Quickly Growing SandRidge Energy Could Surprise To The Upside Soon

| About: SandRidge Energy, (SD)

SandRidge Energy (NYSE:SD) has been consolidating for about a year (see chart below). During that time it has been growing production quickly, with a clear emphasis on oil production. In Q2 2012 SD increased production 36% to 90.2 Mboe/d year over year. Approximately 56% of this was oil production, which is a boon with the miserably low natural gas prices currently.

In the Mississippian wells, SD increased production 31% quarter over quarter and 199% year over year. It also improved its financial stability by raising $615 million by completing the IPO of SandRidge Mississippian Trust II and selling more units of SandRidge Mississippian Trust I. The company raised another $130 million through the sale of non-core tertiary assets. SD also increased FY 2012 production guidance to 33.0 MMboe from 32.3 MMboe. In Q2 it achieved record production of 4.6 million barrels of oil and total production of 8.2 million boe. It also managed to decrease its lifting costs by 6%. The above items have allowed SD to fund its 2012 capex budget fully out of cash flows. Given SD's $2.1 billion capex program for 2012, this is very impressive. It plans to finance capex out of cash flow for 2013 also.

Of course, the obvious question then becomes: Can SD keep growing quickly? The answer would seem to be that it can. It has the following oil and gas producing leasehold assets:

  1. The Mississippian, with about 1,700,000 net acres and about 8,000 net drill locations.
  2. The Permian with 225,000 net acres and about 7,350 net drill locations.
  3. The Gulf Coast with a five-year inventory of low-risk recompletions and a two- to three-year inventory of drill sites.
  4. The West Texas Overthrust, which is a mostly natgas producing field.

In other words, SD can go on growing quickly for many years into the future. Furthermore, there is the likelihood that SD will add more new fields to these assets in future years. The Mississippian and the Permian wells are solidly profitable. The Mississippian wells cost an average of $3.2 million per well. They have a PV-10 value of about $5 million per well on average, and the PV-10 value is often a very conservative estimate (an underestimate). They have an average EUR of 456,000 boe, of which about 45% is crude oil. The Permian wells cost an average of $643,000 per well. They have a PV-10 value of $627,000 per well. They have an average EUR of 58,000 boe per well, of which about 78% is crude oil. Clearly these are not as profitable as the Mississippian wells. However, the PV-10 value is usually an underestimate of real value. SD estimates the NAV of its Permian holdings is $7.2 billion.

SD has guaranteed its profitability with hedges. It is 75%-85% hedged for FY 2012 production. Plus, it is substantially hedged in future years as well. SD has $3.548 billion in senior notes outstanding, but the average maturity of these notes is 7.4 years, so SD has no immediate financial problems, although its credit rating is only a B2 at Moody's and a B at S&P. With the progress SD is making in drilling the Mississippian, these ratings may go up soon.

The more important problem from a shareholder perspective is the preferred stock. SD has $200 million in preferred stock (6% yield) that will be automatically converted after Dec. 21, 2014, to common stock at $10.856 per common share. It has $300 million in preferred stock (7.0% yield) that is convertible after Nov. 20, 2015, to common stock at $7.7645 per common share. It has $265 million of preferred stock (8.5% yield) that is convertible to common stock after Feb. 20, 2017, at $8.0125 per common share. All told this amounts to about 90.1 million shares of new stock, if all of the preferred is converted. SD currently has 461.0 million shares outstanding with a float of 329.8 million shares. The 90.1 million potential new shares represent a 19.5% dilution of the shares outstanding and a 27.3% dilution of the float. This dilution will be at an approximate average price of $8.48 per share. This could present a significant obstacle to the stock going significantly higher than that in the near term, or even in the semi-long term. Still, there is no ignoring the growth. Within the next year or more the growth could easily be enough to push the stock much higher regardless of some lingering dilution. The increased cash flow will start to look very attractive after a while, and this is one of analysts' favorite evaluation tools. Keep in mind that SD keeps itself 75%-85% hedged at good prices.

The two-year chart of SD provides some technical direction for the trade.

Click to enlarge image.

Click to enlarge

The slow stochastic sub chart shows that SD is near oversold levels. The main chart shows that it has been in a consolidation phase for about a year. The yellow lines show a long term pennant formation. Normally a stock will break sharply up or down out of a pennant formation. This pennant is drawing to a close. That means it should break up or down soon. The huge growth I noted above should help it break to the upside.

However, there is still the chance that a worldwide recession could make it break downward. If you take away a possible U.S. recession and a Chinese hard landing, I think you could safely bet that this stock would soon move up significantly. With those two possibilities in mind (taking an EU recession as a virtual certainty), you might wish to average in over the long term. It does appear that SD has a very bright future long term.

Furthermore, SD management may decide that it sees a recession (or serious trouble for the U.S. economy) coming. It may hedge its oil production nearly 100% for 2013 while oil prices are still relatively high. This would de-risk a lot of SD's earnings potential. It might well spur a stock price increase. Even a $1.00 rise in the price amounts to about a 15% gain when the stock is at $6.54.

SD has an average analysts' EPS growth estimate per annum of 218.10%. This is outstanding growth for a mid-cap with a $3.01 billion market cap. The Beta is high at 2.94, but the average analysts' one year price target of $9.61 (approximately a 47% gain from its current $6.54 stock price) is also high for a stock that may be facing a U.S. recession. The analysts know a recession may be coming. They have likely just come to the same conclusion I have. If you buy this stock for the long term, its growth will pay off for you. It currently looks sound enough to weather a recession.

However, I would feel better if SD hedged 95%+ of its oil production for 2013. This may hurt possible profits, but it would prevent a quickly growing company from possibly suffering a significant setback. SD may also benefit longer term by LNG exports by companies such as Cheniere Energy (NYSEMKT:LNG). Current plans call for it to be able to export 1.1 Bcf/d by the end of 2015. There is also the Pickens Plan, which would spur natural gas use for transportation, especially trucking. Both of these possible coming uses for natural gas should help natural gas prices rise in the future. In the near term, early weather predictions call for an El Nino winter this coming winter. This colder than average winter will mean more natural gas use for heat. This should boost prices. Averaging in over the long term will help investors avoid any serious losses in this stock over the near term. SD does look like a long-term winner.

Other companies that are big new players in unconventional oil (two of which are diversifying from natural gas production) are Chesapeake Energy (NYSE:CHK), EOG Resources (NYSE:EOG), and Continental Resources (NYSE:CLR). If you like SD, you may also wish to look at these relatively big, strong players as well.

(Note: Some of the fundamental financial data is from Yahoo Finance.)

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SD over 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.