Analysts at RBC Capital inaugurated coverage of SandRidge Energy (SD) with an "outperform" rating. SandRidge certainly has the early indicators of a stock about to skyrocket, with trades in recent days hovering below average volume while it enjoys an increase in positive media coverage. The company is also undergoing what appears to be an unannounced restructuring, which in my opinion is not critically necessary in SandRidge's case, but a definite positive nonetheless. This stock will be one to watch in the coming weeks.
Unannounced Corporate Restructuring Indicates Distance from Chesapeake
SandRidge recently announced a deal with MRC Global, Incorporated, in which MRC will acquire most of the operating assets of SandRidge's subsidiary, Chaparral Supply, LLC, which produces pipe, valve, fitting and related supplies primarily for SandRidge. Under the terms of the deal, MRC will become SandRidge's primary supplier for these materials. The value of the agreement to SandRidge is not yet disclosed.
SandRidge also recently closed a small deal selling enhanced recovery subsidiary SandRidge Tertiary LLC, which operates in West Texas, to private company Trinity CO2 Investments for cash amounting to $130 million. The deal will see 1,100 boe per day of production and reserves of 24 mboe taken off SandRidge's balance sheets.
SandRidge's recent spate of divestitures is interesting given competitor Chesapeake's (CHK) lack of success in attempts to do the same, and the past relationship between SandRidge CEO Tom Ward and Chesapeake CEO Aubrey McClendon. McClendon learned many of his most complex financial tricks from Ward, including the practice of sheltering non-core operations under subsidiaries and complex trusts. Chesapeake is coming under fire for the practice due to its underperformance and poor corporate governance over the past year (or longer, depending on who is asked), so SandRidge's timing on these subsidiary sales appears to be much more than coincidence.
Given the relatively small size of these deals, I think it is very unlikely that SandRidge's activities have anything to do with Chesapeake's inability to move on its much needed asset sales, and even more unlikely that SandRidge's actions were meant to put impediments in front of Chesapeake. There is, though, one thing beyond CEO friendship that the two firms have in common, and that is fear of Carl Icahn. Until Icahn purchased a 7.6% stake in Chesapeake, Chesapeake's executive management did very little to appease shareholder calls for change; once Icahn came on board, changes were immediate. Icahn is blasting Chesapeake for its huge stakes in non-core assets, complicated by the fact that even Chesapeake is having trouble justifying its asset purchases. Chesapeake's land management subsidiary may well be the next target for shareholder and regulator investigation of McClendon's apparent inability to distinguish between personal and business interests.
I think it's quite possible that Ward, seeing the troubles that Chesapeake is having unloading assets, much less finding a buyer for the whole company, is finally aware of the drawbacks of complex subsidiary and trust hierarchies. These corporate arrangements may work well when a company is performing, but Chesapeake is showing exactly how devastating these types of hierarchies can be when a company is not delivering healthy returns to its shareholders. In my opinion, Chesapeake's overly complex ownership strategies are one of the major reasons that none of the other oil and gas companies operating in the U.S. are jumping at the chance to own its premium acreage in the Permian and the Niobrara, despite the clear fact that Chesapeake is open to negotiation.
Bullish on Kansas, Getting Creative on Water Supply
SandRidge is bullish on Kansas, estimating that formations in the state could hold 15 billion barrels of recoverable oil. SandRidge already holds the most horizontal drilling permits of any independent in the state, and is planning to continue drilling throughout 2012 and beyond, telling one local news outlet that it plans to continue drilling and hiring for at least the next ten years.
Fracking activities require a great deal of fresh water - as much as 2 million gallons per well - and as players congregate in hot plays firms are looking outside the box for water supply. Chesapeake recently reached a deal with the city of Louisville, Ohio to purchase both potable and treated sewage water for activities on the Utica Shale. SandRidge is using sources as small as ponds and creeks, according to SandRidge President Matt Grubb. Private company Select Energy is excavating an existing lake in Harper County, Kansas in hopes that the larger footprint will retain more rainfall, which water can then be sold on to oil companies. Yet as drought creeps across many states where fracking is reaching new peaks, concerns are emerging over the diversion of fresh water from traditional uses in these areas such as agriculture and animal husbandry, as well as potential contamination from the chemical mix used in fracking.
In a recent interview, Ward was quick to note that concerns in Kansas are relatively recent. In his words, "there was never any question about fracking until they started drilling in Pennsylvania," where environmentalists are more numerous, or at least more vocal. Nonetheless, these types of concerns can quickly erode drillers' profits through increased regulatory costs, litigation, and enhanced construction requirements, not to mention a higher cost to acquire the water necessary to drill. In a drought situation, these concerns are compounded.
I think that as fracking becomes more common in the mid-continent, small and mid-size players are going to need to think outside the box for water supply more frequently. Furthermore, I am betting that EOG Resources (EOG) will be one of the first to try to corner its own water supply. After cornering its own frac sand and crude by rail transportation system, it seems like the next logical step. With its new lighter weight and a little extra cash on hand, SandRidge probably will not be far behind.
SandRidge is currently trading around $6, with a price to book of 2.1 and a forward price to earnings of 20.0. With its recent divestitures, I expect that its current debt to equity of 1.9 will see a nominal decrease. If the divestitures continue, that debt to equity will certainly reach more palatable levels. By comparison, Kodiak Oil & Gas (KOG) is currently trading around $8 with a price to book of 2.3, a forward price to earnings of 7.9, and a debt to equity of 0.7. Competitor Devon Energy (DVN) is trading around $58, with a price to book of 1.1, a forward price to earnings of 8.5, and a healthy debt to equity of 0.3.
I believe that SandRidge's recent activities are characteristic of a company ready to make big moves. A SandRidge unencumbered by various trusts and subsidiaries could be a more nimble competitor, as the capital siphoned by non-core activities can be substantial for a company of SandRidge's small size. Its high forward price to earnings and debt to equity ratio prevent SandRidge from being viewed as a very attractive buy, but the potential is certainly there, which is why I say this stock is one to watch in the near future.