SM Energy Company (SM) Earnings Call Transcript & Summary

Well, everyone, welcome to day 2 of Vail presentations. Glad everyone can make it. And to kick off the day with us are Jay Ottoson, CEO of SM Energy. SM has grown tremendously in the last several years for our Howard County and for -- starting this year, really, the focus is shifting to free cash flow and deleveraging the balance sheet. So with that, I'll kick it off to Jay.

Thank you, Betty. Thank you, everyone, to be here. Boy, we have a great lineup of speakers today. It should be terrific. I wish I could sit and listen to them all. In our leadership training at the company, we often talk about the concept of trying to not operate in the whirlwind. We teach our people to try to step away from the whirlwind and think about things that are really important. The best example I have of that, when I talk about it, is the morning I spent in New York not too long ago. I was sitting on a window seat at a coffee shop just at an intersection, just down the street from one of the big train stations, Grand Central Station there. And those of you who spent time there know it was an absolute madhouse. It was rush hour and all these cars going back and forth beeping at each other and big trucks, and people walking across the street and walking through the intersections and across the street in other places and just a chaotic scene. It was kind of interesting because I was watching it through the glass. You couldn't really hear it, you could just see it, and it was -- it looked like an anthill. And right in the middle of that, a young man comes from my right, and he's reading a book, walking down the sidewalk. And he walked up to the intersection, he walked across, he walked down the street a little bit and walked into a building. He never took his eyes off the book. He didn't get run -- I thought the man is going to be run over. There's no way he's going to get there. But he never took his eyes off the book and he walked straight up, straight out, got into his building. Looked like he was perfectly calm, obviously, used to the chaos. So I think it's a great example actually of the kind of focus that you have to have in our business. And I pity all of you in the investment world, a lot -- there's so much coming at you right now and all the things that are coming your way. For us, over the last couple of years, it's actually been an extremely focused strategy. So when you think about that guy with the book, that -- it's really been us for the last few years. That 2015, '16, when things really turned down, we looked at our strategy and really revamped the strategy of the company to transform the company in a couple of really important ways. And the mantra at our company is that we want to be a premier operator of top-tier assets because we really believe that to be a sustainable enterprise over the next 10, 15 years, that's what a small company has to be. We got to be a great operator and we have to own great assets. And we have made a tremendous amount of progress on that over the last couple of years, and I'll share with you some results today. We're right on track with where we expected to be. And we also knew that we needed to become self-funding. That -- the only way this was going to work over time for us was that we needed to become a self-funding enterprise. We had a couple of years of overinvestment or spending more than our cash flow, but we've now made that turn to free cash, and we are now self-funding. Very, very important transition that we made last year, and I'll show you that as well. So we're really focused. And frankly, really calm about this. It obviously helps to be 80% hedged right now, okay? Always good to be in that position. But as we saw -- as we look at the year, and really no change to our plans. A lot of the stuff that's going on in the last few weeks. Again, we had a very strong hedge book. We're looking out several years now, looking at how we use that free cash to delever the company and make us stronger. I will be making some forward-looking statements. I think I just made a few, and we'll go on here. Those of you who don't know us well, we are -- as I said, we're an extremely focused company at this point. We actually operate in only 6 counties in the state of Texas. During that strategic transition we made, we made very intentional decisions to get off federal acreage, to close a number of our regional offices in other places and really consolidate our operations in the state of Texas. So we only operate in the Midland Basin, in the Permian and in the Eagle Ford areas in South Texas. And you can see just some rough numbers there. I'm going to talk to you -- I'm going to give a 3-point presentation this morning. First, I'm going to talk just a little bit about our results in 2019, then I'll talk about our 2020 plan and kind of fill you in on how that fits with the strategy I laid out earlier, and then I'll touch just a little bit on highlights and specifically on those 2 specific assets before I close. So 2019, we really did -- we're right on track with where we expected to be in terms of our activity and the work we did in the asset. As you can see here, we did generate free cash flow in the second half, and that was a major goal. One of our single largest goal for last year was to make that turn. So we -- it's a pretty dramatic turn. Actually, we outspend $200 million in the first half, and we were free cash flowing $29 million in the second. So we made a big dramatic turn toward free cash, and we expect that to continue as we go forward. That's really been driven by our oil percentage going up, being driven, and most of that is kind of the Midland Basin although I'll talk in a few minutes about how we're making a turn toward oily activity in South Texas as well. But 25% production growth in our Midland Basin assets after several years of very high growth, driving higher oil percentages, higher margins. I'll talk in a minute, our margins have come up dramatically over the last several years which is really driving cash flow growth for us. We had a great year as well, improving up new intervals, driving down costs. You're going to see that our capital program this year is 20% lower than it was last year. We're accomplishing a great deal with less money. A lot of that is cost savings driven by both efficiencies and service cost reductions. And we continue to see those benefits rippling through our process. We also did some G&A reductions last year as we, again, continue to simplify the business. And one of the other key goals for last year was to start really working down our leverage. Actually we were -- ended up ahead of our plan a little bit last year. We ended up with less total debt than we expected at the end of the year because our outspend was less than we expected and our leverage is actually moving down as cash flows go down as well. So a great year in 2019, a lot of things accomplished. Just to give you a status on the balance sheet at the end of the year, just -- these are end of year's numbers. So -- a lot of liquidity. So if you just kind of look at, it is pretty simple balance sheet. We got one convert. And then we -- all the rest of those are unsecured bonds. And then we have our revolver, which is due in 2023. Now we redetermine that twice a year. So we have a redetermination coming up. This one, the data you see here is from last fall. So a $1.6 billion borrowing base, $1.2 billion in committed capital. At the end of the year, we had $120 million. We are also about -- again, $1.1 billion in liquidity here. Our first bond due date maturity is in 2022, is actually 33 months from today. We had quite a bit of time -- quite a bit of runway here before that needs to be refinanced or paid off. Our expectation at this point is we will generate quite a bit of free cash flow before that point and that at some point in time here, we'll probably get an opportunity to refinance that. But that's sort of the balance sheet. It's pretty straightforward. Again, 2.8x levered at year-end. Obviously, I mean there's been a lot of stuff going on in the bond market. There was a brief opening in the bond market very early this year, about 2 days, I think, and then we've had this chaos over the last few weeks, but we certainly expect, over time, to be able to refinance quite a bit of this and pay it off. That's -- it's the ultimate plan. All right. Move to 2020. So our priorities really haven't changed. We're just farther along in our process. If you look at, it's very simple priorities for the year, and this is the same ones we share with our folks internally. It's really about cash flow growth, not production growth here. We're not really going out and trying to build our -- we have a significant amount of gas in our portfolio, but we're not really trying to add gas production at this point. Really focused on oil growth, both in the Midland Basin and in South Texas. And that will drive cash flow growth, which -- that free cash flow, and we'll use that to reduce debt. And we're absolutely going to use -- just first, we'll get our revolver down to 0 and then we'll start paying off debt as we refinance our bonds. So free cash flow-funded debt reduction, pretty straightforward. That should lead then to improved leverage metrics, obviously, which we think has been our higher-than-average leverage, has been a drag on the equity, we believe. And then the one -- the number one number that we really focus on and embedded in our compensation programs and everything we do is this cash flow growth for debt-adjusted share. If you look at that particular metric, we think it has the highest correlation of any metric we can come up with to actual equity value over time. And that is -- it's a fundamental metric in our compensation systems, which is to drive cash flow growth for debt-adjusted share. Obviously, if you do reduce debt, that helps that number. If you increase cash flow, that helps that number. So we're working very hard to try to drive consistent cash flow growth for debt-adjusted share. So what does that look like? If you look at the last couple of years, our Midland Basin production has been up 180% from 2017 into 2020 -- in our expectation of 2020. You can see those are the dark blue bars as we go there. The light blue bars is our South Texas production, which, as I mentioned, was pretty gassy. But as we move forward, it gets oilier in that mix, so our oil percentage going up. You can see the dramatic improvement in our production margins, up 75% in margin from 2017 to '20. And that really is a result of the fact that we are just getting a lot of oil. Gas price has actually gone down in that time period. So it's actually been a drag on our results. But as our oil percentage goes up, continues to go up, those margins will continue to improve. So here we are. This is growing EBITDAX with less capital. We show our capital program. Our capital program is actually down almost 40% over the last 2 years. A lot of that driven by efficiencies and lower costs, but also our drive to get to free cash flow. And you can see EBITDAX growing. So cash flow growing, production is not growing in this next year. It actually goes -- ticks down just a little bit because we're allowing our gas assets to fall some. But oil continues to grow at about 5% to 10% a year, driving cash flow growth with CapEx down. And we expect CapEx to be down -- flat to down again in 2021. So as we move forward, again, we continue to see expanding free cash flow going into that. And you can see the price, so we used the $50 price deck this year for our plan. I know a lot of other people use numbers somewhat higher, but again, $50 deck for this plan. So if you look at the plan and extend it -- kind of extend it to 2021, it's kind of a tough time to do with -- given all the movement that's going on right now in oil prices. It's kind of hard to say, "Well, okay, what happens if you go to $60 in 2021?" That's a big reach. But if you look at the plan, at the $50 case we've got here right now, we expect to be single-digit free cash flow yield in 2020 and double-digit free cash flow yield in '21 at almost any reasonable price deck that you'd run, $50 deck, say. Obviously, if we get higher prices, it's a lot higher, and we'll pay down debt faster. I mean that's -- that will be the plan. You can see our leverage numbers there are coming down. It's been a tough grind the last couple of years because gas prices have fallen along with our margin improvement and gas prices have moved down. But again, continuing to move leverage down into the right, obviously, higher pricing than $50 will drive that even quicker. And we want to get below 2x. Our goal is to get below 2x, heading towards 1.5x because in the long run, we think being about 1.5x levered is where a company like ours should be. So you can see, again, we're really focused on that leverage covenant. That's the only covenant in our revolver that is one that really -- we really focus on and moving down below 2x is where we want to get to. So great trajectory, you can see, in free cash flow growth. We expect that to continue as we continue to grow oil volumes in upcoming years. Here's the capital program and, again, it's down almost 20% from last year. Drilling and completions about -- we don't spend much money outside the drilling and completion program, a little bit on facilities and you have some overhead there. But about $850 million program. We'll complete about 85 net wells in the Permian this year. That's down a little bit from last year, but the lateral lengths are a little longer. So it actually -- the net lateral is not down much. And then in South Texas this year, we plan to complete 9 net wells. I'll say, our plan right now is that all those will be Austin Chalk completions, and they will be pretty oily. And they'll compete very nicely with our Permian returns based on the math that we have today. Probably one of the most exciting things we've done in the last year actually is the Austin Chalk testing that we completed in South Texas. It really proved up what we think is going to be a highly economic and pretty sizable resource for us in that asset, and we're excited about continuing to prove that up here in 2020. I mentioned that we are very well hedged, and we are. We have 80% of our oil volume hedged and oil volumes are 70% or 80% of our total revenue. So we're very strongly hedged at very good prices. Swaps well above $55. We got $55 floors on all of the collars. So again, it's a very strong hedge book. And so we look at this year and really it would be hard to envision a case in which we would change our plan for this year given the way we're hedged. We definitely want to go into '21 strong. And so it would be -- okay, it's hard to, again, to envision a scenario in which we would change our activity level. All right. So in summary, 2020, capital costs are significantly down. Great well performance. I'll show you some more of that in just a minute. That's baked into our plans, and we continue to see lower operating costs. From an operating standpoint, great job. I will show you on the drilling and completion side, we're clearly in the top quartile, top decile in terms of people doing great jobs on well cost, and you can see that in almost anybody's numbers, who looks at us. So it's -- in terms of executing on our plan, we've done extremely well to this point. And as we look forward now, we're in this mode of continued moderate oil growth and cash flow growth at least to free cash flow, self-funding, paying down the debt, reducing leverage. It's a pretty straightforward plan. So let's touch on the assets just a little bit. Midland Basin is obviously, it is a great asset. It's hard to overstate how good it is. It's one of the lowest EUR portions of the entire Permian Basin. Highly prolific wells in the Wolfcamp A and Lower Spraberry. We have other intervals that we're proving up and testing. As I said, we're going to drill 85 net wells this year, probably average about 5 rigs running and 2 frac spreads. We've gotten so much more efficient on all those things. I'll let you read all the details here on this slide. I'll point out a couple of things. I mentioned premier operatorship. What does that mean to us? Well, this is -- here it is in lemon color. Tremendous improvements in our operating efficiencies over the last several years. If you look at it from 2017 to '19, we're drilling 26% more lateral feet per day. You can see the complete -- we're 96% faster than we used to be on completing wells. Increase in average lateral length and really this is a testament to our land group. We don't -- this year, I think we're averaging 10,000 -- I think it says on the previous slide, we're averaging 10,700-foot lateral length, really big improvement with that over the last few years. And then our sand costs continue to drop, and you'll see another drop in our sand costs this year, in fact. As we've gone exclusively local sand, we have a great relationship there with the provider who also provides our transportation on that. And we continue to drive lower and lower cost here. So tremendous work by our group. We're drilling wells. We're drilling and completing wells out here for about $650 a lateral foot, which -- it really is a top decile kind of or best decile kind of number in our area, and our productivity has been tremendous. Here's an example of that. I don't think anybody -- we really need to show people anymore how good Howard County is. It's tremendous rock but the light blue line is our last 41 wells and the dark blue line is our historical average in Howard County. What's remarkable about this -- by the way, this doesn't account for lateral lengths. So there's a little longer laterals. It's a mix, but there are some longer laterals in that light blue line. But what's really important about it is that light blue line, those wells are drilled at spacing. So we're -- these are wells drilled at our expected development spacing now. A lot of the wells in the dark blue line were actually drilled early on at wells out there right themselves, right? So our downspaced wells are actually outperforming our historical averages. And that's because we continue to improve our completion efficiencies and our technique as we do this, and we're not spacing the wells too closely together. We've really never made the big error here of getting too tight in the Permian. And our average inventory spacing is quite wide compared to many of our peers. With that said, we have some of the very best inventory in the entire Permian Basin. This is a study RSEG did on inventory, and we don't ordinarily show other people's work, but we actually agree with this a lot, and we think it was done in a way that's pretty comparative across the various companies, which is hard to do in inventory. I think they did a pretty good job this year. And what it shows is that the inventory they show for us, which is about 12 years where they're doing inventory, I think that 100% of that inventory will breakeven below $45 a barrel. What -- by breakeven, I think they're using a 10% rate of return here. So 100% of our inventory, well over a decade of inventory, breaks even at lower than $45 a barrel. Now there's other companies, you can see, that look really good in their tune. There are some bigger companies in there as well. The key thing here is that 100% of our inventory will breakeven at pretty low prices. So it's just an indication of the quality of the inventory -- the quality of the asset that we own, and that we've been able to do. And it goes -- falls right into that strategy that we built of having top-tier assets. This is what we set out to do, and it's what we have accomplished. South Texas. South Texas, historically, has been a big gas-producing area for us. And we targeted the Eagle Ford interval. We had some very prolific gas wells and had some success -- great success over the last few years in actually making those wells more prolific by widening spacing and lengthening laterals. The big thing we've been focusing on over the last couple of years is trying to figure out a way to get oilier in this area in South Texas. And there are portions of the Eagle Ford, as you move north, that get oilier. But there's also a really significant Austin Chalk section right above the Eagle -- sits right on top of the Eagle Ford. And so we've been testing Austin Chalk wells. Now the Austin Chalk geologically is very different here than it is in East Texas. And typically, when you talk about the Austin Chalk, and I've been in it several times in my career, it's a fracture play, right? And so you typically -- you find the Austin Chalk productive where it's highly fractured. And so what you tend to get is you tend to get wells that come on strong and then die pretty fast. And so whenever you say the Chalk, that's what most of us think of. This Chalk in our area is not fractured or not heavily fractured at all. It actually has significantly higher porosity and perm than our Eagle Ford section does. So it's a great reservoir from -- relative to most shales. And so what we're finding here is highly prolific oily wells. And I'll show you the results here, it's been pretty dramatic. This is our last well. And this is the best oil well we've ever drilled in South Texas, significantly better than almost any wells you will find -- I'll say it is a much better well than you'll see an average Delaware Basin well, for example. In terms of oil content, these wells are well over 50% oil. That one I think I can't read it from here, but I think the number is 73% liquid, total liquids. They produce a little more propane and ethane, which is a great thing again for us here. So these are highly prolific wells. And we've drilled a number of them now. I think there's a -- you can kind of see the map there. We've kind of spread over the acreage. I'll say this. That doesn't look that many wells, but we have penetrated the Austin Chalk on every one of our Eagle Ford wells, so we know what this rock looks like over a much larger area here. So we have a very good sense of what this looks like at this point. We think there's a significant economic resource here. And we're excited about the prospect of moving again. We just completed or just TD-ed another well in the Chalk, and we're drilling a number of additional wells this year. So it's an exciting resource. Again, we think the returns here can compete with the average of our Permian activity, and it was a big oily leg of potential growth for us. If you look in the Eagle Ford, we've had the same kind of capital efficiency gains here as we have had in the Midland Basin. It's kind of funny right now. We're actually drilling wells at that same $650 per lateral foot in Eagle Ford as we do in the Permian at this point. We're drilling long -- typically we drill a little longer in the Eagle Ford. I keep saying the Eagle Ford when I should be saying South Texas. I'm so used to saying it that way. But again, in the Chalk and in the Eagle Ford interval of our South Texas assets, really high drilling efficiencies. You can see how much we've improved over time, 26% reduction in well costs over the last couple of years. Great, great, great work. And then if you just look at our activity for the year, again, I mentioned we're going to plan to complete 9 wells. Based on the way the rig counter lays out, I think we'll have 16 drilled by year-end. So we'll have some additional completions in the first quarter next year. If the chart goes as well as we hope, I really hope, and we're able to push our capital program and gain some more cost efficiencies, I really hope we can sneak a few more completions into this year. Certainly, our goal. We'll see if we can get that done, but a great -- it's a great opportunity we think and very exciting oily leg of potential growth in South Texas. Before I close, I want to mention corporate responsibility. We've been producing a corporate responsibility report for a number of years, several years now. It's on our website. I really encourage you to read it. And we disclose a number of key factors in that. There's actually some new disclosures in this particular slide that we'll be -- we're putting on our website here pretty quick. And we specifically have some here on green -- total greenhouse gas emissions. We showed a number there on methane emissions. There are some statistics you may not have seen it from us there before on flaring. And as a company, we flared about 1.3% of the gas we produced over the last 6 months. So well below some of the numbers you may have heard from people as it being a good number. We actually believe, based on the disclosures that we've looked at, other people's disclosures, that we're actually in the top quartile or the best quartile of our peer group in terms of total greenhouse gas emissions and methane emissions. It is a very important factor. We focus a lot. It's connected to our compensation, our people get paid. Some of their incentive is based on these kinds of goals. And we've been around as a company for a long, long time, very, very involved in the communities where we live, work and operate, very committed to environmental safety and health. And our Board is very, very engaged on these issues. We have a relatively small Board, but we talk about this at every meeting. Talk about how we can do more in terms of both disclosure and actually improving -- continually improving our activity. So it's a big part of the business now, becoming a bigger part of the business. And I think we're actually leading in many ways for companies our size. Let me close then by just rehashing. Again, getting back to that focus, the man with the book, okay. What are we focusing on? Why should you care? Again, the mantra at our company is to be a premier operator of top-tier assets and that includes -- being a premier operator includes being a great corporate citizen. That's part of what we mean when we say that. We are growing annual oil production and expanding margins. We continue to see expanding margins as we go forward and increasing oil percentages, and that is driving growth in cash flows. And with that free cash flow then, as we reduce debt, we will drive debt-adjusted per share cash flow growth, which is what we think drives value for shareholders. So with that, I'll close, and thank you for your time and attention.

Great. I'll kick off the Q&A.

Okay. I didn't know we're going to do it. Great.

We have a few minutes. So Jay, just looking at the 2021 outlook, seems like sort of the capital efficiency continues to improve like you're delivering the same amount of oil growth, 5% to 10%, but CapEx is flat to down. So I guess, what are you seeing there to give you the confidence of that growth trajectory? Just help us think about the well cost reduction or some of the efficiency gains.

Well, we continue to see efficiencies improving across the platform. And we drive lower costs, we're getting lower bids for pumping services, our frac -- our sand costs are going down by contract. So as we go into the year, we think well costs will be declining throughout the year. So as we look forward to '21, we're thinking, "Hey, at the same level of activity, we think capital costs are down." Now, obviously, that depends somewhat on oil price. If oil prices stay low, you're going to see costs even lower. If you really did see a big uptick in oil price and costs, I think costs will -- eventually will start coming up. But in the world we see, which is sort of that $50, $55 world, we think our costs at least are going to continue to head down into '21. And we'll be able to amount basically the same program we had this year at slightly lower cost.

Maybe looking a bit longer term, like, what's the appropriate growth level for SM in the $50, $55, now that you return free cash flow?

We've done. We've spent an enormous amount of time trying to model to figure out, okay, what's the best mix here. I mean obviously, you can grow cash flows faster if you're willing to spend more and outspend, so -- with less free cash. But you don't get your debt paid down if you do that. So there's a balance here between absolute debt reduction and leverage reduction that you have to play. And I think we're -- our view at this point is this kind of 5% to 10% oil growth is kind of an optimum, a sweet spot for that. We generate enough free cash to be able to actually make real progress on paying down absolute debt. And at the same time, we still generate a very respectable debt adjusted per share cash flow growth number, which is what we believe really drives value. So I think that 5% to 10% number is a kind of a sweet spot. And that's really our plan over the next future few years, is to kind of stick around that number.

That's helpful. And then switching gears a bit to the Eagle Ford. I know on the call, you have been talking about looking for a JV partner for the Eagle Ford. So I guess help us think about how is the JV agreement going to enhance the 2020 outlook that we see today? And from your perspective, what's the goal of that agreement? Is it just to offload the CapEx? Is it to delineate the play? Or is it to help bring some cash flow and then delever?

Well, you mentioned 3 reasons to do it right there. And I think all 3 of them are good ones. I think shareholders should expect us to -- what we're doing with our Eagle Ford assets, we're trying to look at every option with that asset given where we're at today. Where gas prices are today and where we are at in terms of developing the Austin Chalk and saying, okay, what could we do? What's the most impactful thing we could do for shareholders with that asset? Now I will tell you the A&D market is not great, okay? And I have very low expectations for any deal getting done, and I've made that very, very clear. But we do have a bank out, talking to a number of potential participants, specifically about joint venture opportunities and the idea there would be to get somebody else's money involved, allow us to essentially raise our returns as a corporate -- on a corporate level and use that spare cash to pay down debt faster, or you could increase that -- if you see this going well, you can increase activity a little bit and basically get to that same point. With the same capital spend, you'll get to more free cash. And we're hoping that something like that pops out of this. We're talking to international parties, to strategic gas buyers, to all kinds of people in this process. My expectations, as I said, are very low. I think yours' and shareholders' should be low, but I think we're doing the right thing. We're trying to look at things that -- we have a plan that's just fine. It's a good plan, generates free cash, does what we need to do, self-funding. But anything we could do here that would be beneficial, we just simply add to that. It would be additive to our program. And at the end of the day, if it turns into a big deleveraging transaction, that would be great. I don't have that expectation at this point, but it could happen. And that would be something that would allow us to accelerate value.

That's great. All right. Please join me in thanking Jay.

Thanks.