Photo credit: SandRidge Energy  

SandRidge Energy's (NYSE: SD) plan to unlock a billion dollars in value just hit a big road block. The company recently sent a letter to the IRS asking it whether its salt water disposal business would qualify for the special tax break that comes with being housed in an MLP. That process, however, is now on pause as the IRS considers whether these assets deserve the tax break.

What this could mean to SandRidge Energy
SandRidge has said on a number of occasions that its salt water disposal system holds more value in an MLP than if SandRidge continued to own it. As the following slide notes, the company is slowly separating the business so that it can pursue a value-unlocking transaction.

Source: SandRidge Energy Investor Presentation (link opens in a PDF)

The reason for this is simple: CEO James Bennett noted at the company's analyst day that while the company has poured more than $470 million to build the system he believes it's worth at least twice that invested capital. He noted that the system is capable of generating $135 million in EBITDA and if those earnings were valued in the 8-11 times EBITDA range where most MLPs are valued, it would push the value of those assets up over a billion dollars. That number is key for the company to achieve a value closer to the $15.50 per share that Bennett thinks its assets are worth.

MLP craze has the IRS taking a closer look
Because investors value MLPs much higher than a traditional exploration and production company, it's forcing producers to take a hard look at their assets to see if it makes sense to take advantage of the value differential. Devon Energy (DVN -0.46%), for example, recently took advantage of the MLP tax loophole to unlock the value of its midstream business. In Devon's case it merged its midstream business with an existing MLP to create EnLink Midstream LP (NYSE: ENLK) and EnLink Midstream LLC (ENLC 0.37%). In so doing Devon was able to get an immediate trading value for its midstream assets that are now worth about $7 billion, or 30% of its market capitalization.

Where that deal might come into play for SandRidge is the fact that EnLink Midstream owns a saltwater disposal system in the Marcellus and Utica shale plays. As the following slide notes, EnLink owns eight brine disposal wells as well as brine truck stations.

Source: EnLink Midstream Investor Presentation (Link opens a PDF) 

While that's no guarantee that the IRS will rule in SandRidge's favor, there is a precedent that these type of assets fit in a tax advantaged structure. Further, one of the main reasons MLPs are tax advantaged in the first place is to incentivize investors to provide capital to America's energy industry so that there wouldn't be infrastructure bottlenecks holding back production. Without its saltwater disposal system SandRidge Energy wouldn't be able to grow production out of the Mississippian Lime formation as the system provides it with a cost advantage that makes drilling possible. By putting the system in an MLP, SandRidge could use the MLP units to fund the growth of that system, freeing up capital elsewhere to grow production.

Investor takeaway
While SandRidge's MLP plans were put on pause by the IRS, I don't think it will be denied. This special tax break is there for a reason, and that's to enhance oil and gas production. That's exactly what would happen if SandRidge created an MLP around its saltwater disposal assets.