SandRidge Energy: You Don't Know What You Don't Know
Nov. 25, 2014 3:37 AM ET | 3 comments | About: SandRidge Energy, Inc. (SD)
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)
Summary
Since the ousting of former CEO Tom Ward, SandRidge Energy has been promoting itself as a turnaround story.
This “turnaround,” however, may be more words than reality.
Investors must look beyond the trumpeted turnaround story and consider the full range of troubling issues outlined in this article before making a decision to invest in SandRidge.
Investors need to be especially careful when considering SandRidge Energy (NYSE: SD) as an investment. The company is trying very hard to promote its turnaround story; however, much of the information it presents to investors and shareholders is framed or presented in ways that are unclear at best and misleading at worst. In this article, I will call attention to some of these not-so-obvious issues, then I will cover the first four issues in depth and leave the remainder for investors to dig into on their own.
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Summary of Issues/Concerns:
SandRidge does not include salt water disposal (SWD) well costs, electrical infrastructure costs, and other necessary field-development costs when computing and presenting its individual well economics.
The company claims it can spin-off its saltwater disposal operations to raise more cash without any offsetting consequences. To the extent that this is possible, it would be an accounting fiction and not economic reality.
In the past eight months the CEO, James Bennett, has reversed positions on the company's maintenance CAPEX. He first argued that only $300 million would be required, but later conceded the figure would be closer to $500 million.
The company's operations, in the context of the whole enterprise, are not economic under current circumstances. This fact, combined with the front-loaded production profiles inherent in oil and gas wells and the distortions inherent in the use of EBITDA as a debt-service capacity metric creates a paradoxical situation where the company must borrow more and more money to keep its leverage ratio within debt covenant restrictions.
The hedged oil prices presented by the company are higher than their competitors because the company uses three-way collars to get higher pricing in exchange for taking on greater risks. This means the company is re-exposed to the effects of market prices if and to the extent that oil prices fall below $76.47 in 2015.
The company is currently being sued by shareholders, mineral rights owners, and even its own former employees. A new shareholder class action lawsuit was announced on November 11th of this year. The company is also under investigation by the U.S. Department of Justice regarding possible antitrust violations.
The company's most recent 10-Q has been delayed due to disagreement with the SEC over an admittedly minor issue; however, minor issues can lead to other discoveries and opens up the possibility that the SEC will find something else it does not like.
Issue #1: Saltwater Disposal and Infrastructure Costs
The Mississippian Lime is not a shale. It is a conventional reservoir with a high water-cut, meaning it produces vast quantities of salty brine water with every barrel of oil it produces. The company's saltwater disposal system handles 1.2 million barrels of water per day. The company's current production rate is 67,000 BOE/d (barrels of oil equivalents per day). That means roughly 18 barrels of water have to be disposed of for every one BOE produced. This is an expensive additional cost for operating wells and yet SandRidge does not include this amount when computing and presenting its individual well economics.
E&P companies typically use third-party SWD service providers. These providers capitalize their own expenses incurred when building out the SWD system and then charge the E&P customers a per-barrel fee. The E&P companies experience (recognize) these fees in the form of lease operating expenses. By owning its own saltwater disposal system, SandRidge shifts what would normally be a lease operating expense to a capitalized expense. What's more, rather than including this capitalized expense as part of its individual well drilling and completion capital expenses (the $2.9 million figure), the company classifies the SWD pipeline expenses as "Other E&P" expenses and the SWD drilling expenses as "SWD Well" expenses. As a result, neither expense is reflected in the individual well economics.
While management does not deny this fact, they do not make it readily apparent either - one gets the impression they would prefer to have this caveat go unnoticed. Yet, given the significance of the issue, this is precisely where management, as a display of good faith, should highlight the issue to earn and maintain the trust of investors.
In the most recent conference call, an analyst getting at this issue asked CEO James Bennett if the costs used in computing company's per-well economics represent the "full cycle" cost of the wells, to which Mr. Bennett responded:
"No . . . if you take the 40% return and put in our infrastructure dollars on top of that, that takes about 10 percentage points or 1,000 basis points off the return. So the 40[%] loaded for infrastructure is about 30[%]."
But even with the CEO's clarifying comment, it's still not entirely clear how much of these costs he's including when bringing the return down from 40% to 30%. Is it really fully loaded this time? Or is there just one more "minor" thing left out?
It's also important to note that the 30% figure almost certainly does not include the $100 million in workover costs nor the $170 million in land/seismic costs expected to be incurred for full-year 2014. The economics of the overall enterprise depends on how these wells perform in the full context of the interest-burdened enterprise, including interest expenses, workover costs, seismic, etc.
Issue #2: Salt Water Disposal (SWD) System Spin-off
While the company can shift its SWD costs away from the individual well economics as long as it owns the SWD system, it's not so clear how the company will be able to do this going forward now that they're talking about spinning-off the SWD system to raise some cash. The way Mr. Bennett explains it, the company is somehow hoping to spin-off the SWD system as a Master Limited Partnership, enticing new owners with a stream of distributions, and yet somehow not having those same distributions increase the lease operating expenses for the company's wells. This has a certain "you can have your cake and eat it too" quality.
To get a better sense of the issue, I recommend listening to the actual audio of an exchange between James Bennett and HETCO's Anne Cameron during the 2014 Investor/Analyst Day. The exchange between the two covers more issues than the SWD spin-off, and I highly recommend listening to the whole thing (starting at time 01:55:05), but the part where she challenges Bennett on the SWD system spin-off begins at time 01:56:50. Here's a link to the video.
The fact that the Bennett holds his ground so firmly on this issue makes me think there may in fact be some way to pull this off, but in such a case it would be an accounting fiction, i.e., some way in which the new MLP owners would get distributions, but where such distributions would not technically hit lease operating expenses or well economics. Nonetheless, this is the kind of contorted, smoke-and-mirrors accounting that should make investors wary.
It should also be pointed out that there are risks facing would-be owners of the MLP that could lead to much lower cash proceeds than the CEO suggests: SandRidge is overwhelmingly the dominant customer of the system, so if they fail, scale back, or stop drilling, there would be serious revenue interruptions for the MLP. Then there's the issue of SWD-induced earthquakes: Oklahoma has begun experiencing earthquakes associated with SWD wells on an unprecedented scale for the region. Personally, I suspect the physical dangers posed by such earthquakes are exaggerated; however, I am not an Oklahoma state regulator or lawmaker, so my views are not what counts here. The real danger is that state legislators and/or regulators will feel compelled to take at least some action, which could increase costs for the system. Wells may have to be plugged and relocated, some might require special testing, or special fees might be levied to pay for various studies or set aside in some kind of escrow account to cover concerns over future damages.
Issue #3: Maintenance CAPEX
HETCO's Anne Cameron hit on another key issue during her exchange with Bennett - one that cuts to the core of the company's problems. She asked Mr. Bennett how much the company would have to spend to keep production flat (their "maintenance CAPEX"). Perfectly straight-faced, Mr. Bennett replied that the company could keep production flat with 200 gross new wells per year, and that it would only cost the company $300 million per year. This figure glaringly does not align with the company's own numbers. The math is pretty simple: 200 wells times $2.9 million per well times 70% working interest equals $406 million, not including the infrastructure costs we discussed under Issue #1 (see above). Factoring in those additional costs, Mrs. Cameron came up with $660 million - a number Bennett rejected. Just eight months later Bennett changed his position (likely realizing the absurdity of his prior statement) and said the following in response to a similar question during the most recent conference call:
"...we can spend in the neighborhood of $500 million just on D&C [drilling and completion] spending. So that wouldn't include land or associated infrastructure or any capitalized items. But we can spend about 500 million on D&C spending and keep our production flat year-over-year." (emphasis added)
Adding in the infrastructure costs, that figure would rise to at least the $660 million Ms. Cameron originally came up with. Of note, the company's production volumes did not increase during those nine months in an amount that would naturally require such increases in this maintenance CAPEX estimate. So why did Bennett originally give such a low number and then change his position? Most likely, he understands how important it is that the company be able to maintain production while spending within cash flows. If the company cannot do this, then it means it must take on more and more debt simply to hold its ground. This is obviously not sustainable in the long run. Coming at it from a different angle, the company's current 40%-return wells... no wait, I mean 30%-return... no wait, I mean... throw in G&A, interest expense, workovers, and who knows what else… and what we find is that, in the full context of the enterprise, drilling more of these wells does not represent an economic, value-creating activity under current circumstances.
If this is true, why doesn't the company shut down or change its approach? Well, there is in fact a way out of the current uneconomic situation. The company is currently doing some experimentation and trying to improve its per-well economics. If successful (that's a big "if"), they could transform their ongoing uneconomic operations into economic operations. The company can also be saved by higher oil prices, which would have the same effect. Essentially, the company is in "survival mode" hoping to survive until circumstances turn in its favor. If they do not, shareholders will likely suffer.
The last point I'd like to make on this issue is that the CEO's initial firm stance on the $300 million figure, despite the glaring inconsistency, calls into question the objectivity of what is being presented to shareholders and potential investors.
Issue #4: The EBITDA Paradox
In accordance with the company's credit facility covenants, the company's so-called "leverage ratio" (Net Debt/EBITDA) cannot exceed 4.5. This ratio was 3.5 at the time of the most recent conference call and was projected by the CEO to climb to 3.75 by the end of the year.
Here's the paradox: While this "leverage ratio" metric is intended to be a measure of a company's capacity to service debt (the lower the better) and is meant to prevent borrowers from overextending themselves, when combined with the front-loaded nature of oil and gas well revenues it actually makes it so that producers with relatively steep declining production bases, such as SandRidge, actually have to accelerate production and borrow more in order to keep their leverage ratios below the specified limit.
Let's take an extreme case to illustrate: If SandRidge were to completely cease operations for 2015 so that current production for the year could be used to pay down some of its debt (a seemingly conservative approach), the numerator, Net Debt, would change relatively little due to the fact that current operating and interest expenses would still need to be paid, reducing what's left to repay principal. Revenues, taking into account declining production during the year and assuming favorable pricing ($90 WTI oil, $4.5 HH gas), would be roughly $1.2 billion. After operating expenses, production taxes, G&A, and interest payments, there would be $500 million left to pay down the $3.2 billion in debt. Assuming $400 million in cash at year-end 2014 (another favorable assumption), net debt of $2.8 billion could be paid down to $2.3 billion - an 18% decrease. While this looks like a sizable decrease in net debt, meanwhile, EBITDA would fall much more dramatically. By the company's own estimates (from slide #6 of the 2014 Investor/Analyst Day presentation), production would fall from roughly 85 MBoe/d to 55 MBoe/d - a 35% decrease! With the denominator falling faster than the numerator, slowing down growth to reduce debt would paradoxically raise the so-called "leverage ratio."
Now for the other extreme: If SandRidge were to issue more debt to accelerate its drilling program, drilling one thousand wells in 2015, the EBITDA would surge thanks to the high initial production rates from the 1,000 new wells, the exclusion of drilling and completion costs, water disposal costs, and interest expenses from EBITDA, while the Net Debt would grow at a relatively slower pace. Here, taking on more debt would paradoxically lower the so-called "leverage ratio."
The underlying cause of this paradox is the use of EBITDA as a proxy or a firm's capacity to make interest and principal payments. This idea only works in a theoretical world where ongoing capital expenses are not required to preserve the earnings capacity of the enterprise. The closest real-world example of this might be a nuclear power plant, where large up-front costs are required but where ongoing operations require little additional capital expense once the plant is constructed. Since these costs are not repeatedly incurred (at least not for several decades), in theory, the associated non-cash depreciation expenses realized over the life of the asset can be ignored when looking at the business' capacity to service debt.
Oil and gas drilling operations, however, are almost the exact opposite. Taking SandRidge as our example, if 200 gross wells are required per year just to keep production flat, that means the company has to bring at least one new well online every two days, incurring capital expenses virtually every single day of the year. Drilling and completion capital expenses for an E&P company, therefore, are more like paying the monthly electric bill to keep the lights on than the one-time expenses involved in nuclear power plant construction.
Further exacerbating the paradox is the fact that the most significant cost that moves in tandem with the front-loaded well production - the salt water disposal costs - has been transformed from a lease operating expense to a capitalized expense. Consequently, this cost that would otherwise act as a countervailing force, pushing back against the front-loading effect of oil and gas production, has no impact on EBITDA whatsoever. In fact, this may be why the CEO is so determined to keep these costs from hitting lease operating expenses, as it would likely push the company over the 4.5 limit. Keeping it away from lease operating expenses thus serves to buy the company time.
What I find baffling is that, despite all of this, the CEO announced in the most recent conference call that SandRidge would in fact be cutting back on CAPEX for 2015. In such a case, I think there is a good chance the leverage ratio will breach the 4.5 credit facility limit by year-end 2015. I am no expert in the intricacies of renegotiating these kinds of contracts, so I don't know what would happen exactly if this limit were to be breached, but even if it were not somehow catastrophic for the company, I do not imagine the consequences would be good overall for shareholders.
Conclusion
I'll close with a quote from Warren Buffett, that I think, combined with what I've outlined above, should give investors pause before investing in SandRidge Energy:
"When management takes the low road in aspects that are visible, it is likely they are following a similar path behind the scenes. There is seldom one cockroach in the kitchen." - The Essays of Warren Buffett (2nd ed., p. 39.)
Disclaimer: Opinions expressed herein by the author are not an investment recommendation and are not meant to be relied upon in investment decisions. The author is not acting in an investment advisor capacity. This is not an investment research report. The author's opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is illustrative in nature, limited in scope, based on an incomplete set of information, and has limitations to its accuracy. The author recommends that potential and existing investors conduct thorough investment research of their own, including detailed review of the companies' SEC filings, and consult a qualified investment advisor. The information upon which this material is based was obtained from sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Any opinions or estimates constitute the author's best judgment as of the date of publication, and are subject to change without notice.
