A couple of days ago, Mississippian Lime-focused oil and gas driller SandRidge Energy (NYSE:SD) reported its first-quarter earnings. While the company reported a solid quarter, it highlighted an important strategy shift which is now bringing its future into better focus. Part of that strategy shift has the company giving up and letting go, which actually will turn it into a much better company.
On the company's quarterly conference call with analysts, one of the analysts wondered what the company is planning to do as some of its leases come up for expiration. With the company's more prudent capital plans, it cannot possibly drill all of the acres it has accumulated before leases expire. SandRidge has spent millions to acquire these acres which are now a sunk cost. In order for that capital to not be wasted, industry practice has been to drill on as much land as possible to hold it by production to keep the leases from expiring.
SandRidge's management team had an interesting take on the subject. CEO Tom Ward, in response to the question, gave a bit of a history and a math lesson all rolled into one:
We have bought over 2.3 million acres, we have a little over $400 million invested in that, we made sales of $2.33 billion and kept nearly 1.9 million acres. So we have no basis in the acreage that we have and now we have developed a system that we have in place that you can drill the least expensive wells because of infrastructure in and around the system and that's if you look at our focus areas you can see six focus areas that are all fairly tightly together even though that covers nearly 2.8 million acres.
Basically, what he is saying is that while the company spent $400 million to acquire the acreage, it really didn't cost them anything because SandRidge already sold a small portion of it for $2.33 billion. So, in Ward's estimation, those sunk costs have been recouped. Further, it's a much more efficient use of capital to let some of its acreage expire rather than be forced to spend capital just to keep the acreage.
What the company is doing instead is focusing its capital around the infrastructure it's built. This frees the company to give up on some acreage and instead spend the capital to acquire additional acres inside its focus area. The company has already purchased 35,000 acres within its focus areas so far this year for about $400 an acre. Because of its infrastructure, SandRidge has a competitive advantage to develop this acreage within its core that its competitors don't have. That's makes for very smart capital allocation.
You're starting to see this a bit more in the industry. Take Chesapeake Energy's (NYSE:CHK) recent deal to sell 99,000 acres in the Marcellus and Utica shales to EQT (NYSE:EQT). The $113 million dollar deal was really about 25,000 acres which were adjacent to EQT's core operating areas. EQT said that 42,000 of the acquired acres were unlikely to even be developed do to near-term lease expirations or a more scattered footprint. This is a case where Chesapeake is just getting some non-core acres off its books, even if they were a throw-in to the deal. For EQT, it's getting the acres it wanted, even if it does have to take some additional acres until they do finally expire.
In the case of both Chesapeake and SandRidge we have companies that are really now just focusing on the best acres and letting the rest go. In some cases those acres will be sold off at perceived fire-sale prices and in other cases the acres will just be left to expire. Either way, it's more prudent from a capital allocation standpoint to invest around a competitive advantage because the returns on the capital that is invested are so much better.
Motley Fool contributor Matt DiLallo has no position in any stocks mentioned. 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.