SandRidge Energy, Inc. (fka SDOCQ)

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I have some good news and some bad news for those with exposure to SandRidge Energy.
The good news is that if SandRidge can hang on past the next 12 months or so it looks like its probability of default will come down considerably.
This of course would assume quite a few variables fall into place exactly how SandRidge would need them to.
The bad news is that I don’t think SandRidge selling is over and that isn’t good for the pain trade that’s currently on.

I have some good news and some bad news for those with exposure to SandRidge Energy (NYSE:SD).

I'm assuming if you're buying SandRidge equity at today's pricing with the knowledge that the E&P is under considerable stress that you're treating the exposure as a long-term CALL-like option that can provide significant upside if the E&P can make a survival turn. This makes sense if you're stressed equity investing as the common does in fact offer CALL-like return potential yet has no decay. For those with exposure from higher pricing I don't presume to know your particular reason for holding on the way down.
The Good

The good news is that if SandRidge can hang on past the next 12 months or so it looks like its probability of default will come down considerably. This of course would assume quite a few variables fall into place exactly how SandRidge would need them to. I'll explain before getting to the bad news.

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(Modeling using Kamakura risk management software KRIS. Kamakura is an institutional risk management and consulting firm. It currently does not offer this software to non-institutional customers.)

You can see that SandRidge offers an extremely unusual default probability curve. In fact, for SandRidge, the default probability has no curve. This of course is directly influenced by the extremely stressed nature of the E&P currently which skews the curve to being much higher in the immediate term.

Essentially what the above modeling and curve are showing is that if SandRidge can make it past the next year and still be operational that would assume it has experienced a turn in factors currently pressing on long-term viability. These factors have been detailed below.

SandRidge's probability of default would show to fall from ~31% in 12 months to ~24% in 24 months with a slow progression to lower risk in time. Still, with its uber-levered model and super oil and gas pricing sensitive asset base you can see that even 10 years from now SandRidge will still have a considerable resting probability rate of default. That doesn't mean that this model can't create attractive financials and attractive returns for investors it just means it's a very consistently risk heavy model to invest in.

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Second, SandRidge is going to need the broader economy to hold up and for interest rates to remain within a tight range. The macro factors that have shown to have the most dramatic effect on SandRidge default simulations are unemployment, real estate pricing, and general interest rates. Of course this makes sense as the economy is directly correlated with energy demand and any increase in interest rates would 1) have existing SandRidge debt looking less attractive to investors and 2) make newer debt/refinance options for existing debt more expensive.

The good news is that if SandRidge can make it 12 months it likely can make it 10 years.
The Bad

The bad news is that I don't think SandRidge selling is over and that isn't good for the pain trade that's currently on.

As I've detailed in previous articles, this assumption is largely based on the following:

I believe SandRidge has understated/been deliberately unclear with the economics of its operations (without outright lying) and that at some point it will need to clarify these - I don't anticipate this clarification is applauded
I believe we will see a sustained low oil pricing environment (my top-end range is set in the low-$60's for Brent, bottom range would show pricing below $50)

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From what I've taken from SandRidge earnings calls, SEC filings, and investor decks I believe the E&P (I've confirmed this anecdotally with sources in the field with intimate knowledge of SandRidge operations) has implied what are grossly understated all-in costs of production which have skewed its projected IRR. That said, with this assumption being speculation it should be noted that this assumption could materially impair my short/avoid thesis if wrong. Still, even assuming SandRidge's economics are actually in line with what has been reported the selling should be a long ways from being over.

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You can see that after a long period of the market ignoring SandRidge's uptick to default risk in the face of a precipitous decline in both oil and gas pricing that the market is now consistently pricing in a higher default risk as the low pricing environment is sustained. This is what it should be doing but it is interesting to note the late move and now progressively punitive nature of the move. Again, anything but sustained higher oil and gas pricing environments should show SandRidge to have a higher default probability and to consequently have a lower equity price. I reiterate my feelings that oil will at best be trapped in the range outlined until at least beginning 2H/16.

The same market ignorance followed by punitive make-up action is visible when viewing the market's view of SandRidge's seemingly perpetually growing leverage, although to a lesser degree as of course the leverage is more and more sustainable as oil and gas pricing moves higher:

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Finally, general market sentiment is still, even with the current default expectation and punitive equity pricing (to reflect the uptick to implied risk), at a wide divergence to Kamakura risk and default probability expectation:

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You can see very clearly that the majority of the risk pricing only took place over the last 90 days. That's the absurd level of delay that the market exampled in actually taking SandRidge equity lower. While T30D SandRidge default risk has increased ~8% and the equity has been hit fairly hard the green and yellow lines in the chart above remain considerably lower than the blue line (which is representative of Kamakura assessment). I would think investors would do well to track that blue line as the blue line was a leading indicator of the lower SandRidge equity pricing (as it showed risk moving higher). Simply put, SandRidge common has quite a bit of room to fall before being adequately reflective of implied default risk.

I continue to recommend that readers avoid SandRidge.

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