SandRidge Energy: Execution Remains The Key, Valuation Still Not Compelling

| About: SandRidge Energy, (SD)

Summary

SandRidge has been taking steps to improve its capital efficiency and is growing its resource base in Mid-Continent.

SD is calling for a three-year organic production CAGR of 20-25%.

Although the company’s strong production growth and falling costs should narrow the funding gap, SD is projected to incur cash flow deficit in 2014 and 2015.

SandRidge Energy Corporation (NYSE:SD) operates as an independent natural gas and oil company in the United States. The Oklahoma City, Oklahoma based SD has transitioned from a natural gas focus to an oil focus company over the last several years and is rapidly ramping up in the Mississippian Lime play. The company has been taking steps to improve its capital efficiency and is growing its resource base in the Mid-Continent.

The company recently held its first investor day after James Bennett took over the role of CEO in June 2013. The management team projected a confident and improving outlook of the company. The company is calling for a three-year organic production CAGR of 20-25% on capex of ~$4.6 billion in the next three years ($1.48 billion in 2014, and $1.55 each in 2015 and 2016). With a focus on both growth and return the company is focused on becoming the premier Mid-Continent resource conversion company.

Both the Mississippian and Mid-Continent program will be the driver of the company's production growth, as SandRidge redirects even more of its capital here following its recent Gulf of Mexico ("GOM") divestiture. The Mississippian focus area accounts for the majority of the company's capex. The company currently plans 331 net wells in its Mississippian focus area for 2014; however, there is some upside potential to production and resource estimates on the back of 55 additional net appraisal wells to be drilled in the region.

SD's Well costs have been falling and are projected to average $3.0 million per well for 2014, down from approximately $3.6 million in 2012 and $3.1 million in 2013. Moreover, costs are expected to fall further towards the end of 2014 as the company continues to improve efficiencies in its core asset.

The company is evaluating the viability of multilateral development patterns in the Mississippi Lime, which could materially reduce costs in the play. In September 2013, the company drilled a trilateral well and developed an entire section, contracting 14,500 feet of reservoir, for approximately $5 million, which is $4 million less than a typical three-well development pattern. SD is currently evaluating well performance and has planned 6 additional multilateral sections for 2014. SD's strong expected production growth in the Mississippian over the next several years combined with lower well and other operating costs should narrow the funding gap for the company.

The company also high-graded its PUD locations by removing approx. 6% of its year-end 2012 reserves causing PUD Estimated Ultimate Recoveries ("EURs") to rise to 380 MBOE from 369 MBOE, which included a 10% increase in the oil EUR to 118 Mbbls. On a $90 per barrel and $4 per MMBtu flat price deck and assuming the company's 4Q13 average well cost of $2.9 million these wells are expected to generate ~60% pre-tax IRRs. During the analyst day presentations, the company also mentioned that 2014 drilling program's average PUR EUR is 400 MBOE and disclosed additional EUR detail by area. While the market should find the details helpful, it is important to note here that more prolific areas do not necessarily equate to higher productivity as the liquids mix can vary considerably.

Although the company's strong production growth and falling costs should narrow the funding gap, SD is projected to incur cash flow deficit in 2014 and 2015. As of end of last year, the company had $1.8 billion of total debt and $815 million of cash. In addition, the company had an undrawn credit facility with a borrowing base of $775 million and $29 million of letters of credit. According to Barclays estimates, to fund the capital budget of $1.475 billion, preferred dividends of $56 million, and estimated trust distributions to non-controlling interests of $155 million, SD will incur a cash flow deficit of approx. $900 million in 2014. However, the shortfall can be entirely funded with cash on hand and proceeds from the Gulf of Mexico sale. Similarly, in 2015, the company is expected to incur a cash flow deficit of about $825 million to fund capital outlays. SandRidge continues to evaluate alternatives to monetize its saltwater disposal infrastructure in which the company had invested $470 million through year-end 2013.

Conclusion

Improving capital efficiency and returns has been the company's key theme over the past year. By narrowing the scope of the drilling program in the Mississippi Lime to areas with better defined geology and capturing cost synergies through its saltwater disposal and electrical power systems, SD has delivered more capital efficient production growth from the play and expects to continue doing so over the next several years. However, the share performance will largely depend on the company's ability to translate its efficiency gains and a growing Mid-Continent resource into higher balance sheet adjusted production growth. The company is also trading at a premium compared to its peers.

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.