SandRidge Energy, Inc. (SD) will unleash, on April 18th, its third high yielding trust in less than 2 years. I have received more questions about this new offering than any other security. I am referring to the initial public offering (IPO) of SandRidge Mississippian Trust II (the symbol will be SDR). Brokers have been calling clients to sell the 26 million shares to income focused investors. I will review the price sensitivity of the shares based upon the projected price range of $19 to $21 per share. I believe income investors should avoid these units due to the below analysis.
Units Outstanding Post IPO
SandRidge Mississippian Trust II will issue 26,000,000 common units to the public. This represents a 52% interest in the trust. The sponsor of the trust, SandRidge Energy, will own about 11.3 million common units and about 12.4 million subordinated units convertible into common units. There will be a total of 49,725,000 units outstanding once the IPO is completed.
Oil vs. Natural Gas Production
Investors should anticipate, per page 9 of the prospectus, 78% of net revenues will be from oil and 22% of net revenues will be from natural gas. 49% of production will be from oil and 51% of production will be from natural gas production.
The SandRidge Mississippian Trust II will own producing wells and development wells to be drilled by SandRidge on approximately 53,000 net acres in the Mississippian formation in northern Oklahoma and southern Kansas. The trust's termination date is December 31st, 2031.
SandRidge Energy management has hedged approximately 42% of the expected production and 69% of the expected revenues for the trust. This is based upon the distributions occurring within the time window of April 1st through the end of 2014. The following table shows investor price sensitivity in purchasing SandRidge Mississippian Trust II's units at $18:
This table assumes an investor's entry point is $21 per SandRidge Mississippian Trust II unit:
SandRidge Mississippian Trust II's projected quarterly distributions are based upon the following hedge percentages. These hedges, per page 50, are all price swap contracts.
The trust, within the SandRidge Energy legal structure, fits in as follows:
SandRidge Energy has introduced two other high yielding trusts. Here is a synopsis of each name.
SandRidge Mississippian Trust I (SDT)
SandRidge Mississippian Trust I had its IPO on April 7th, 2011. The SandRidge Mississippian Trust 1 was formed in December 2010. The goal was to own royalty interests in oil and natural gas properties owned by sponsor SandRidge in the Mississippian formation in Alfalfa, Garfield, Grant, Major and Woods counties in Oklahoma state.
Here are the SandRidge Mississippian Trust I's distributions through present date:
The distributions have been successfully consistent with the SEC S1-A prospectus.
SandRidge Permian Trust (PER)
SandRidge Permian Trust was formed by SandRidge Energy, the sponsor, in May 2011 to own royalty interests in oil and natural gas properties leased by SandRidge in the Central Basin Platform of the Permian Basin in Andrews County, Texas.
The trust has successfully paid out anticipated quarterly distributions since its IPO.
My Concerns about sponsor SandRidge
SandRidge Energy, the sponsor, is offering 3 trusts for a reason. The sponsor needs the money to fund other projects. The credit agencies are explicitly aware of the extent of the sponsor's high financial leverage.
As of April 2nd, Standard & Poor's Ratings Services revised its recovery rating on sponsor SandRidge Energy's senior unsecured notes to '4' from '5'. This is an indication of S&P's belief of loan recovery in case of a default. A '5' represents a 30% to 50% recovery chance. The company and notes have a credit rating of "B". Moody's has a B3 credit rating on SandRidge Energy's recent debt offerings.
The reason for the negative credit rating, per S&P, is due to the sponsor's "highly leveraged" financial risk and aggressive growth strategy. The company is spending more money than internally generated free cash flow.
I recommend income investors avoid the hype surrounding SandRidge Mississippian Trust II. The trust is likely to pop up due to media hype and due to the success of the first 2 trusts. On the positive side, both SandRidge Mississippian Trust I and SandRidge Permian Trust have successfully met the targeted distribution levels per quarter.
My concerns are the sponsor's financial risk. This should be a warning sign to trust investors. A weak sponsor can have a negative impact upon the successful operation of an ongoing trust.
I recommend investors avoid the trust and consider investing in the following two upstream entities. These two names do not have a defined trust life. These entities are invested in growing, stable, and long life oil and natural gas projects.
Linn Energy, LLC (LINE)
Linn Energy, LLC, is an independent oil and natural gas company. The focus is upon acquiring, developing, and maintaining long life oil and natural gas properties. Strategic locations are in the Mid Continent, the Permian Basin, Michigan, California, and the Williston Basin. The company's goal is to pay a stable and growing quarterly distribution to shareholders. The entity is a limited liability corporation.
I believe Linn Energy is more suitable to income investors than a finite life trust. Linn Energy currently offers a 7.3% annual distribution yield. The company has almost 100% of oil and natural gas production hedged through 2015.
EV Energy Partners LP (EVEP)
EV Energy Partners is an upstream partnership. As an upstream entity, the partnership's goal is to acquire, maintain, and develop oil and natural gas properties. The partnership's strategic locations are in Barnett Shale, the Appalachian basin, the Mid Continent, and the San Juan basin.
The partnership was formed in September 2006. The returns have averaged an annualized rate of return of 33%. The current distribution yield is 4.7%. Per the April 17th presentation, the company has an extensive hedging program in place through 2014.
The company's Utica assets are a major find and have drawn increased attention from competitors and peers. The partnership is deleveraging via partnerships and hedging.