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This Beaten Down Oil Company Could Turn 'Trash' Into Treasure

According to the International Energy Agency, US oil output could overtake Saudi Arabia's as soon as 2020.

The Mississippi Lime, located in Oklahoma and Kansas, is among the more active plays in the United States -- distinguished by its thick marine limestone layers and shallow nature.

Like the Bakken in North Dakota and the Eagle Ford in Texas, the Mississippi Lime play emerged as a result of advancements in horizontal drilling and multi-stage fracturing.

Between 2009 and 2010, several well-known gas companies including Royal Dutch Shell (RDS.A), Chesapeake (CHK), and Encana (ECA) scrambled to take advantage of this promising patch of land.

Out of all the players, Sandridge Energy emerged as the biggest winner. By early 2011, Sandridge had accumulated 2 million Mississippi Lime acres at a total cost of $350 million ($175 per acre) and had then sold one quarter of that land position (500,000 acres) for proceeds of $1.83 billion ($3,660 per acre).

It was truly incredible.

In a couple of years, Sandridge turned a $350 million investment into $1.83 billion and held on to 75% of the acreage (worth $5.5 billion if valued at $3,600 per acre when sold previously).

With the benefit of hindsight, though, it might appear that Sandridge should have sold the entire land position back then when the play was hot.

Since then, the Mississippi Lime has revealed a few negative surprises for the major leaseholders including:

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Oil to Gas Ratio: The original projections predicted higher oil yields. However, Mississippi Lime production was considerably “gassier” than expected. Because oil production is more valuable than natural gas, the lower oil content greatly changed the expected economics of the play.

Less Hydrocarbons: The amount of hydrocarbons recovered per well turned out to be less than originally estimated.

High Operating Costs: The play produced enormous amounts of water which required a significant investment in water handling and water disposal facilities. This greatly increased costs and slowed down the time between drilling and production. High costs don’t leave much room for error.

In fact, production levels were so disappointing that several major companies with big land positions -- including Royal Dutch Shell (RDS-A) and Encana (ECA) -- panicked and exited the play completely.

Now it's looking like they left too soon, and Sandridge could be sitting pretty. Let me explain…

As it always does, the energy industry was forced to attack these challenges and innovate quickly. While there isn’t much that can be done about the oil to gas ratio of the play, improvements can be made to the amount of oil and gas that is recovered and the cost of drilling wells.

For example, Sandridge Energy (SD) has recently shown some serious progress in improving the economics of the play on these two fronts.

By experimenting with its drilling and completion techniques and focusing on the core areas of the play, Sandridge has significantly increased the amount of oil and gas it is able to recover per well. The slide below from Sandridge’s most recent presentation shows how much recoveries per well have increased in 2013 (green) versus prior years.

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By sharing facilities with other operators, introducing an artificial lift system and focusing on sectional development, Sandridge has also significantly lowered well costs. Wells that cost $3.9 million each in the first quarter of 2012 are now being drilled for right around $3 million.

In short, increased recoveries combined with lower well costs equals more profitable wells.

There was also a recent noteworthy annoucement from Mississippi Lime that referenced Petro River Oil (PTRC). Petro River announced the acquisition of Spyglass Energy Group which has 106,000 contiguous acres in the Mississippi Lime in the county of Osage Oklahoma.

That is a big block of land, but that isn’t the only thing I found interesting. Petro River also mentioned that it has been seeing initial production rates as high as 900 barrels per day from “short laterals” which could be important for every company in the play. By comparison Sandridge’s 2013 wells have initial 30 day production rates of about 400 barrels per day.

It is important to remember that if any company in a given play makes an improvement the entire industry can adopt that new practice. So if Petro River has hit on something important -- which it appears that it may have -- it could be big for everyone.

The market gave up on Sandridge and the Mississippi Lime. This is looking like an opportunity for the rest of us -- as companies like Sandridge and Petro River have been making signficant improvements in the play.

Implications For Investors

The market gave up on Sandridge and the Mississippi Lime. This is looking like an opportunity for the rest of us -- as companies like Sandridge and Petro River have been making signficant improvements in the play.

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And if the industry continues to innovate this rapidly, even a small reevaluation of Sandridge's 1.5 million acres could have a significantly positive impact on the firm's share price.

Consider this an early warning… if companies in the region -- like Petro River and Sandridge Energy -- further demonstrate that they have cracked the code and significantly moved the economics of the play forward then you're probably going to want to be invested.

Risks to Consider: As of today, the Mississippi Lime is not yet in the upper echelon of plays in terms of profitability. That means if oil and gas prices fall, producers in this play are going to get hurt.

Action to Take --> If Sandridge and other producers continue making improvements (lower costs, better production) to the Mississippi Lime, then buy shares of Sandridge.

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