SM Energy Company (SM) Earnings Call Transcript & Summary

All right, Good morning. Thanks for joining. We are going to move on to our next E&P presentation. We have SM Energy. We are fortunate today to be joined by Herb Vogel, President and CEO. Herb, thanks for setting aside some time for us this afternoon.

Hi, thanks, Bill, and good morning or good afternoon, everyone. I'm going to show some slides here and go through a deck. But first, I just wanted to say how much I'd rather be there in-person and seeing you all. I know COVID has had a lot of impact on different people across the country, and I hope all the best for everyone and your family. So I am going to take here a second to try and get my screen shared and I am going to start here. And hopefully you can see that. And now I'm just going to shift. Okay. Bill, can you see a slide up there?

I see your slide. Now I see it full screen. I think we are good to go.

Do you see a full screen?

Yes.

Okay. Great. And no disclaimers up there yet, right?

It looks like the next slide. So I think you're still on the cover. Yes.

Okay. Well, let me just start by pointing you to the cautionary language. Do you see the cautionary language there?

Yes.

Okay. So I'm going to be making forward-looking statements. I think that's pretty much the standard disclosure statement there. So many of you are quite familiar with SM Energy. So we're founded in 1908, and we went public in 1992. And we were publicly listed then. And then in 2002 we switched over to NYSE, and we operate largely on private lands in the state of Texas. And there are -- our production is all in the Midland Basin or in South Texas. And the slide here shows some of the key metrics, the enterprise value of $4 billion, proved reserves of 405 million barrels equivalent and you can see some of the activity levels. I'm going to be digging into that in a little bit more detail. So let me go next to -- we long consider ourselves a premier operator of top-tier assets, and I really hope to show you today why that's true. And if there's just 3 things that you take away from the presentation today there that SM has extremely high-quality assets and that we're committed to reducing our absolute debt and our leverage. And that ESG focus is an integral part of what we consider the integral part of being a premier operator. I'm going to be going over our plan. This is probably the first time that we're showing a 5-year plan, and we're quite excited about it. So I'm going to start, though, with some of the key results from 2020. And here, you see we had objectives around cash flow growth, and about free cash flow funded debt reduction, and we were much more successful at those than we ever anticipated. Our focus on free cash flow and that we were cost-focused across the entire company to reduce costs and then increase efficiencies. And then we generated $240 million in free cash flow, and that exceeded probably all estimates that were out there. And it's really a testament to the team and especially during really challenging 2020. The debt reduction of nearly $500 million was in part from free cash flow applied to debt reduction, but also reflects the outcome of that exchange offer that we did in the second quarter. And then we were doing market purchases of bonds at market rates and we were buying back at a discount, and that wound up with a significant reduction in our long-term debt. So here are some of the highlights of 2020, and I'm not going to hit on all of these, but the key ones are the capital efficiency in the Midland Basin. We really stand out compared to other operators. We continue to improve on our well costs, and we averaged less than $500 per lateral foot in the fourth quarter, which is phenomenal, never would have thought that was possible a few years ago. Well performance is really strong. So our base well performance outperformed expectations. I'm going to cover inventory a little bit later. And then on the ESG side, this is where we really increased our disclosures during the year quite a bit. We -- to CDP or TCFD and SASB disclosures, but we also put in place an oversight with the Board ESG committee and a management ESG committee. And we -- and I'm going to talk a little bit more about this. We've put in place in our compensation structure to make sure that every employee was aligned on the ESG front. I've got a couple of the key points there from the ESG aspect and the safety is a priority, obviously. And we are top quartile among industry peers there, and then we did significant emissions reduction from the prior year. I'm going to cover some more on that also. So here's the -- despite all the macro challenges of 2020, it was pretty exciting for us because really pivoted from being focused on high oil growth to free cash flow generation, and we were able to do that during 2020. And that really set the foundation for what I'm going to show you, which is a sustainable free cash flow period going forward. As we were putting together our 5-year plan, we were really defining the activity levels to optimize free cash flow over that 3- to 5-year period. And that was to enable leverage reduction during that time period. And it's really to move into that sustainable reinvestment rate that I'm going to talk about more. And I wanted to point out too that we really dialed back activity in 2020, and we do increase activity in '21, and then we pulled back a little bit in '22 and beyond when we're in that lower reinvestment rate. So I'm going to show that graphically with this figure. So you can see our free cash flow in 2020 was $240 million. 2021, we dropped down to like the $100 million level, and then we really bounce back up in 2022 and beyond. Our leverage will -- and this is assuming script prices from January, along with current costs that our leverage drops to the 2x level at the end of '22, and then we get down towards 1 by 2025. And that script price in current costs, no improvement in efficiencies and no sector inflation included. So our reinvestment page, which were in 2020, were about 69%. And then we get to a level south of 75% beyond 2022. So this is something we haven't shown before, but it just goes to -- again, this is only possible because of the quality of the assets we have and the returns we're able to get there. So here's the plan itself, and we've put these out about 2 weeks ago. But now we were in the middle of that weather event in Texas at the time. So we've got something new here that we just shared starting yesterday morning and that's our Q1 guidance also. So here, the goals are generating positive free cash flow, reducing leverage and then we will be continuing to grow inventory and inventory value importantly and meeting top quartile rank on a lot of metrics with our AXPC peers of about 32 companies. So there's the, in a nutshell, $650 million to $675 million in capital, 47 million to 50 million barrels equivalent production, which is a little bit of growth, single digit to growth over 2020. And then the other metrics there, but the Q1 guidance is at the bottom there. You'll see that's down from first quarter as we did shut in some areas for some period of time. I'm happy to say now we're fully up 100% or better than we were at maybe which was around February 15. We will be at 53% to 54% oil, and we did have some delayed completions that was basically shutting down frac spreads, because we couldn't move sand on the icy roads with trucks. But importantly, our full year production guidance remains unchanged. So the impacts weren't significant, not for to have us alter our full year guidance production standpoint. Capital expenditures, we maintained the $180 million for the first quarter, which we gave out before. So that's in a nutshell, our 2021 goals. Switching over to the capital program. This is just a bit more detail about it. We expect about 90% of our capital to be in drill and completions of wells, 70% to the Midland Basin and 30% to South Texas and that increased allocation compared to last year is really so that we can better define the full value of the Austin Chalk, and that's what the program is dedicated towards. So I'll go into that in more detail. On the right, it's an important context. First in 2019, I think we were over our capital program, and we're still in that high-growth oil. 2020, we really dialed back hard. I think our original budget was about $840 million and then as a result of COVID and commodity price decline, we dialed back capital to about $540 million, which was well below expectations, but we still managed to deliver production within our guidance range at the start of the year. In 2021, you can get the context of being up about $650 million, $675 million, and then dropping down to not quite maintenance capital level, but a level that winds up with low single-digit growth. That's not the target, though. The target is the free cash flow over the 5-year period. So that's what we're calling rightsizing for long-term sustainability. That's the really point there. Let's switch over the balance sheet real quickly. We've shown this slide many times. I'm not going to do much but I will on this one, but just say that our liquidity is strong. Our leverage at 2.3x is a lot lower than anybody would have expected. and it's really all those things we did to get the principal debt reduction to $500 million. Our -- we believe our free cash flow from our plan is going to be able to cover all those maturities through 2024. So if you look at that stack, all that's covered from free cash flow and that's at strip and current costs. With a tailwind on prices, we could obviously generate more free cash flow. So that's the story on the balance sheet. Let me turn to hedging, which is really something we've had a long-term hedging program in place, and the level we hedge is driven by our leverage level. In this case, we went into 2021 with 75% to 80% of our oil hedged and 85% of our natural gas hedged and that was really driven by the leverage level we were at 1 year, 1.5 years ago when we really start putting the hedges in place. We're quite programmatic and deliberate at it. So when we look forward, though, to 2022 and beyond, because our leverage is lower, we do not expect to be hedging at that level in 2022 and beyond, but we will still be programmatic, not speculating about it at all. And we understand with a backward dated market, obviously, is a bit more challenging to hedge plus there is -- if activity does increase, there is the possibility of sector inflation coming in late '21, '22. And that wouldn't be helpful either. So let me go now to the people in the portfolio. This is what makes SM happen and the returns that we get. And it comes down to the top-tier execution, the well performance because of the quality of the assets and then continued improvements in capital efficiency. We have -- the details are there in the Midland. We're going to drill 72 wells and -- drill 55 wells and complete 72. So we're going to be drawing down DUCs in the Midland Basin. The lateral feet per well will increase slightly from last year and then our PDP decline drops a little bit, just from another year of production from peak years of drilling. The wells are great. So we're co-developing nearly everywhere and breakeven flat pricing to $16 to $31 per barrel. And our drill complete and equip costs are going to be reduced to about $520 per lateral foot. And that does include a little bit higher sand completion intensity than we had previously. Currently, we're running about 3 rigs and 3 completion crews on our 82,000 acres. I'm going to now talk over -- this is one of my favorite slides. It's such a great slide because every year, we think, "hey, we can't do any more, we can't get any better, and we continue to do better each and every year. We drill faster, and we complete faster than before and that's really not just us. It's also how we work with industry partners, and we typically will have more than 1 rig from 1 rig contractor, and we'll have more than 1 frac spread from 1 frac contractor. So that allows them to get efficiencies also. I did mention in our call 2 weeks ago that we just set a record length well. We drilled the longest ever lateral and completed and cased it, longest ever in Texas at almost 4 miles. So it's 20,900 feet, that's more than 3,000 feet longer than the previous longest lateral in Texas. And it's really -- it was enabled us to reach a lease that would have been less economic to drill with a shorter lateral. So it was the right economic decision, better returns on accessing that lease. And you probably know by now that longer laterals lead to better capital efficiency. And because of the contiguous nature of our acreage, we have drilled 25 of the 50 longest laterals in the Midland Basin. From an ESG perspective, it's not mentioned on the slide, but we've shifted to dual fuel on some of our rigs and on one of our frac spreads, and that gives us cost efficiency gains as well as overall emission reductions. Let me now turn over to South Texas. And here, the plan is 21 completions and 39 drills, that's increasing our DUC count by 18, but I do want to point out that we have CapEx spent in the back end of the year on completing some of those DUCs so they just turn on just on the other side of the year in 2022. Average lateral feet per well also goes up. It's longer than the Permian. Same DC&E costs, we believe, are doable. And then the PDP decline is quite low, and that's partly because we only had 4 completions last year. That's where we really dialed back our capital. We've mentioned this for several quarters now, our contractual transportation cost decreased by $0.25 in MCF starting in midyear '20 and July of this year, and then there'll be another $0.35 reduction per Mcf in mid 2023. And if you look closely at our 10-K, you'll see that our condensate or oil prices have improved significantly compared to where they were before, and that was, as a result of prior contract terms rolling off. So here is the big point I want to make, and that's the Austin Chalk success. So if you look at the performance of our latest wells, which are targeting a certain landing area, the breakeven flat oil price range of $13 to $28 per barrel. That's right, they are competitive at the Permian. So what we know this from our delineation program, 9 wells, what we want to show you over the next year in the 2021 wells is that same level of performance. So you can see the value of the Austin Chalk on these 158,000 acres, and that's critically important. And that's why we're dedicating the capital there. There's -- also, I should mention that we are using an electric frac fleet or started using one in October, and it will go fully electric on that frac spread starting in the second quarter sometime. So more on the Austin Chalk here. We show the 9 delineation wells there on the left, and you can see they're quite strong. I'm going to give you and show you what these really look like with more context. These are 3 stream production and actual history on the wells. The new wells produced 61% to 81% liquids, which is significantly increased from our old Eagle Ford. Our old Eagle Ford had 6% oil, whereas these Austin Chalk wells will be 30% to 6% oil and then the NGL content is high. So there you see the breakeven flat oil price. Another important thing, and we have a slide in the appendix to elaborate on this more. The operating cost per BOE are about 30% to 40% lower than our existing South Texas wells, and that's really because it's oilier and NGL rich. So there's less gas produced per BOE. So there's less gathering costs. On the bottom right, that just shows how we're doing a combination of delineation and development. This year in 2021, you can see the wells that are stretched out sideways in red. Those are delineation wells, the ones that are more compact, those are development wells at development space, and that's what we'll be completing in 2021. So here's the comparison where we say it's not your old East Texas Austin Chalk, where you might have had a vertical well or in the Giddings field in East Texas. But you can see the progression really -- we are really fortunate that on our acreage we have quite high capacity Austin Chalk, and that's what enables and differentiates the performance of the wells. It's also quite, quite thick, particularly on the northwestern part of our acreage. It thins towards the southeast, and that just means we look at spacing a bit more closely. Also did a comparison to the Delaware Basin, just so you can get a perspective when you see where Delaware Basin. I'm going to point out, these are 2 stream curves. That's all you can get from public data versus the ones I showed before with 3 stream. But the key crux of it is, if we get more wells like the Briscoe G 109H, that paid out in its first 9 months, and that's where you can really contribute to your free cash flow contributions and accelerate that reduction. So turning to inventory here. Total company inventory is about 13 years, and our Midland Basin expected inventory is about 9 years. But what really is important to point out is the quality of the inventory. So everything we've got here on average is a 50% return. There is additional potential for inventory that we've not shown here, and that's in what we call contingent resources, and that could be tighter spacing in some areas and then prospective new intervals that we're testing as we go on with our program. We did include this point from Enverus or formally RSEG that how resilient this inventory is to lower oil price has really benefited us over the last year. And Enverus estimates that we have 8 years of sub $40 WTI and $2.25 Henry Hub inventory, and that's to achieve a return. I believe they use 10%. So that's what really differentiates our portfolio is that quality that we're resilient to down prices, but we generate a lot of cash in our price recovery scenario. And in our case, we'll be dedicating that to debt reduction. So ESG, critically important to be a premier operator. And just showing you a picture of our first electric frac fleet that we started using in October of 2020. We had significant reduction in flaring in 2020 in the Midland Basin and really, that was accomplished by the previous higher flaming level was a result of generally third-party gas plant shutdowns. So what we've done is we've put an interconnection so that if one plant goes down, we have the ability to deliver gas over to plant another plant so you could go from Plant A to Plant B or Plant C and not be exposed to flaring. And then that total reportable injury rate of 0.26, that's well within the top quartile of our peers. Couple of things that I pointed out there on the right is the annual cash bonus and long-term incentive plans. We do have a number of metrics that are in there on the STIP, our short-term incentive plan. We do have ESG metrics, and they include safety, spills and greenhouse gas emissions. Our long-term incentive compensation plan, we did switch in this past year. So we include key environmental and safety metrics, but we also have free cash flow and leverage reduction as the metrics for the payouts of long-term incentive plan. I point you to the website on sustainability, and you'll be able to see our progress on those metrics. So then coming back to the people, the portfolio and the plan. We put forth a few years ago that our objective was to be a premier operator of top-tier assets. And I think others have recognized how we are just that, and we've achieved that. So let me just close with the key take home messages. First, we are a premier operator with very extremely high-quality assets. We're focused on free cash flow generation and debt reduction, and we're committed to the ESG. And finally, we have a very clear 5-year plan, which achieved a sustainable reinvestment rate in 2022 and beyond. So with that, Bill, those are my prepared remarks from the slide deck.

Thanks, Herb. great overview. I want to sort of maybe start where you just ended on the 5-year plan, which I'm sure you're getting a lot of questions. And I thought it was really helpful to give sort of an illustration of CapEx and the reinvestment rate and really just focus on optimizing free cash flow. And the question I'm sure that I had is, can you make any commentary on what production looks like? I know it's not an objective of the plan, but I'm just wondering what production might look like in an optimized free cash flow model as that seems to be the question for most E&Ps today?

Right. No, and that's a great question, Bill. And the way we work the whole planning process is we generate a number of scenarios and of different mix of CapEx between South Texas and Permian, and that doesn't make as much difference now because of the quality of the Austin Chalk. But we lay out activity levels and then we look, okay, which one generates us the most free cash flow over a 3-year period or the most over a 5-year period? And then we run that through, and we strip pricing and current costs and we say, "okay, what leverage level do we get to after 3 years, after 5 years? And then we set the CapEx program to -- from that free cash flow forecast and we have multiple scenarios to do that. That's one. And then we test it against a low price and a high price, and that determines the capital we put in. Then we get the rate forecast and what it turns out in our case, it's low single-digit growth on average. If it gets a little bumpy through there, obviously, because you're running a program, but that's what it works out to and that's what optimizes our free cash flow in a script and current cost environment.

All right. That's helpful context. It seems like that low single-digit is sort of where a lot of E&Ps are landing on an optimized program. So hopefully, that tells us that we're not going back to the 15% to 20% growth pace. So I think that's encouraging. So that's great context. Maybe a little bit on the Austin Chalk, and that was a helpful overview. I know you've mentioned the 9 delineation wells. Sort of maybe a little more color on what gives you confidence repeating those results, extending the inventory across the greater slot of your acreage would be helpful.

Right. Bill, and the Austin Chalk is really -- I got to go back to 2017 and '18 when we first started to recognize the potential of the Austin Chalk, and it was when we drilled a well and saw quite a bit of potential. But we -- we had 500-plus penetrations through the Austin Chalk because the Eagle Ford is deeper, right? We have 550-plus development wells in the Eagle Ford. And so we could map it extremely well. We had logs that actually know what its velocity was. Then we took a core, a 500-foot core across the entire Austin Chalk, and we did a lot of detailed work, and we figured out which logs would correlate the best and then we really mapped out what the Austin Chalk potential was Then we needed to test it. And we chose a landing zone. We tested it down in the southern part of our acreage, and we had a great well. It was gassier down there to the south, oilier to the Northwest. And then we came in and laid out a delineation program to identify where things were. At the same time, we were optimizing the landing zone and the completion design and that led to the 3 wells that we had basically in late 2019 and early 2020. And that told us that, "well, these are fully competitive with where we are in the Permian. And we continue to optimize the completion design and the landing zone. We think we've sorted out where the best landing zone is. So now we just have to prove it to everybody that what we believe is true from the 9 delineation wells we have so far with the 21 wells that we complete in 2021, we should be able to demonstrate that. And the reason we have the confidence is because the model has been borne out on our interpretation of the logs and our interpretation -- and what we know from core and actual well performance.

Yes. Sure. Those will be closely watched throughout that year. So look forward to that.

And then I will say, Bill, we have that same story in Howard County. When we first spot those assets there, everyone will say, yo, and it took about 2 years before people really recognize, "hey, we did to figure out something that have been dismissed before as being too much carbonate but they didn't turn out to the case they're being quite economic.

Yes. Trust but verifying. Maybe I'll try one on M&A. I know acquisitions and divestitures have been part of SM's strategy in the past. With the recent and strength in commodity prices, I'm just wondering if you could share, obviously, no specifics, but is there anything on opportunities that you're seeing or looking for on either the A or the B side would be helpful.

So well, so you want to talk more of M&A, Bill, or do you want to talk like A&D like asset type.

A&D, asset level.

Okay. So at the asset level, you -- I guess, 2020 you know, from the banker side that it was a pretty desert year for A&D and asset acquisitions and primarily it was around consolidation in the M&A side. So I think you'll probably see more of that picking up, but the focus over the first quarter was still the consolidation. And we believe that more consolidation will appear but that needs to make sense from an asset standpoint and from a balance sheet perspective. On the A&D side, it's not something where we're really focused on. And we're really focused on using our capital to develop because we have so much running room on our inventory and develop and then generate free cash flow and reduce our debt. And we want to get to certain debt levels before we contemplate doing more from an A&D perspective. I think M&A could happen at any time we're open to however it would make sense, but it does have to make sense for our shareholders.

Context on both. And actually, I think that takes us right to our time here. So I appreciate the insight and the overview and then for spending some time with us Herb. Thanks.

Okay. Appreciate it, Bill. All right. Take Care. Thanks.

Bye.