Sandridge Energy's Key Question: Can It Bolster Its Cash Flow?

| About: SandRidge Energy, (SD)

Sandridge Energy (NYSE:SD) is a young company - the initial public offering was in 2007. SD has aggressively acquired land for drilling rights and has become a major oil exploration and production player in the Southwest. This stock will scare off some investors with its high level of debt and small level of net income. The company has potential as an investment if an investor believes Sandridge Energy will hit the big goals management has put in place for the next few years.

The current version of Sandridge Energy started with Chesapeake Energy (NYSE:CHK) co-founder Tom L. Ward, buying a significant portion of Oklahoma City based Riata Energy in 2006. The next year the name was changed and the company taken public through an IPO. Tom Ward is the current CEO and Chairman of the Board. The company was a hot energy IPO, going from a $26 initial price to over $65 in mid-2008 as the company rode the energy boom, which fizzled out later in 2008. Initially, Sandridge Energy was a natural gas exploration and production company.

In 2009, after energy prices collapsed, the company decided to redirect its efforts from drilling for natural gas to exploration and drilling for crude oil. In a recent investor presentation, CEO Tom L. Ward said, "...oil was at $39.96 and gas was at $4.13, and that was the transitioning date basically 3 years ago today that we looked back and said, we want to change the company." At that point the company was spending 95% of its efforts drilling for natural gas. Now the 95% is spent drilling for oil. The move was a timely one, since the price of crude has moved steadily upward towards $100 per barrel and the spot price of natural gas has sunk to below $2.50. In September 2009, just 20% of Sandridge's production was crude oil. In 2011, crude made up 57% of production - old gas wells keep producing.

The current exploration and production is focused on two developments: Sandridge is the most active driller in the West Texas/New Mexico Permian Basin. In the Permian, the company drills shallow, low cost conventional oil wells, producing an excellent return on the money invested. The company's Mississippian Project is located in the mid-continent region on the border of Oklahoma and Kansas. On this project, Sandridge Energy is using horizontal drilling techniques to produce higher production oil wells. In this new project, the company has drilled just over 200 wells with plans to drill 380 in 2012. The company owns drilling rights to 1.5 million acres in the Mississippian Project - room for 7,000 potential wells. Just under 1,000 wells in total were drilled in 2011.

The challenge for Sandridge Energy as it ramps up drilling rates has been cash flow. In 2011, the company spent about $1.8 billion on capital expenditures - drilling for oil - and only generated $535 million in free cash flow. That leaves the company about $1.3 billion short. Already highly leveraged, Sandridge went to some alternative sources to raise capital and has been able to round up $2 billion since the start of 2011. The company sold 500,000 acres of the 2 million it held in the Mississippian Project. Joint development ventures brought in more money to fund drilling. As a final method to raise capital, Sandridge formed a pair of royalty trusts to drop down producing wells and then sell shares of the trusts to raise capital. The trusts, Sandridge Permian Trust (NYSE:PER) and Sandridge Mississippian Trust I (NYSE:SDT), trade publicly on the NYSE. Paperwork for a third trust, Sandridge Mississippian Trust II has been filed with the stock symbol SDR. The royalty trusts allow Sandridge to raise capital without incurring more debt or issuing stock, diluting the outstanding shares.

In its major development areas, Sandridge Energy competes with 10-times larger Apache Corporation (NYSE:APA). Apache is the second most active driller in the Permian Basin, after Sandridge. Apache recently inked a deal to purchase privately held Cordillera Energy Partners III LLC, providing Apache with 240,000 acres of prime Oklahoma and Texas panhandle drilling rights. Sandridge Energy - with its 1.5 million acre holdings in the mid-continent - seems well positioned to compete with larger companies such as Apache.

The stated goal of the Sandridge management is EBITDA of $2 billion in 2014. The 2011 EBITDA was $700 million. The result would be a tripling of cash flow in the space of three years. CEO Ford has stated the $2 billion goal would provide cash flow to fund $1.6 to $2 billion of cap-ex every year, allowing the company to grow production organically from that point. This is the factor on which investors should focus. If Sandridge does triple cash flow in three years, the share price should follow along. Once the company reaches the point of self-funding exploration, large amounts of revenue should drop to the bottom line as net profits. The investment decision on Sandridge Energy is whether it can reach the goal before running out of places to find money. If it can, this stock will be an excellent investment for the next five plus years.

As an additional piece of the financial puzzle, Sandridge Energy has made a deal to purchase privately held Dynamic Offshore Resources LLC, a Gulf of Mexico oil and gas production company. The $1.3 billion deal is being funded approximately 50/50 with cash and Sandridge stock. It is expected to close in the second quarter of 2012. Gulf of Mexico production assets continue to carry low valuations due to the BP Deep Water Horizon explosion in April 2010. Dynamic brings 25,000 barrels of production per day to the current 67,000/day rate of Sandridge Energy's existing wells.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.