in late December. The company acquired the high quality oil assets for the price of the proven reserves. The company has hedged commodity risk by entering into oil hedges that guarantees $975 million in revenue through 2012 from the acquisition. The market cheered the acquisition before smacking SD’s shares right back down.
Risks: SandRidge has a massive amount of debt at $2.5 billion; very large for a company with a market cap of roughly $1.6 billion, although not out of the ordinary in a very high capital intensive business as market leader Chesapeake Energy has over $12 billion in debt. It should be noted that SandRidge has a credit revolver close to $1 billion in which they recently drew on with the purchase of Permian Basin from Forest oil for $800 million in late December. The company financed the transaction by issuing $200 million in preferred shares to Fairfax holdings along with an equity offering raising roughly $220 million; leaving the remaining $380 million or so to be drawn from the revolver.
We shall see when SandRidge reports this week how much the company drew on the revolver in Q4 in addition to the Permian Basin acquisition; something I will be paying close attention to. Another risk is the price of natural gas. Considering SD has 80% of its inventory hedged in 2010, it isn’t a concern in the short term, but with the massive supply of natural gas given the breakthroughs in exploration of the past couple of years, demand is yet to match supply. This could put pressure on prices.
What do I think the company is worth? Because of the company’s debt picture, you can expect multiples to be depressed. In addition, because SandRidge has a sizable amount of debt, it isn’t appropriate to value the company on an earnings per share basis as the company can show positive net earnings but still have negative cash flow and not be able to pay their debts. On a cash flow per share basis, after paying out preferred dividends, SD should generate around $350-$450 million in operating cash flow in 2010, amounting to $1.75-$2.25 per share. Mean analyst estimates come in at $1.99 per share. With a 7x multiple on CFPS, you are left with a value of $12.25-$15.75 per share representing a 43% and 83% premium respectively to today’s price of $8.56.

Long SandRidge Energy