SandRidge Energy: Exploration and Production Company Positioned to Succeed

| About: SandRidge Energy, (SD)

When I invest in common stocks I have set parameters that I use to pick my stocks, and if the companies do not meet these parameters, then I do not select them for investment. The requirements for non fixed income type investments are as follows:

  1. The companies must be sound and generally earning a profit with positive cash flow.
  2. I need to make a case for the stock price to at least double in three years time.
  3. The company should have a future price earnings or cash flow per share that is no more than 25 times.

This does not mean every stock that I invest in doubles in 3 years; many things can and do go wrong with the companies that I cannot foresee when I invest in them. Many of these companies are smaller and risky investments. I would recommend that you never fall in love with any company and never put more than 5% of your total investment dollars in any one company or more than 20% in any one industry group. Diversification is a very important part of any investment program. Many of these companies more than double which more than offsets the ones that do not increase in value. My goal is to earn at least a 25% annual rate of return on my investment in these companies. What I have discovered in my 45 years of investing is if I cannot make a case for a stock doubling in three years, it eliminates most stocks that do not significantly increase in value.

I have many companies that meet my criteria to invest in at the present time. One is SandRidge Energy (NYSE:SD). This company has two major oil plays that it is currently developing. These plays are in the mid section of the US. They are the Permian Basin Play in Texas and the Mid Continent Mississippi Play in Oklahoma and Kansas. Both of these plays have significant oil and other liquids production. This company is in the process of changing from a natural gas to an oil production company.

The company has very large acreage positions in both plays and has over 11,000 oil drilling locations and in addition they have over 8000 natural gas drilling locations with many held by production or on longer term leases so they will not have to drill these natural gas locations until natural gas prices recover from their current low prices. The internal rates of returns on these two oil plays are very good as shown on SandRidge's latest company presentation on its website, and these internal rates of return do not include the proceeds from the royalty trust below.

SandRidge has also filed an S-3/A with the SEC to sell a Royalty Trust IPO (Initial Public Offering). This will provide between $250 million and $287 million of proceeds with which to drill wells. SandRidge will retain between 51% and 43% of royalty trust units plus 50% of the revenue from oil and gas produced from the wells drilled in the future. The proceeds they receive from the offering should cover most of the costs of drilling these wells and the drilling costs of the existing wells that are being put into the trust. After the trust units are sold SandRidge will have about 70% of cash flow after expenses from its interest in the trust and the 50% production interest not in the trust. This should increase the internal rate of return on this play tremendously. It also appears to be a good deal for the initial unit royalty holders in the trust since SandRidge will subordinate about half its units and reduce the payout to the subordinated units if the royalty trust does not reach certain payout levels within the trust for the first five years. SandRidge stated that 60% of the trust's production will be hedged through year end 2015. SandRidge's CEO also stated that it will try to sell additional royalty trusts in the future if the stock market is able to absorb additional royalty trusts.

When you compare other oil companies price earnings and cash flow to SandRidge's, and the potential production from the land it holds, SandRidge's common stock appears to be underpriced. Also, their major oil plays are not in areas like the Bakken, Marcellus, Niobrara, and Eagle Ford shale plays which have generated much more media coverage. SandRidge's Mississippi Play could have up to 4 wells per section over the approximate 950,000 acres when all their lease offers are accepted. They will have approximately 6,000 wells times an average of 250 thousand barrels of oil reserves per well (using the approximate mid point between 1.5 B and 2.5 B cases) according to their latest corporate presentation pages 13 and 14. This would result in approximately 1.5 billion barrels of oil reserves and about 8 trillion cubic feet of natural gas reserves if all the land is proved up in the future as they expect. There is also Eagle Energy a private company which has similar production information on the Mississippi oil and gas play.

SandRidge becomes even a much better investment if you consider that the royalty trusts are paying the majority of the drilling costs, and SandRidge is retaining about 70% of the revenue. This assumes that they can market enough royalty trust units to cover all or a significant amount of their production. They could also decide to sell or do some type of joint venture with another oil company.

If you review SandRidge's SEC 13 G filings, you will find that some large mutual fund and hedge fund operators have taken large positions in SandRidge's common stock. SandRidge does have more debt and is more highly leveraged than many of its peers, so if the price of oil declines significantly in the next few years, SandRidge could be put under pressure to pay its interest and repay its debt. However, if oil prices stay at the present level or go higher, then this should not be a major problem, particularly if more royalty trust IPO's are sold. SandRidge also has a hedging program in place that covers the majority of its expected production at or above current prices for the next two and half years.

As with all investments there are risks involved with oil investments. These risks are as follows:

  1. The price of oil could decline for a significant period of time.
  2. The federal or state governments could impose major new regulations on oil drilling.
  3. The use of alternative energies could reduce the amount of oil used.
  4. Natural gas or other types of fuels could reduce the amount of oil used.
  5. The federal and state governments could restrict the use of oil.
  6. The amount of oil produced could increase dramatically.
  7. The production from future wells will not meet or exceed production from current wells.

It is also very important to understand what is happening to the oil industry. It has changed dramatically in the last 5 to 7 years by the use of horizontal drilling and new fracing procedures that evolved in drilling oil wells. This has resulted in areas that produced no or very little oil or gas 15 to 50 years ago now being able to produce wells with up to 5,000 barrels of oil and gas in the initial 24 hour production period like the Bakken oil play. It is really amazing when you view the North Dakota State website and look at the old well drilling information for a non producing well that is in a similar location as a new well that is now a large oil producer. This is the summary of the amount of oil that the Bakken contains and this is Leigh Price's paper which is the definitive study on the amount of oil in the Bakken shale formation. This paper does not include the Three Forks formation layer below the Bakken, which appears to have at least 50% of the oil that is in the Bakken formation.

The older conventional oil plays relied on finding pools of oil; the new plays are producing oil contained directly in large beds of shale and carbonate rock. This oil is contained in the rock over very large areas. This has resulted in very few, if any, dry holes once the oil area has been delineated, usually with what the industry calls vertical strat wells.

A good example of this is the Mid Continent Mississippi play of SandRidge's. Various oil companies have drilled thousands of vertical producing wells using the old technology in this formation, and the new horizontal wells are producing over 3 to 7 times the amount that the old vertical wells produced in the same location - see the link to SandRidge's presentation above for more information on this. These old vertical wells provide SandRidge with a tremendous amount of information on this formation.

From my research, peak oil is now a myth based on new large oil plays in US, see Bakken Shale links above. However, this doesn't mean we will all be swimming in oil and that oil is headed for $30 to $50 a barrel any time soon. It will take at least a minimum of 10 to 15 years to produce the amount of oil that the US uses in a day and even if we are able to do that, we will only be able to extract from 5% to 20% of the oil in place with the current technology over many years. The length of time to drill all of these wells is also illustrated by the number of years it will take SandRidge to drill all its locations: over 11 years and 25 years in its two major oil plays at the present rate of drilling. Most of the intermediate size oil companies like SandRidge have from 4 to 10 years of drilling locations. Also, during the first year of a well's life the amount of oil produced declines by 35% to 90% of the initial production in the first 24 hour period. During the second year a well declines by 10% to 35% from what it is producing at the end of the first year and after that usually much smaller yearly declines.

China, India and many other developing countries are increasing their use of oil very fast. Within the next 8 to 12 years it appears China will probably use as much oil per day as the US does; although their per capita use would be about 1/6 to 1/8 of our use. It appears that if the world economy continues to grow for the next few years, the price of oil will continue to increase or at the very least stay in the price range of the last few months. This should provide the support for oil companies to increase their income during the next few years, especially since most of these oil companies have a very large number of drilling locations for oil. SandRidge appears to be positioned to succeed and its share price should appreciate significantly over the next three years if the market and economy continue to grow.

Disclosure: I am long SD. I may buy or sell SD based on things happening in the world or news from the company at any time.