SandRidge Energy Inc. (SD), Chesapeake Energy Corporation (CHK): Investing in Small Energy Companies Is Dangerous

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Modern finance explains that investors are compensated for increased risk with a possible increase in returns. A look at the small upstream firm SandRidge Energy Inc. (NYSE:SD) shows just how true this is. SandRidge Energy Inc. (NYSE:SD)’s CEO, Tom Ward, had a number of side interests that potentially conflicted with SandRidge. The company’s stock price and earnings have behaved poorly and yet, Tom Ward continues to walk away with multi-million dollar salaries.

SD Total Return Price data by YCharts

SandRidge’s economics

In 2012, SandRidge Energy Inc. (NYSE:SD) had production expenses of $14.31 per barrel of oil equivalent (boe). Given that the majority of the firm’s production is highly priced crude oil, there is little reason that the company should be posting such low earnings. It has a five year revenue growth rate 24.71% and yet, it has posted losses in seven of the last 12 quarters. Tom Ward’s $116 million paycheck since 2007 shows where a large portion of these profits have been going. He has also helped saddle the company up with a substantial total debt to equity ratio of 1.69.

SandRidge Energy Inc. (NYSE:SD)

Steep declines in SandRidge’s trusts

SandRidge Energy Inc. (NYSE:SD) has spun off a number of its assets into separate trusts, and investors have been surprised with declining distributions. It is easy to forget that horizontal wells’ production rates can fall off quite steeply. Falling production also hurts SandRidge Energy Inc. (NYSE:SD) as it remains the owner of all of the subordination units of the trusts.

SandRidge Mississippian Trust I (NYSE:SDT) has been around for a little more than a year. In that time, it has seen its dividend fall from $1.07 per share to $0.65 per share. In just seven quarters, its dividend has fallen 40%. Due to overly optimistic projections, SandRidge was recently forced to take a hit as its subordinated units distribution was decreased to $0.50 per unit. Based on current analyst projected 2014 earnings, investors can pick up shares in the trust at forward price to earnings (P/E) ratio of around 7.

With SandRidge drilling more wells SandRidge Mississippian Trust II (NYSE:SDR) has increased its dividend from $0.27 in Q2, 2012 to $0.53 in Q1, 2013. SandRidge is expected to keep drilling new wells for the trust until 2016. Based on 2014 expected earnings, the trust is trading at a forward P/E ratio around 6. The second trust warrants a lower P/E ratio than the first trust, because the second trust’s earnings are 70% derived from cheap natural gas as opposed to 59% for the first trust.

Don’t ignore history

CHK Total Return Price data by YCharts

Chesapeake Energy Corporation (NYSE:CHK) has a similar story to SandRidge. Chesapeake Energy Corporation (NYSE:CHK) had a fiscally liberal CEO who ultimately drove the company to the edge of bankruptcy. Also, the CEO’s ability to purchase partial interests in Chesapeake Energy Corporation (NYSE:CHK)’s wells created questionable conflicts of interest. Chesapeake’s famous purchase of Aubrey McClendon’s personal map collection only made his relation with the company more questionable. Tom Ward worked with Chesapeake Energy Corporation (NYSE:CHK) for an extended period of time before starting SandRidge, and the similarities between the companies should not be too surprising.

Chesapeake Energy Corporation (NYSE:CHK)’s share price has continued to suffer. Low natural gas prices and expensive acreage is not a profitable combination. With a total debt to equity ratio of 1.06, a return on investment (ROI) of (5.2)%, and a profit margin of (11.4)%, there are many better places to park your funds.

Sometimes, bigger is better

Exxon Mobil Corporation (NYSE:XOM) isn’t very attractive and its large size makes replacing reserves difficult, but the company gets the job done. It still benefits from its legacy assets and shows why investors find it easier to trust in large multinationals. The company enjoys a very low cost of production and its refining assets help to even out its earnings. In 2011, its average production costs per boe in the U.S. were $11.14 while its global production costs were only $12.33 per boe.

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