Reuters reported that SandRidge Energy (NYSE:SD) plans to slash its rig count from 28 all the way down to eight. That is a nearly 75% reduction in its rig count, but one that makes a lot of sense given the likely poor returns the company would have earned by drilling more wells in today's oil price environment. The move is clearly intended to ensure the company survives the downturn in oil, which has made its large debt load a heavy weight to bear.
No need to drill
While the price of oil has recently bounced back a bit, it's still about 50% off its high from last summer. That's just too low for SandRidge Energy to make much money drilling new oil wells. As the following slide shows, at current oil prices the company's internal rate of return is less than 10%, which is barely above breakeven for an oil company.
It's tough to justify spending significant amounts of money to capture such a low return -- particularly since that money would have only added more girth to SandRidge's already weighty debt metrics. The company's cash flow has never been enough to cover its drilling program.
Maintaining its rig count around 30 would have accelerated the growth of the company's debt. As the following slide illustrates, the company's leverage has risen over the past few quarters as SandRidge burned through its cash balance to drill new wells.
While that cash balance recently stood at $590 million, it was likely to be depleted before the end of the year as the company's capital expenditure plan has averaged about $1.5 billion per year. With its petroleum-fueled cash flow falling due to weak oil prices, SandRidge really has no choice but to dramatically cut its rig count, as those rigs would have hurt the company a lot more than drilling would have helped.
Retreating to fight another day
By slashing its rig count so dramatically SandRidge Energy is putting its growth plans on hold for now. While the company has not yet made public its updated production plans for 2015, the company clearly won't grow production anywhere close to its previously stated plan of 20%-25% with just eight rigs running. The company faces a real uphill battle in just keeping production flat because of the decline rate of its legacy wells. As the gray line in the next chart shows, production from the company's wells peaks quickly and then declines.
The slide shows oil production declines by about 80% in the first year and heads lower thereafter. That means new wells the company drills each year are just to replace lost oil production from legacy wells.
Because drilling isn't all that economical, SandRidge Energy will have to turn its full attention to driving returns in other ways. This includes only drilling wells that will move the needle economically even if overall production declines. This can be done by focusing its smaller rig fleet on only its best locations while working to further reduce costs so that it can bump up its returns from meager to respectable.
The company can also focus on improving its balance sheet. This might mean monetizing its saltwater disposal assets or even its strong hedge position and using that cash to pay down debt. Liquidating its hedges would be a bold move, but the company has nearly 5.6 million barrels of oil hedged using swaps at $92.44 per barrel this year. Those swaps are worth upward of $250 million right now, or about a quarter of the company's market capitalization. Monetizing its swaps could bring in a boatload of cash, which could be used alongside its cash on hand to take out a quarter of its debt.
SandRidge Energy's stock has been decimated by lower oil prices. This is forcing management to take bold steps to ensure the company stays afloat. Its first bold move is to slash its rig count by 75%, which means growth is on hold for now. However, by retreating, the company is doing everything in its power to make it through the downturn so that it can grow once the price of oil improves.
Matt DiLallo owns shares of SandRidge Energy, which just hasn't worked out quite as planned. The Motley Fool has no position in any of the stocks mentioned. 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.