Selling a premier, cash-gushing asset to fix a funding gap created by former missteps isn't usually a well-received idea. That's especially true when the received cash will be used to pay for the development of an asset that doesn't currently produce that much cash. It's no wonder why the market reacted harshly to SandRidge Energy's (NYSE:SD) decision to sell its Permian Basin assets to fund the development of its Mississippi Lime acres. That decision when combined with its string of miscues since going public in 2007 has left investors with without much to reason to celebrate.
Those former missteps, when combined with an all-in bet on the Mississippi Lime, have caused the market to be skeptical of the company's ability to pull off this transition into a fast-growing, liquids-focused production company. Some investors are betting heavily that the plan will fail, with more than 15% of the publicly traded float being sold short as of the end of last year. Is the market missing this company's true potential to finally unlock value for investors?
SandRidge's plan to sell the Permian Basin assets and use the money to fund the development of its acreage in the Mississippi Lime play didn't sit well with investors. One of its largest investors, TPG-Axon, is fed up and taking that battle public with a recently launched proxy battle to oust the board. However, given the company's limited options to raise capital, the deal does make sense if the Mississippi Lime becomes the growth driver that management thinks it will be.
Of course the company wouldn't have had to sell such a prized asset if it had other options to raise capital. That's in the past and the sale, when taken with its current liquidity has enabled the company to fully fund its capital expenditures through 2014. Basically SandRidge traded a known cash-flowing asset for the ability to invest in an asset that it believes will produce even more future cash flows.
The Mississippi Lime
The play was initially discovered by Chesapeake Energy (NYSE:CHK) in 2007 and it remains among the industry's largest leasehold owners with about 2 million net acres. As of the end of the third quarter it had 227 producing wells with a production mix of 41% oil, 10% natural gas liquids, and 49% natural gas. Chesapeake has its own funding issues, and it's looking for a joint venture partner, or to sell a portion of its leasehold in the first half of this year.
Range Resources (NYSE:RRC) also has a position in the play, though much smaller at 157,000 net acres. However, the company estimates that this is a billion barrel of oil equivalent field net to the company. It sees this as a high-return project, which is currently generating an internal rate of return of over 120%. Both Range and Chesapeake both see the play as a key growth driver going forward, but neither is betting as heavily on the play as SandRidge.
With 1.85 million net acres, SandRidge is one of the play's top leasehold owners. Its 600 wells are industry-leading, and its 39 days until first sales is the best in its class. Simply put, SandRidge dominates the play. The big questions mark is the concern that these wells, which appear to have a much shorter productive life, will end up not being as profitable because of production declines. Unfortunately, only time will tell whether decline rates will turn this boom into a bust.
The bottom line
That's why it cannot be understated that SandRidge is making a very big and potentially risky bet. It is early to the play and has amassed an industry-leading position. However, the early indications are that Mississippi Lime appears to be the real deal.
That's why its so important for investors to keep watch over this story closely. There are a lot of moving parts with the story as the proxy fight with TPG-Axon could yield a management shakeup, which could in turn unlock value much quicker through additional asset sales, and potentially even a sale of the company. If the current management does fend off the proxy then it also must prove that they are correct on their bet that the Mississippi Lime's development will yield a windfall for investors. Because if SandRidge is wrong and the Mississippi doesn't play out as planned then then this will not end well for investors.
Fool contributor Matt DiLallo has no position in any stocks mentioned. The Motley Fool recommends Range Resources. The Motley Fool has the following options: Long Jan 2014 $20 Calls on Chesapeake Energy, Long Jan 2014 $30 Calls on Chesapeake Energy, and Short Jan 2014 $15 Puts on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools may not 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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