Looking Past SandRidge Merger Integration to Diversification (SD, XOM, APA, ME, DVN, BP)

Sometimes the short-term interests of a company’s shareholders and the future of that company are not in perfect synch. That’s exactly the situation at SandRidge Energy Inc. (NYSE: SD), which just last week completed its $1.6 billion merger with Arena Resources, Inc. Like the recent merger of Exxon Mobil Corp. (NYSE: XOM) with XTO Energy, the SandRidge deal seeks to diversify the company’s assets, although in a different direction. Exxon bought XTO to stake a claim in the booming shale gas business, while SandRidge bought Arena to boost its position in liquids.

The diversification approach is countered by Apache Corp. (NYSE: APA), which has offered about $2.7 billion for Mariner Energy Inc. (NYSE: ME) and has paid Devon Energy Corp. (NYSE: DVN) $1.05 billion for Devon’s Gulf of Mexico assets. Apache is also reported to be in discussions with BP plc (NYSE: BP) to buy some of BP’s assets, though none in the Gulf. Apache prefers to stick to what it knows, which is oil.

SandRidge’s diversification strategy acknowledges the huge price differential between natural gas and crude oil. Arena was a real bargain — SandRidge paid just a 17% premium and most of that will be paid in new SandRidge stock. For each proved barrel of oil equivalent, SandRidge paid $21.80. The stickier point is that for each barrel of daily production, SandRidge paid more than $177,000, according to Oil & Gas Journal.

That latter figure could make a SandRidge shareholder what management is thinking. A price of $177,000/flowing barrel is pretty steep. Clearly SandRidge thinks it can increase production dramatically at very low risk.

Shareholders aren’t so sure about that. Since the Arena acquisition was announced the share price has fallen around $7.50 to around $6.30 today. Not only that, average daily trading volume of about 11 million shares has gone as high as 4X that volume and hit nearly 30 million shares traded on the day the deal closed.

At its last quarterly report, Arena had about 39.5 million shares outstanding. SandRidge will issue 4.7771 new shares for each share of Arena stock. That’s another 188 million or so SandRidge shares to add to the 165 million already floated.  That kind of dilution rarely makes shareholders happy. Couple that with the unusually high price SandRidge paid per flowing barrel, and it’s no surprise that trading volumes have been high.

The upside to this deal is that most of SandRidge’s new oil is located in the Permian Basin of west Texas, and the company plans to use secondary and tertiary recovery techniques, including CO2 injection, to further drain known reservoirs. The company owns its on CO2 deposits, most of which it sells to other oil companies.

SandRidge expects the Arena acquisition to be accretive to cash flow in 2011, even after hedging a planned $3 billion of oil revenues. Shareholders don’t think a whole lot of this deal so far, but if everything goes according to plan, they’ll like it a lot better a year from now.

Paul Ausick