Making Sense of SandRidge Energy Inc.s Most Recent Acquisition

By Matthew

Photo credit: SandRidge Energy.

When SandRidge Energy announced the $190 million acquisition of developmental oil acreage in Colorado it seemed like a huge step in the wrong direction for the beleaguered oil company. With a balance sheet weighed down with billions in debt and a precarious liquidity position, it would seem like the company could ill afford to spend its precious liquidity to open up a position in an entirely new oil basin miles away from its current core. However, when that deal is seen through the eyes of risk management, it actually makes perfect sense.

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The risk that has SandRidge Energy investors quakingEarlier this week, the AP put out a report titled "Is SandRidge Energy Close to Crumbling?" whereby it detailed the risk that fracking earthquakes could pose to the company. These earthquakes are thought to be caused not by fracking but by disposal wells used by companies like SandRidge to properly dispose of the water and chemicals that are produced alongside hydrocarbons after a well comes on line. SandRidge, in particular, uses an army of disposal wells to reduce its costs in order to economically produce oil and gas from the water-saturated rock formations found beneath northern Oklahoma and southern Kansas.

The report noted that 40% of SandRidge's disposal wells were within a 9-mile radius where hundreds of earthquakes have been recordedin the region. Given the link between quakes and these wells, the company was even ordered to stop operations at one of its newest disposal wells after a recent earthquake. The risk facing the company could be severe with a worst-case scenario being that it could be forced to cease operations in the region altogether if these quakes continue. That would devastate the company because, unlike rival Chesapeake Energy , which also operates disposal wells in the area, SandRidge doesn't have another region to turn to should it be forced to cease drilling in this part of the Mid-Continent.

Diversifying away riskIt's in this context that SandRidge Energy's Niobrara acreage acquisition in the Rockies makes perfect sense because it gives the company another area to invest in so that all of its eggs aren't in that shaky Mid-Continent basket. While clearly a developmental area that comes with only 1,000 barrels of oil equivalent production per day from just 16 horizontal wells, the upside is compelling with upward of 1,300 future locations that could be drilled by the company over the next decade. There's good reason to believe that those wells will be solid performers after the seller and its partner,EOG Resources , delineated much of the acreage, with the last six wells drilled with EOG Resources delivering strong 30-day initial production rates. Further, the returns on future wells are expected to be solid with SandRidge estimating that its internal rate of return will be 32% at the recent forward-projected oil price. That rate is as good, if not better, than the rate of its standard Mississippian well in the Mid-Continent, noted on the slide below.

Source: SandRidge Energy.

Because of this potential it will enable SandRidge Energy to shift more capital to this play and away from its higher-risk Mid-Continent assets. In one regard, that's a similar strategy to the one employed by Chesapeake Energy and EOG Resources during the downturn with each shifting capital to the best opportunities within their portfolio. Here's how Chesapeake Energy shifted its investment focus this year:

Source: Chesapeake Energy.

Because of Chesapeake Energy's portfolio diversification, it was able to pursue its best opportunity across multiple basins instead of being limited to just one. This is what enabledChesapeake Energy to actually pull back on the allocation of capital it spent in the Mississippian Lime in favor of places like the Utica and Niobrara.

EOG Resources, likewise, pursued a returns-driven drilling program in 2015 with the company minimizing its investments in lower return areas in favor of those places where it could earn the highest returns. What's worth noting is that EOG Resources actually reduced its development spending in the Rockies because it could earn better returns in the places like the Eagle Ford shale and Permian Basin where its after-tax rate of return at a $50 oil price is 35% and 45%, respectively.

Investor takeawayThe increase in earthquake activity in the area surrounding SandRidge Energy's core Mid-Continent acreage exposed a significant flaw in its business model with it being too focused on one area for its survival. It has addressed this weakness with the acquisition in the Rockies, which now provides the company with the flexibility to shift capital to its best opportunities. While that doesn't mean the company will survive its current storm, it does help to somewhat insulate it from the looming earthquake risk that threatens to shut down its main operating area.

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Matt DiLallo owns shares of SandRidge Energy. The Motley Fool owns shares of EOG Resources,. 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.

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