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The Gambler's Edge: SandRidge Energy Inc. Preferred Shares

SandRidge Energy preferred shares are highly distressed right now.

If the price of oil hits $75 per barrel then SandRidge could avoid bankruptcy.

A firm footing could send these shares back to par value for over 1,200% in returns.

However improbable an oil price hike seems, the preferred shares have the gambler's edge.

SandRidge Energy Inc. (NYSE:SD) took a beating in the market since September 2014. Falling oil prices hit SD earnings and profitability hard, and the price of SD shares went from roughly $6.00 to $0.35 today. Both bankruptcy and/or heavy share dilution are now discounted in the share price.

The shares of SD are not interesting in my opinion, however. The SD management has been active in reducing the company's debt leverage, but this has come at the expense of share dilution. If SD continues reducing debt, as it should, it is likely that more share dilution is to follow.

This brings us to the SandRidge Energy Inc. (SDRXP) preferred shares. SDRXP shares have a par value of $100, and now trade on the market at $7.90 to give an approximate 92% discount to par. They also pay an 8.5% dividend on par, thus at current prices of $7.90 they have a 107% annual dividend yield.

The advantages of going with SDRXP versus SD shares and/or the SD bonds were made very clear in another article by Mr. Richard Lejeune. Mr. Lejeune also pointed out that SD merely needs to avoid bankruptcy for the preferred shares to recover, and he described how avoiding bankruptcy is feasible for SD if oil can recover over the next several years. The analysis was very well thought out and I feel no need to speak about the advantages of the preferred shares over the other options. Read this article for more information.

My article aims to address the gambler's edge in going with SDRXP with a small amount of your portfolio. Why do I call it a gambler's edge? Because technically, an investment with SDRXP is a gamble. SD is likely to survive only if oil prices recover, thus SDRXP will only become a good speculative position if oil prices recover. Since nobody can predict oil prices in the future, we must consider this to be a gamble.

What price recovery for oil does SD need to avoid bankruptcy? There are many estimates by different people. It is also important to understand that there are various factors that make this estimate different. Elephant Analytics wrote an article two days ago making the argument that SD needs roughly $80-$90 oil to break even. The CEO of SD, James Bennett, stated in the November 2014 quarterly conference call that the $60 dollar range would give an acceptable return, and costs have already been reduced considerably since the time of this statement. Tom Randall stated on Bloomberg news in 2014 that acceptable returns for shale are around $70 per barrel in the United States, though this will vary by region. Seventy per barrel also seems to be the consensus estimate for shale profitability from several other analysts.

Let's just say to be conservative, oil needs to rebound to $75 per barrel in the next three years for SDRXP to recover its par value over time. We must ask, what is the probability of $75 oil and above occurring?

Nobody knows the probability of $75 oil in the next three years. However, this is not a deal killer. What we can do is reverse engineer what the market is pricing the probability to be and use our intuitions to determine if that is too high or low.

Let's start with the simple equation of expected returns:

Expected Return = [Chance of Recovery x Profit] + [Chance of No Recovery x Loss]

To begin reverse engineering the market's assumed probabilities for oil recovery, let's first set the expected return to zero, so no side of the bet gets an edge over the other.

The equation now looks like this:

0 = [Chance of Recovery x Profit] + [Chance of No Recovery x Loss]

We know the upside of SDRXP in the event of oil recovery is the par value of $100 divided by the current price of $7.90, which equates to a 12.65x upside for every dollar invested, and an 11.65x profit over the initial investment. For purposes of simplification, we'll ignore the 107% annual dividend you would also receive annually. So let's update the equation.

0 = [Chance of Recovery x 11.65] + [Chance of No Recovery x Loss]

The most you could lose for that 11.65x profit is one dollar. The loss is thus negative 1, or -1. Let's update the equation again.

0 = [Chance of Recovery x 11.65] + [Chance of No Recovery x -1]

Now, let's solve the chance inputs in both brackets so that the equation is equal to zero.

0 = [.079 x 11.65] + [.921 x -1]

To balance the equation to zero, the market is assuming the chance of oil recovering to $75 to be approximately 7.9%. To me, this is too pessimistic. I realize nobody can predict the price of oil, but the market thinks there is only a 7.9% chance for oil to recover to $75 in three years?!

My gut is telling me that the market is off on this one. I think the probability of oil rising to the $75 range is higher than this. This means that if I go long on SDRXP at $7.90 per share, I receive the gambler's edge.

For instance, let's assume the actual probability of oil rising to $75 is 30%. What is my expected return? Let's do the math.

[.3 x 11.65] + [.7 x -1] = $2.80

If the actual probability of oil recovering to $75 was 30%, my expected return would be $2.80 for each dollar invested. This is a huge edge, if only we knew that 30% was the actual probability.

Since we don't know the probability of an oil recovery, our only thesis is that the market's expectation for a 7.9% chance of recovery is too low. I believe we have the edge going long on SDRXP, I just don't know the size of the edge. However, the edge is there and to me that justifies a position in SDRXP.

Don't get me wrong. There is a good chance of losing all of your money with SDRXP. A 100% loss might actually be higher than a 70% chance. But when you combine probability with payoff, this becomes a good speculative bet. You'll never win all the time, but when you do, you win big! As long as your expected earnings are positive, your big winners will outweigh your smaller losses over time. This is the gambler's edge. I believe it is there with SDRXP at current share prices.

I think there's a decent case to pick up some shares with a very small percentage of one's portfolio. Personally, I have 3% of my portfolio in SDRXP right now. In my opinion, this is a reasonable amount for a high risk, high return speculation. However, let me make it clear that I am prepared to lose all of it. This is often a necessary sacrifice for a large return over a short time period.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.