Initially, SandRidge Energy (UNKNOWN:SD.DL) investors and analysts liked the company's second-quarter earnings report, as its shares popped shortly after SandRidge reported. It was for good reason: Its earnings were actually pretty impressive when considering that, well, it actually earned money this quarter when analysts were expecting a loss. Further, the company was able to drop its Mississippian well costs down below $3 million per well and even raised its production guidance for the full year as its wells are exceeding expectations.
It wasn't until the company's quarterly conference call that reality apparently started to settle in for investors and analysts. That's when investors began to realize the company still faces a pretty massive funding gap starting in 2016. Further, it appears the company isn't yet ready to be proactive and get ahead of that fiscal cliff. Because investors don't like that kind of uncertainty, they soon forgot that SandRidge reported solid numbers and started to sell off its stock.
Investors are certainly justified in having this concern. While the company has a range of options including selling off its Gulf of Mexico assets, its saltwater disposal infrastructure assets or its royalty trusts, the fact that the company plans to wait before unloading these assets caused some investors to fret. Investors have watched Chesapeake Energy (NYSE:CHK) struggle to sell assets each year to meet its own funding gap. That is why SandRidge investors don't want to see the company burn through its own capital and then be forced to sell assets at bargain prices just to make ends meet.
Chesapeake has actually decided that using asset sales to fund its growth simply isn't driving the returns it had hoped, which is why the company is shifting gears to balance capex with cash flow. With founder and former CEO Aubrey McClendon now out of the picture, Chesapeake is embracing a new phase of fiscal discipline. I think it's safe to assume that SandRidge investors were expecting the same fiscal discipline now that its founder and former CEO Tom Ward, who also co-founded Chesapeake, is out of the picture. Investors expecting that sort of discipline were sorely disappointed when new CEO James Bennett said that he is "confident that we can maintain a double digit, total company production growth rate," which investors interpreted to mean its not even considering a spending cut.
SandRidge isn't ready to embrace capital discipline like its peers, because it does have several visible levers that it can still pull to meet its gap post 2015. That is why it believes the right course of action is to take the capital it has available and deploy it to develop the Mississippian Lime because the returns right now are so good. With internal rates of return increasing to 50% now that it's well costs are down below $3 million, it's easier to understand why the choice is being made.
When looking at another company that has taken the leap to fiscal discipline, it's a bit clearer why SandRidge is sticking to its plan. Natural-gas-focused Ultra Petroleum (NASDAQ:UPL) has cut more than a billion dollars from its capital budget. That has the company spending $415 million this year when it was spending $1.56 billion just two years ago. Not only does that keep the company from outspending its cash flow, but it forces the company to only allocate capital in wells that can produce an internal rate of return above 20%, which is less than half of what SandRidge can get in the Mississippian. The higher oil-levered returns make much more economic sense for SandRidge.
While investors might not like the fact that SandRidge hasn't yet embraced fiscal discipline to the same degree as Chesapeake and Ultra, that doesn't mean the company is making a poor decision. Unlike those two peers, SandRidge still has the capacity and the inventory of high-return projects where it makes sense to continue with its well documented current plan. It's quite possible the company will eventually tone down its capital program, but right now the company views the current plan as its best plan to create value for investors.
Fool contributor Matt DiLallo owns shares of SandRidge Energy and has the following options: short September 2013 $5 puts on SandRidge Energy. The Motley Fool recommends Ultra Petroleum. The Motley Fool owns shares of Ultra Petroleum and has the following options: long January 2014 $30 calls on Chesapeake Energy, long January 2014 $30 calls on Ultra Petroleum, long January 2014 $40 calls on Ultra Petroleum, and long January 2014 $50 calls on Ultra Petroleum. 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.