Is Sandridge Just Another Fossil?

In the early 18th century, debonair Scotsman John Law, a renowned gambler, convinced much of France that he would make it filthy rich off the mineral wealth of the Mississippi basin.

In the early 21st century, debonair American Tom Ward, a renowned gambler, convinced much of Cramerica that he would make it filthy rich off the mineral wealth of pretty much the same place.

Law sold the promise of profits on gold, silver and tobacco, while Ward has peddled gushers of gas and oil. But while the commodities may have changed, the moral of the story has not: Where greed, arrogance and ignorance mix, tears tend to follow.

Law turned into a tycoon thanks to his friendship with the Duke d’Orleans, the nephew and son-in-law of Louis XIV and regent to his five-year-old son after the king’s death. Law — a banker in his spare time from gambling — and d’Orleans — a ruler in his spare time from carousing — proved kindred spirits, and Law was soon serving up memos about getting the over-taxed economy going and the hefty royal debt reduced by supplementing the oft-debased coinage with a paper currency.

Ward turned into a tycoon thanks to his friendship with Aubrey McClendon, a rival landsman (purchaser of drilling rights) who went on to found Chesapeake Energy (NYSE: CHK)  with Ward’s help before Ward struck out on his own. And of course he had the backing of the economy’s regents on Wall Street, who marketed the shares in Ward’s SandRidge Energy (NYSE: SD) to an enthused public just as the worst bear market in half a century was getting under way.

One thing led to another for Law, and he went from running a royally favored bank to acquiring the charter to France’s North American commerce and selling Mississippi Company shares to a ravenous mob of investors panting after the fabulous returns he promised. The business of extracting riches from the new world was soon rendered nearly pointless by the much more lucrative business of speculating in the Mississippi Company’s shares and selling luxuries to that game’s many winners. The share-price multiplied 36-fold as the company extended its monopoly to the East Indies, China and the South Sea, and every new issue of shares was too small to meet the appetite of the investing public.

Fast-forward a little under 300 years and Ward’s marginally humbler commercial empire also does not lack for luxuries — in its case executive jets and luxury boxes — thanks to similarly forgiving financiers. The number of shares outstanding has increased 3.5-fold in the five years since the IPO, while the company’s debt has ballooned from $1 billion in 2007 to $4.3 billion by the end of 2012. No wonder the share price is down 78 percent since the initial offering, while the market value of the company has declined 20 percent.

In those five years Ward’s interest has shifted from gas to oil and from Texas and the Gulf of Mexico to northern Oklahoma and southern Kansas.

Until recently, shareholders and bankers bankrolled such strategic zigzags without complaint. But now that the stock is in the dumpster and activist shareholders are baying for Ward’s head as a downpayment on drastic change, no one’s quite sure where the money for next year’s big spending plans will come from.

SD stock chart

And it seems odd that a man who claims to have made so many good deals and farsighted bets over the years still lacks the funds to develop the super-profitable acreage he bought for a song without raising even more capital.

This is a bit like the pickle Law found himself in when some astute insiders began gradually converting their Mississippi shares into sturdier stores of value. Eventually, the rest of the herd also began to sniff excessive leverage in the inflation all around it, the bubble burst and none of the desperate trading restrictions subsequently decreed had the desired effect of stemming the rout. Law sought refuge in the royal palace and was eventually forced to flee the country. He died poor in Venice.

In contrast, Ward remains fantastically rich and faces nothing more threatening than a proxy battle seeking his ouster. No one’s after the more than $180 million of compensation Ward has received from SandRidge since it went public. The hedge fund leading the proxy insurrection, TPG-Axon, is using that to assert the board’s incompetence, just as it’s highlighting purchases by a company benefiting Ward’s children of huge tracts of land across SandRidge’s home-state Mississippian Lime play. Some of this land was subsequently sold to SandRidge, and much will benefit from the infrastructure getting built by the company. This is a much better deal than the couple of palaces Law managed to extract from his privileged status.

And if Ward does lose the proxy fight to his critics he’s be in line for another $97 million payout from the company under the “change-of-control” clause in his employment contract. In contrast, Law left quietly, and reportedly refused his friend the regent’s offer of a golden parachute.

Ward’s angles are covered well enough for him to obliquely admit that it was debt and dilution that impoverished his investors.

On the recent earnings conference call, famed hedge-fund manager Leon Cooperman finally chimed in with a layman’s question:

“Most everything you say is positive, yet your stock is down about 8% this morning, and we’re hovering near historic lows. …In your view, why? What is the Street missing?”

“I’m not positive why we’re here,” Ward responded, “but one theory might be that we, in 2009, had to make a fairly dramatic move with the company, and that did require us to work in an unorthodox way to get to the point that we have with the liquidity we have today, and people sometimes like more orthodoxy.”

The “dramatic move” was buying into the Permian shale oil assets in west Texas to curb Sandridge’s reliance on natural gas, and the “unorthodox way” was presumably to lever up the company to an extent that haunts it even now that the Permian assets have been sold and some of the debt paid down..

Still, Cooperman’s question hasn’t stopped his fund from accumulating a 5.5 percent stake in Sandridge. Other funds are on board too, so that TPG-Axon is not out of the proxy race despite the high hurdle of having to win more than half of the outstanding shares.

Unlike Law’s luckless investors, Ward’s do have a big stake in a valuable asset — the Mississippi Lime niche energy play that’s now become a make-or-break arena for the company. The question is whether that stake is valuable enough to cover even Sandridge’s much reduced valuation.

Some 350 million years ago, the land beneath modern-day northern Oklahoma and southern Kansas was part of a shallow equatorial sea crawling with critters like sharks, seven-foot centipedes and the early amphibians, which grooved on the hot, humid climate and an atmosphere 40 percent richer in oxygen than the air today. Their remains, accumulated along the bottom of the sea over millions of years, have by now turned into pockets of fossil fuels trapped in porous limestone.

The limestone sits closer to the surface than, for example, the Bakken shale, and is in fact less than half as expensive to drill. Unfortunately, it’s also permeated with saltwater so that drilling in the Mississippi Lime also entails the boring of disposal wells for this byproduct. And the geology  of the play is highly variable, making it difficult to extrapolate from the results for a specific set of wells to the entire play’s production potential.

SandRidge’s valuation (and its balance sheet) were bolstered in recent years by the sale of royalty trusts (one in the Permian and two in the Mississippi Lime) to investors, including many readers of The Energy Strategist based on a former analyst’s advice. The trusts looked attractive based on the hefty quarterly payouts projected by Sandridge, but much less so based on the price paid per acre relative to other deals in the same areas.

Those projections have since been painfully revealed as overblown, inflicting severe damage on the trust shares. Investors who thought they were partnering up with Sandridge learned instead that they were mostly exploited as a cheap source of capital.

But Sandridge is hardly in the clear either. It’s still sitting on two million acres in the Mississippi Lime, and reducing estimates for the play’s reserves for the second time in four months, as it did recently, did not improve the valuation of that asset. Neither did the recent deal by Ward’s former employer Chesapeake to sell a half-interest in its 850,000 acres of the Mississippi Lime to China’s Sinopec (NYSE: SHI) at a bargain-basement price of $1 billion, way below the per-acre price Sandridge got for its royalty trusts.

Perhaps Chesapeake, which is nearly as overleveraged as Sandridge, was simply that hard up, or perhaps the Chinese guys it partnered with are even smarter than Cooperman and Co. The Mississippi Lime could still make someone a mint if it develops as hoped and if the buy-in price is right.

But the retail investors who piled into the play over the last two years based on percolating crude prices and a sales pitch from a company hungry for cheap financing didn’t get the sweetheart deal, needless to say. Like the victims of the Mississippi Bubble in Law’s day what they got was an expensive education about the ultimate cost of buying the promise of faraway riches sight unseen.

Around the Portfolios

Westport Innovations (NasdaqGS: WPRT)
Shares of the natural-gas engine developer have been in rally mode since Thursday’s quarterly results announcement, as stronger than expected revenue and an upbeat forecast overshadow a wider loss than analysts have forecast. The red ink should remind investors that Westport remains a speculative growth play leveraged to greater adoption of natural gas as a transportation fuel. This seems to be proceeding apace, with the CEO of Fedex (NYSE: FDX) telling The Wall Street Journal that between 5 and 30 percent of the long-haul US trucking fleet will be converted to run on compressed or liquified natural gas in the next decade. Meanwhile, the BNSF railroad owned by Warren Buffett’s Berkshire Hathaway (NYSE: BRK-B) plans to test natural gas as locomotive fuel. Such stories won’t tamp down recent speculation that Westport could be bought out, perhaps by its joint venture partner Cummins (NYSE: CMI). On the other hand, speculation is all we have at this point. Buy WPRT below 28.

Nabors Industries (NYSE: NBR)
At first glance, Thursday’s press release from the board of the laggard drilling rig supplier
reads like a blow for shareholder rights: CEO Anthony Petrello has signed a new deal giving up various perks to more closely align his incentives with the goals of investors. Further down, it’s clarified that he did so in exchange for an up front payment of $27 million in stock, $18 million in cash and restricted shares worth $15 million vesting by 2016. How such up-front largesse aligns with shareholder interests was not explained. But the deal does illustrate how the shares got so cheap. This, after all, is the same company that made Petrello’s predecessor and mentor one of the best-paid exceutives in the US, and then gave him $100 million for assuming the chairman’s post (which the current CEO has now grabbed for himself.) At this point, NBR remains a Buy below 20 very much despite its board.


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