On Feb. 16, 2016, the management of SandRidge Energy Inc., (OTCPK:SDOC) elected to invoke the grace period to delay payment on some of its debt. On March 15, the company made its interest payment on the debt within that grace period, so no default had occurred. However, the company is negotiating with its creditors and once companies start down the path of either not paying interest or paying interest late, the road to bankruptcy is very likely. In fact, the company announced that it hired advisors to evaluate all of its options. This is the usual route to a bankruptcy filing.
The company showed lease operating expenses of $9.70 BOE for the fourth quarter. While this was down from $11.01 BOE from the year before, the figure is still pretty high for a company that has most of its production in gas and substantial natural gas liquids. Oil production has fallen sharply to less than a third of production while natural gas is more than 52% of production. Meanwhile daily production dropped to 72 MBoed in the fourth quarter from 88 MBoed the last year fourth quarter. This is a production drop and shift that the company cannot afford with its debt load.
Depletion dropped to $8.14 BOE from $13.57 BOE. However, most of this decrease was due to the cost ceiling impairment charges. The company is really not drilling enough new lower cost wells to impact the average depletion cost anywhere near the amount of the drop. Plus management may not be able to drill enough of the newer lower cost wells to significantly impact the company's overall operating costs. So this relatively high cost situation may not only persist, it looks likely to get worse in the short term.
SandRidge Energy has had some tussles with the Oklahoma regulatory authorities. As noted before, neither the company, the industry, nor the state did their homework on the effects and issues of earthquakes in the state. This has left the state grappling for answers and solutions for an increasingly aggravated citizen base. Meanwhile the company's production is in danger of being shut down if it cannot dispose of the waste water produced. The temporary agreement did shut some production down and diminished the company's disposal capacity, but it also added some certainty to the future of the production ability of the leases in question.
The effect of all the haggling in Oklahoma caused the company to reduce its drilling activity to one rig and purchase a property in the Niobrara North Park Basin, Colorado. The company allocated a second rig to this property to drill 22 laterals, and hopefully shift new production firmly into mostly oil and away from gas and earthquake controversies. The new budget of more than $200 million is a far cry from what investors would want to see to assure themselves of the company's solvency.
The company reported that in the fourth quarter cash flow from operations dried up to a very minimal positive amount ($13 million) and that cash flow for the year was a little better than half of last year's at $374 million. The company had hedged its oil production, but not its gas production, so when gas prices continued to drop, the cash flow from operations dried up. These cash flow from operations amounts are nowhere what is needed to service the nearly $4 billion in debt or its interest payments. The company basically emptied its credit line with the bank at year-end and put the cash proceeds into its checking account. It now has about $800 million to negotiate with the creditors and a very shaky future.
General and administrative costs climbed to $6.22 BOE in the latest quarter which is nearly double from the year before. These expenses will continue to run high until the company reaches agreement with its various creditor classes on a reorganization plan or files bankruptcy.
The company management does have some things in its favor. The unsecured bonds have covenants that allowed the company to issue senior second lien secured bonds ahead of them earlier this year. These covenants may also be used as a negotiating tool with the unsecured bondholders, although in current market conditions, the unsecured bonds and the common could well be worth nothing in the bankruptcy. That threat alone may keep the various stake holders at the negotiating tables. However, there are always holdouts who dream of getting all their money back if they don't agree to the current negotiating terms. To be successful, the company needs a very high percentage (probably 90% or more) of the bondholders to agree to a plan. If there are enough of these holdouts in the various bond classes the company will have no choice to but to file bankruptcy to reorganize.
As disclosed in the 10-K, the bank lenders have also destabilized the company's financial situation more by doing a special redetermination subsequent to year-end and giving notice that the company has insufficient collateral for the $500 million bank line. The banks want as much of their money back as they can get. The company for its part has offered more assets to the banks and alternatively is disputing the bank valuation. The deadline to settle this dispute appears to be April 20, 2016. That deadline may be a moot point if the negotiations with the bondholders are not satisfactory.
The company reported interest expense of $108 million for the fourth quarter and production of 6.7 MMBoe. That means for every barrel produced the company had roughly $16 BOE of interest expense. That figures more than doubles the operating lease cost of production and makes the company non-competitive in the current operating environment. Honestly, breaking covenants is the least of the company's worries, as the company has no future unless it has competitive operating costs and interest costs, as well as reasonable bond commitments in the future. While no bonds are due for a few years, there is currently no cash flow from operations to operate the company unless the company finds a significant amount of cheap new production to turn the tide or commodity prices rally significantly enough to restore cash flow.
Derivatives raised the price of oil sold to more than $63 per barrel of oil. That was a price far above the market price, but with oil such as small part of production, the average price received by the company was $27.23 BOE. While that was up from $19.85 BOE without the hedging, it was nowhere near what the company needs to operate, service its debt, and make progress to paying the debt when due. When taking into account drilling new wells, this company needs a price of nearly $50 BOE or maybe slightly more. Since the commodity pricing is nowhere near that even with the hedges, some extreme measures were needed despite the liquidity available and marketable assets because the company cannot survive in the current environment as its balance sheet and costs were structured.
To negotiate with the bankers and creditors, the company will paint the most bleak picture possible, so expect the accounting and the assumptions going into the accounting to be far more conservative than usual. Clearly the company has an uphill battle, but it does have cash, and some expert negotiators in the team to help advise management. The bond covenants may help management negotiate also, as will the threat of bankruptcy if no agreement is reached. The bond holders, even the secured bondholders will most likely negotiate with the company as they know that in a bankruptcy filing, expenses come out of the woodwork and will be superior to their claims. Similarly, the banks will also usually work with management. Management will usually get the first try at reorganizing the company and can go for debtor in possession financing that is superior to all liens and claims. This financing could well wipe out all creditor value if it leads to an unsuccessful reorganizing attempt in bankruptcy. This is another powerful tool to convince lenders to negotiate. Now whether or not management will be successful in keeping the holdouts in total to less than 10% of the value owed is another matter. That is usually an almost insurmountable hurdle. That hurdle has been overcome occasionally but only very rarely.
Therefore investors in the company should probably wait for some solid news on which to base an investment decision. The stock and bonds have already dropped so low that switching out will not yield that much proceeds unless the investor really needs the tax losses now. However, should there be a successful reorganization, the gains from the various securities could be very large, but the possibility of this happening is probably as good as purchasing a lottery ticket. Potential investors need to wait for the future of this company to become far clearer than what it is now.
Disclaimer: I am not a registered investment advisor and this article represents my personal views. It is not an investment recommendation and readers are advised to evaluate their own risk profiles and determine whether or not this investment fits their own risk profiles. The reader is also advised to read the government filings of the companies mentioned for further information (they include but are not limited to 10-K, 10-Q and as well as the press release filings). There is no substitute for doing your own due diligence as due to the financial leverage of the company, these securities would be considered to be speculative.
Disclosure: I am/we are long SDRXP.
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.
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