With natural gas prices lingering at abysmally low levels for quite some time, a number of energy companies are actively seeking to reduce exposure. Instead, they're focusing on oil to boost their bottom line. SandRidge Energy (NYSE: SD ) exemplifies this trend better than almost any other company.
Making the switch to oil
Based in Oklahoma City, SandRidge is a small-cap oil and natural gas company primarily involved in the exploration and production business. Assessing the poor profitability of its natural gas segment, it made an informed decision to expand into oil. In 2008, 90% of its revenue came from natural gas. For 2012, 85% of revenue is expected to come from oil -- a complete reversal of its resource base.
Largely as a result of this move, SandRidge clocked record oil production numbers in the first quarter. Driven by a 3.4% quarter-over-quarter increase in oil production, adjusted EBITDA jumped 27% compared to the year-earlier quarter. The company also boasted a profit margin of around 13%, which is one of the highest in the industry.
The early switch to oil also has other benefits. Because it was a pioneer among natural gas-focused companies moving into oil production, it managed to scoop up huge portions of the Mississippian formation for a paltry $200 per acre. The land is now worth more than 20 times the purchase price, at more than $4,000 per acre, with fierce bidders constantly trying to move in and get a piece of the action.
Given the tremendous success of the company's operations in the Mississippian thus far, this was definitely a smart move. CEO Tom Ward calls it the "best place to drill in the United States." Tellingly, the company plans on having 45 rigs up and running in the play by the end of 2013.
A smart acquisition and a focus on the most productive plays
In February, SandRidge acquired Dynamic Offshore Resources, a smaller oil and natural gas explorer and producer, for around $1.3 billion. SandRidge now has access to Dynamic's nearly 63 million barrels of oil equivalent, helping it edge closer to its goal of doubling oil production by the end of the year. The acquisition also appears to be a smart move given that more than half of Dynamic's resource base is located in shallow water, to which SandRidge dedicates the bulk of its offshore drilling operations.
Unlike other E&Ps, SandRidge is focusing on two key plays: the Permian Basin and the Mississippian Lime. In fact, it's the leading driller in both, ahead of Chesapeake Energy (NYSE: CHK ) in the Mississippian and ahead of Apache (NYSE: APA ) and Occidental Petroleum (NYSE: OXY ) in the Permian. Within the Permian, SandRidge made a clever decision to focus on the Central Basin Platform, which contains the least expensive oil.
While this is a different strategy compared to competitors like Devon Energy (NYSE: DVN ) , which has multiple holdings throughout North America, it could play to SandRidge's benefit. Given the high production rates in these two prolific holdings, it very well may prove a successful tactic.
A debt pile that's cause for concern
Now for some of the negatives. SandRidge reported long-term debt of $2.8 billion and its debt-to-equity is an alarming 118%. Investors are concerned whether the company can raise the required capital to fund its aggressive plans for growth. In a recent conference call, management addressed these concerns.
The company is raising capital through trust vehicles and an extension of its credit facility. Through a third royalty trust, the SandRidge Mississippian Trust II, it raised net proceeds of $590 million, exceeding its $500 million target. It also increased its bank line of credit to $1 billion, in addition to extending the maturity. Management believes these measures, coupled with cash flow from operations, should be more than sufficient to finance capital expenditures for the year.
While I think falling oil prices still pose a risk, the conference call showed me that management is active in understanding and allaying shareholder concerns. Furthermore, the company is well aware of the downside risk in oil prices and plans to continue hedging aggressively into 2014.
While SandRidge is a riskier bet than many large-cap energy companies out there, it's got a lot of factors working in its favor. In addition, the company's seemingly dirt cheap valuation is compelling. Its market cap of $2.62 billion is less than half its enterprise value of $5.38 billion – a signal the company could be significantly undervalued.
If SandRidge is successful in meeting its aggressive growth plans and oil prices don't collapse, I think this stock has significant upside. If you're willing to take a little risk, this might be the right stock for you.
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