SandRidge Energy: Turnaround In 2014?

| About: SandRidge Energy, (SD)

Summary

SandRidge’s Analyst Day focused on the company’s game plan to achieve operating efficiencies and improved well performance in the Midcontinent.

The presentation highlights ~$0.9 billion outspending in 2014 relative to internally generated cash flow.

The company’s total capital-to-producing wells ratio remains high.

SandRidge’s operational initiatives must succeed to support the stock’s current trading multiples and rich premium to the PV-10 value of developed reserves.

Analyst Meeting Highlights

SandRidge Energy (NYSE:SD) hosted a highly informative Analyst Day yesterday. The presentation focused on the company's game plan to achieve operating efficiencies and improved well performance in the Midcontinent. The four-hour long presentation is a "must-hear and see" for investors interested in SandRidge and the Mississippian play in general.

It was hard not to be impressed by management's discussion of numerous operating initiatives that the company is in the process of testing and implementing. While mostly incremental in nature, these initiatives, if successful, have potential to add together to a significant improvement in operational performance. While the presentation did not contain breakthrough surprises, granular details and clarifications were very helpful in obtaining a better understanding of the company's operating metrics and venues for potential growth.

The presentation and discussion during the Analyst Day also highlighted financial and operating metrics that are central to the understanding of the company's value creation in the Mississippian play.

Production Growth Relative To Capital

SandRidge re-iterated its production growth guidance for 2014 and provided outlook for the 2014-2016 period (slide below).

Click to enlarge

(Source: SandRidge Energy's March 4, 2014 Analyst Day Presentation)

The 20%-25% growth guidance for 2014-2016 and 26% growth guidance for 2014 appear low, given that growth is fueled by significant capital outspending.

  • SandRidge's 2014 budget is $1,475 million.
  • "Recurring" capex is in fact even higher, ~$1,560 million (I add back $205 million of the remaining drilling carries and subtract $10 million budgeted for the divested assets and estimated 80% of the $137 million Trust drilling obligations that do not accrete to SandRidge's interest).
  • This compares to the estimated 2014 cash flow from operations of just ~$548 million (which is the company's estimate based on $95 per barrel WTI and $4.25/MMBtu Henry Hub pricing).

While the budgeted ~$1.0 billion "recurring" outspending in 2014 is aggressive (~170% of the company-estimated CFFO), per se it is not a concern: SandRidge needs to put its $1.55 billion cash balance to work, and the projected year-end 2014 Debt/Adjusted EBITDA ratio of 3.2x, while on a high side, is not alarming yet.

The fact that the outspend does not translate into a high-enough production growth, on the other hand, is a serious concern (assuming that the company's guidance is not outlandishly conservative).

Also a concern is the high ratio of capital spending to the number of producing wells expected to be drilled.

Wells-To-Total Capital Considerations

The Mississippian is notorious for high infrastructure requirements to support operations. Therefore, drilling and completion cost (D&C) per well alone does not convey the entire capital-intensity story.

The following analysis might be of interest. I take SandRidge's $1.4 billion 2014 capex guidance for the Midcontinent as a starting point (the slide below). To that, I add non-E&P capex allocated to Midcontinent (which I estimate at 90% of the $125 million total). As a result, I come up with a "fully-loaded" 2014 Midcontinent capex of ~$1.51 billion.

SandRidge plans to drill 331 net producing wells in the Midcontinent in 2014. This equates to Total Capital/Producing Wells ratio of $4.6 million (I emphasize that this ratio is different from the D&C metric).

Of note, SandRidge's 2014 capex budget reflects the benefit of large capital investments that the company has already made in its acreage, production infrastructure and oil service assets. Therefore, it is difficult to attribute the high non-D&C spending in 2014 to "investing into the future."

Click to enlarge

(Source: SandRidge Energy's March 4, 2014 Analyst Day Presentation)

Maintenance Capital Considerations

Multiple times during the presentation, management stated that the company needs to drill only 200 gross wells to maintain its production flat to its current level. The Q&A session clarified that a 70% average working interest assumption should be used, which suggests that ~140 net wells per year should keep the company's production flat.

Using $4.6 million "fully loaded" capital per well, as discussed above, total maintenance capex comes out at ~$640 million per year.

What production growth would SandRidge generate if it elected to limit its spending to its internally generated cash flow in 2014?

Using the Q4 2013 annualized Adjusted EBITDA ($166 million x 4 = $664 million) and assuming that the $1.55 billion cash balance is used to buy back bonds (estimated interest expense reduction of ~$110 million), I derive the company's run-rate discretionary cash flow of ~$470 million (Adjusted EBITDA less ~$190 million pro forma interest and preferred dividends).

Recognizing that this cash flow estimate is not based on a specific operating plan (it would have been very helpful if SandRidge included such calculation in its Analyst Day presentation), the calculation points clearly that SandRidge's internally generated cash flow would not be sufficient to maintain its production flat in 2014. Based on this illustrative calculation, the company would need to borrow to the order of $170 million above its cash flow to simply maintain its production flat this year.

Assuming (aggressively) that SandRidge is able to drive its total cost structure down to $4.0 million per well on a fully-loaded basis ($0.6 million per well less than what is assumed in the company's 2014 budget), total maintenance capital would be $560 million, still materially above the estimated run-rate discretionary cash flow.

Given that SandRidge is coming off of a year when capital spending in the Mississippian substantially exceeded internally generated cash flow, capital required to keep this production flat will obviously be elevated in the short term. However, even if a slightly lower maintenance capital assumption were used (let's say, 120 net wells per year), it is still difficult to conclude from these figures how the company can achieve sustainable growth while spending within its cash flow, if the company's existing high cost structure and leverage issues are not addressed.

The calculation implies that very significant further improvements in the operations' cost structure, corporate G&A and well productivity are required to say with confidence that the company is able to create value in the Mississippian at the corporate level (not just at the well level).

During the Q&A session, SandRidge's CEO, James Bennett commented that maintenance capital in the Midcontinent is approximately $300 million. Based on the calculations above, the comment is difficult to rationalize. Assuming 140 net wells needed to maintain production constant, D&C capital alone would be $440 million per year, assuming $3.14 million per well implied by SandRidge's 2014 budget. Other capital categories would exceed $200 million per year, if simply pro-rated.

Are Well Results Improving?

SandRidge has been drilling very actively in the Midcontinent over the past three years, with over a thousand operated wells brought on production since the company entered the play. One would expect the learning curve to have led to substantial improvement in well productivity. However, a careful review of the well productivity charts provided in the presentation (slide below) reveals no meaningful momentum in this area in the past two years.

The most important metric provided by SandRidge in the presentation - the average cumulative oil volume per well over the first 180 days - shows that the average productivity increased only by few percentage points from 2012 to 2013, as visible from the right hand-side chart on the slide below. In terms of natural gas volumes, productivity per well increased more significantly, by ~10%, during the same period. While positive, the improvements are hardly game-changing. Moreover, it is important to take into account that SandRidge has been expanding the use of ESPs, which may have resulted in a more front-loaded production.

Click to enlarge

(Source: SandRidge Energy's March 4, 2014 Analyst Day Presentation)

Turnaround in 2014?

In its presentation, SandRidge laid out an extensive list of operating initiatives aimed at reducing capital costs and achieving stronger well results. Operational improvements are indeed much needed to justify the current stock price that implies significant premium to the company's year-end 2013 proved developed PV-10 value of $2.8 billion (the Enterprise Value is $5.5 billion, based on the stock price of $6.22 per share). In the meantime, the company's premium trading multiples remain at risk.

Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.