Will SandRidge's Gulf of Mexico Asset Sale Pay Off?

Though SandRidge’s recent sale of Gulf of Mexico assets has its drawbacks, it will allow the company to concentrate fully on its most prized asset -- the Mississippi Lime.

Jan 26, 2014 at 12:00PM

Less than two years after purchasing Dynamic Offshore and its Gulf of Mexico business for $1.275 billion, SandRidge Energy (NYSE:SD) has decided to part with those assets at a substantially lower price.

Though the proceeds from the sale will allow the company to more easily fund its Mississippi Lime drilling program, some aspects of the sale are a little concerning. Let's take a closer look at whether the company's bold move will pay off.

SandRidge exits the Gulf
Earlier this month, SandRidge announced the sale of its Gulf of Mexico and Gulf Coast assets to private equity firm Fieldwood Energy for $750 million in cash and the assumption of $370 million in abandonment liabilities. As part of the deal, SandRidge will also retain a 2% overriding royalty interest in two Gulf exploration prospects -- the Green Canyon 65 (Bullwinkle area) and South Pass 60 blocks -- that appear especially promising.

SandRidge follows other U.S.-based energy producers that have shed Gulf of Mexico assets in recent years to concentrate on onshore drilling. For instance, both Devon Energy (NYSE:DVN) and Apache (NYSE:APA) divested their Gulf of Mexico shelf assets back in 2010 and 2013, respectively, to focus on their North American onshore drilling programs.

The good and the bad
The main negative aspects of SandRidge's transaction are the price paid and its impact on the company's leverage. The company will receive a price substantially lower than the $1.275 billion it initially paid for the Gulf assets, which were generating roughly $100 million in annual free cash flow. The deal will also worsen the company's pro forma leverage ratio from 2.4 to 2.7 times, though that's still under the 3-times threshold considered excessive.

On the plus side, however, the proceeds from the sale should boost pro forma liquidity to more than $2 billion and allow the company to redeploy the capital that was previously allocated to the Gulf to accelerate development in the Mississippi Lime, where it commands a whopping 1.9 million net acres.

Will it pay off?
Though several other companies have recently retrenched from the Mississippi Lime, including Royal Dutch Shell (NYSE:RDS-A), which sold its entire 600,000 net leasehold acreage position and 45 producing wells in September, and Chesapeake Energy (NYSE:CHK), which sold a 50% interest in roughly 850,000 net Mississippian acres China's Sinopec for $1 billion in February of last year, SandRidge remains unfazed.

That's because it's armed with numerous advantages that Shell and others didn't have, including a deep knowledge base of the play developed over the course of four years of drilling, a vast existing infrastructure network, and the lowest cost structure in the play. It also has another advantage in the form of "stacked pay potential" across its acreage, which could meaningfully boost the resource potential of its acreage, as well as improve recovery rates.

In the second quarter of this year, SandRidge plans to add three additional rigs in the Mississippian and expects to exit the year with 29 rigs operating in the region. As per the company's updated guidance, it expects Mississippian production to grow 37% this year.

One risk to consider
With Gulf drilling out of the picture, SandRidge has effectively placed all its eggs in its Mississippian basket. Though it's arguably the best-positioned company to exploit the play's potential, there is one risk investors should carefully consider -- the drastic variability of its well results over recent quarters.

For instance, despite connecting more new wells to sales in the third quarter, the company's production grew only 1% sequentially, compared with 20% in the previous quarter. The reason for this could be an abnormally large number of poor performing wells, which resulted in a sharp decline in the company's average oil production rates during the quarter.

This is especially concerning, because it suggests that SandRidge's drilling performance in the years ahead could be volatile and hard to predict. If the company is unable to remedy this issue, all the well cost reductions and infrastructure advantages in the world won't mean much.

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Fool contributor Arjun Sreekumar owns shares of Chesapeake Energy, Devon Energy, and SandRidge Energy. The Motley Fool owns shares of Devon Energy. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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