Why SandRidge Energy Could Outperform in 2014

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I won't beat around the bush. SandRidge Energy (NYSE: SD  ) has been one of the worst-performing energy stocks of the past few years. Shares are down by more than 80% from their 2007 IPO price and about 90% from their June 2008 highs, currently trading at just under $6 a share.

But with the company having made major changes over the past few quarters, 2014 just might be the year SandRidge shareholders are rewarded with double-digit share price gains. Let's take a closer look.

Why SandRidge has underperformed
Over the past few years, investors have dumped SandRidge stock for reasons including balance sheet and liquidity concerns, the surprising and strategically questionable acquisition of Dynamic Offshore in 2012, the company's inability to reduce spending and debt, and questions regarding founder and former CEO Tom Ward's management abilities and seemingly excessive pay package.

Though Ward was instrumental in guiding the company's well-timed decision to focus on liquids production in the wake of collapsing gas prices, SandRidge was arguably a terrible steward of shareholder capital under his reign. Not only did it build up a ton of debt through acquisitions, but it also embarked on additional equity issuances to fund its capital program, which led to a tripling of its initial share count.

But SandRidge is now in new hands and I don't think investors are giving the company enough credit for how much progress it has made. Since James Bennett took over as CEO in June, the company has outlined its new priorities, the most important of which are reducing operating and overhead expenses, while growing production and rebuilding its balance sheet.

SandRidge's turnaround story
Over the past few quarters, the company has made solid progress along these lines. Capital efficiency continues to improve, as evidenced by the fact that the company is drilling significantly more wells with less associated spending. In the first nine months of this year, SandRidge drilled 340 horizontal wells while spending $647 million, compared to drilling 271 horizontal wells while spending $676 million over the same period in 2012.

Production growth has also been robust, with the company's Mississippi Lime output surging 59% year over year to average 47.9 million barrels of oil equivalent, or MBOE, per day in the third quarter, even as its rig count declined by 15% sequentially to an average of 22 rigs. Next year, the company will ramp up activity in the Mississippi Lime, with plans to drill roughly 430 wells with a 25-rig program that is expected to deliver 35% year-over-year production growth.

Meanwhile, the company's Mississippian lease operating expenses continue to fall, declining 22% year over year to $7.02 per BOE in the third quarter. Going forward, SandRidge expects further cost reductions through new disposal wells, as well as through the implementation of new centralized production battery designs serving multiwell pad developments, which should shave off an additional $100,000 per horizontal well.

As a result of strong production and cash flow growth and continued cost reductions, the company now has $1.65 billion of liquidity, with a cash balance of roughly $900 million. Crucially, its leverage ratio has fallen to 2.35 times, a major improvement over previous years and roughly comparable to peers such as Chesapeake Energy (NYSE: CHK  ) and Kodiak Oil & Gas (NYSE: KOG  ) , which have leverage ratios of roughly 2.3 times and 2.4 times, respectively. Given that the average leverage ratio for exploration and production companies is roughly 1.8 times, SandRidge's ratio of 2.35 times -- by itself -- doesn't raise any red flags.

Can SandRidge deliver in 2014?
While several companies have recently backed out of the Mississippi Lime, I believe SandRidge has the necessary advantages, including a vast network of electrical and saltwater disposal infrastructure, unparalleled knowledge of the play, and the prevalence of multiple stacked pay zones, to exploit the true potential of its 1.8 million acreage position in the play.

As long as the company can meet or exceed production targets, while continuing to reduce costs and improve its financial position, the stock should gradually move toward its fair value, which some analysts estimate to be much higher than its current price. Leon Cooperman, chairman and CEO of Omega Advisors, a $10 billion New York–based investment advisory firm, pegs SandRidge's value at $10 a share, which would represent nearly 70% upside from its current price of just under $6 a share.

SandRidge is just one of many companies helping drive the record oil and natural gas production that's revolutionizing the United States' energy position. That's why the Motley Fool is offering a comprehensive look at three energy companies set to soar during this transformation in the energy industry. To find out which three companies are spreading their wings, check out the special free report, "3 Stocks for the American Energy Bonanza." Don't miss out on this timely opportunity; click here to access your report -- it's absolutely free.

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