SM Energy Company (SM) Earnings Call Transcript & Summary

Good morning, and welcome to day 2 of our 7th Annual JPMorgan Energy Conference. I'm Zach Parham from the E&P research team. Joining us now is SM Energy, an E&P focused on development of the Midland Basin in the South Texas, Austin Chalk. We're thrilled to have with us SM's President and CEO, Herb Vogel. Herb took over as President and CEO in November 2020 and has been with SM since 2012. I'll turn it over to Herb for a brief intro, a presentation, and then we'll have some Q&A.

Thanks, Zach. I'm just going to go over a few slides here. But first, I just wanted to thank you for hosting this session and to JPMorgan for having the conference. It's great to be here in person. It's quite a different feel. It feels good, like going back to normal in a way. I hope you guys can all hear me. I see a lot of familiar faces out there and glad you're interested in SM Energy. I'll do this relatively quickly here, just hit a few slides in our deck, got some -- a little bit of new information just based on some questions in the past. Obviously, I'll be making some forward-looking statements. I'll just point you to the cautionary statement there. And the big thing that we've got is that we're fast approaching low leverage for the company. This has been a priority of ours for several years now to bring down something that we felt was holding the stock back and really on the cusp of getting to a much lower level. I'll talk about this a little bit more. But just last week, we redeemed our second lien notes. We paid off USD 550 million in debt this year alone and USD 900 million since we got those second lien notes in the second quarter of 2020. So big things you'll hear about us all the time is the capital efficiency, how focused we are on that, the inventory quality we have, and the long runway that's there, and then just how part of being a premier operator is really being a leader in ESG stewardship. We put those in hand in hand. So what's the first one that we'll talk about is capital efficiency. I'm going to start at the bottom here that we're actually -- relative to our peers, we have the longest average lateral length, and that leads to a lot of capital efficiency. And why is it we can do that? It's because of the nature of our contiguous acreage. We have large blocks of acreage that enable us to drill 10,000 foot, 15,000 foot, and we've actually have one 4-mile lateral, so that's really -- it's the record in Texas. And that leads to the capital efficiency. And here we show as #2 on the well cost per lateral foot, and that's something that's been built over years of drilling unconventional wells. So we really stand out in that area. I'm going to flip now to the top tier assets. This is an interesting one that you don't see this focused on much, but we've started looking at. It's pretty straightforward to go through companies 10-Ks and look at what their standardized measure per BOE is, so that's just the PV divided by the BOE of proved reserves. And where we really stand out here is, and this is standardized measure. This isn't one company doing sticks on a map for inventory and another doing detailed economics. This is standardized measure, and we're actually #2 compared to this large -- and there's a lot of large cap peers in here that we're #2 in the value of our per barrel of reserves. So that's just something that hasn't been really talked about before, but we really stand out on that metric. In terms of the assets themselves and the runway we have, the first thing I wanted to point out is that we are actually in the top 2 basins in the U.S. from a metric of breakeven flat oil price and the West Austin Chalk is the one we opened up on the liquid side and I'll talk about more a little bit later, and then the Midland Basin, obviously, is one of the top basins in the U.S. And just wanted to point that out. The next is, as to our actual inventory, one of the metrics is, well, let's say there's a downturn, which is the company that will be able to sustain drilling through a downturn in commodity prices? And that's where we have 9 years of inventory at under USD 40 a barrel, and this is an independent analysis from Enverus. But what does that mean? That means in high commodity price times, our margins are significant, and that's really just goes to the quality of the acreage. So let me go on and talk about the full inventory, though. Some people -- we showed that slide and some people said, oh you got 9 years of inventory. Well, no, that's 9 years at USD 40. So here's the more full story, and we've said 13-plus years, of which 12 years in the Midland Basin, and the average return on that inventory at this relatively low price deck of USD 55 and USD 2.75, that's our a relatively old metric that we've used, but it was over 55% in 12 years there, 13 overall, and then obviously there's the 9 year in terms of the USD 40 price deck. So I just wanted to really qualify that, that's something that we built out over time, and it was a recognition back in the -- prior to 2014 that we needed to shift the inventory to really handle low commodity prices, and we've been quite successful in doing that with the acreage that we hold. I'm not going to focus on the plans, but here's a new slide, and I'll tell you why we showed this one. So I was talking to one of the companies that does a lot of data, and they said, well, you guys, we count you as having 2.5 intervals through the Midland Basin. I said, 2.5? We have actually quite a bit more than that. So we've got the core intervals at the Lower Spraberry Wolfcamp A and Wolfcamp B. But we've done significant Middle Spraberry development on part of our acreage. And then what we're showing here is some of the other tests that we've done kind of grouped into our development programs in the Leonard and the Jo Mill, the Dean, the Wolfcamp D. And here, what I'm highlighting is one of our Leonard wells, how it's done and how we're going to do more in the Leonard over the next -- basically next year, over the next year. So these first, the Wolfcamp D, these are great wells. This is an interval that underlies the Wolfcamp B. There's a big frac barrier. So it's quite an independent development the way it works, and we've got that mapped out. So I just wanted to show these 2 wells over here, the Sarah Connor 1098WD and the Blissard 2029 wells. So there's quite -- there's up to 8 prospective intervals on some of our acreage. It's not everywhere, but it's missed. When analysts are looking at our data, they're thinking, oh, you only have what you've developed so far, and that's not the case. We are codeveloping the key intervals, and then we can come below. And that's separate. And then we can go above on some of our acreage. So that's just something that we hadn't shown before, but I think it's really important to point out to all of you. I've talked before about the Midland Basin and the completion design. I'm going to talk to the Austin Chalk. So some people have talked about, well, the Austin Chalk, you know, I'm not sure about its repeatability. And I think we're now getting to the numbers of wells on our acreage where you can see the repeatability. So what we're showing here is just that the Austin Chalk through our first 35 wells, and we're actually up to 46 producing now, that it's a P10:P90 ratio. It's the ratio of the best wells -- simple way to put it, it's the ratio of the best wells to the worst wells. It's a ratio of 2. So it's quite tight, and it just means it's much more repeatable. When people are talking about the Austin Chalk, and this is really way over in East Texas, several 100 miles away, in the old vertical wells that were drilled in 1981 to 2011, that P10:P90 was around 17, so there were some really good wells, followed by a lot and not very good wells. And on the horizontal wells from 1988 to 2010, that rate was 41. So that's why the Austin Chalk had a reputation for not being repeatable. Now you can joke a little bit about the Austin Chalk, but someone said, well, you should've named it something different, right? Because now it had this label from a completely different play type and our [ basis ] is different. That was a fracture play, and we're really into a play that is just microfractures and just really high permeability. And that's why we get these great economics. So the returns -- the repeatability is like the Permian and the returns are similar to Permian. And that's what enables us to have this great portfolio where we can shift capital from very oily in the Permian to gassy and liquids-rich NGLs and oil in the Austin Chalk area. So we're just really pleased with that. And you can see we've got a big spread across our acreage. Not only have we delineated, but we've also done a lot of spacing tests, including some staggering with the Eagle Ford. So when I talk about the Eagle Ford, the program this year, we have 38 completions in South Texas, and of those, 6 are Eagle Ford. And here we've had 5 completions since November 21, and they're expected to pay out in less than 6 months. So they're competitive. So we have the ability to codevelop with the Eagle Ford or to develop the Eagle Ford independently or to develop Austin Chalk fully across our group. So we're feeling really good about how things are in that area. So let me go to ESG for a minute. Very topical, and it's just a big focus of the company. All our employees are incentivized by ESG metrics. So that's safety, spills, greenhouse gas emissions, those 2 metrics we use for greenhouse gas emissions. So you can see this is Rystad's ranking, and it's a little bit of a black box on the rankings themselves, but we score really well on governance, social, and on the environmental, and we're an oily company. It's easier to get a really high environmental score on the gas side. With an oilier company, it's a little bit more challenging. But there, we really focus on it, and every single individual is incentivized in the company to do well on those metrics. So with that, let me talk about leverage. I'm going to skip through a couple here. Isn't this a great picture here if you guys have been following us over the years to see no maturities prior to 2025 and then second lien gone in 2024, the other note that we had in 2024 gone, and nothing on the revolver. It's just as a result of all the free cash flow we've been able to generate. And that really goes to the priorities we have. So these were our 2022 strategic objectives, and I'm really pleased to say we're really well on track to achieve them. Building the net asset value through scaling up the Austin Chalk program. We went from 9 wells at the end of 2020 to 35 at the end of '21, and then we're adding another 32 Austin Chalk wells this year. So the confidence in the returns we get from them is quite high. And we've talked about 400 wells in inventory and, obviously, we're working to increase that number. Our growing free cash flow. Clearly, we've had a nice tailwind on commodity prices. We're at 1.05 times at the end of first quarter. We've been talking about getting to this target by fourth quarter. Maintaining top tier inventory. Last year we replaced all the inventory we drilled. As I just showed you on the Midland Basin, we have a lot of intervals we can go to and then the Austin Chalk is a great area for inventory development and the Eagle Ford also works. And the final one is, we're really standing out differentially on the ESG side with scope 1 and scope 2 emissions and methane emissions, which we really track. So with that, I think Zach, I'm ready to go with any questions.

Sure. Herb, thanks for the presentation. I guess, first, could you give us a little more detail on your capital allocation strategy, why you believe that the current program is the right balance of production growth and free cash flow generation?

Okay. Zach, that's a great question, so I think others have probably heard me say this before, but we don't really have a targeted production growth. Every year we go into a planning cycle in September through November, and we really look at how do we maximize free cash flow over the next 2 to 3 years. And so the production growth is an output of that process. We run at a number of scenarios of capital allocation between the assets and a number of different flat price scenarios. And then we get into January and we finalize based on strip prices. And we say, okay, which is the case that maximizes free cash flow for that next 2-to-3-year period. And that's been really -- well, basically really illuminates how things work in a commodity price environment, and it shows that it works out to about low-single-digit production growth is the output that works. In terms of the allocation between the assets, that depends on the commodity prices, and what it's turned out this year, there were 2 parts of that. The returns are about the same in Midland Basin as the Austin Chalk, and we had a strategic objective of demonstrating the value of the Austin Chalk. So we put it at 55% Permian and 45% in 2022. But each year we can flex that. So that's the beauty of having that type of portfolio. We're not locked into just one basin. We can flex and maximize returns. So that's really a story there.

Sure. And I guess just to follow up on that, is there anything that you would need to see in the market to shift from that plan to maybe shift back to a higher growth mode? Or are you sticking with the free cash flow maximization?

So we are sticking with free cash flow maximization. And as we talked about, that's really been focused on debt reduction, and then we're talking about what return of capital would make sense for the company in the future. As we get to that target of one and one. So 1x levered, USD 1 billion in absolute debt. So that's really the area that we're focused on.

Sure. And you mentioned the one and one targets, the 1x turn of leverage and USD 1 billion of net debt. We've seen dislocations in the stock. I think a number of the E&Ps are down 20%, 25% this month. Could it make sense now that you've got line of sight on those one and one targets to maybe shift and use a portion of your free cash flow in the near term to return to shareholders, buy back stock, while also reducing debt? Or do you want to get to those targets before you make any decision?

Okay. This is a great opportunity to just talk also about the previous question a little bit, elaborate a little bit more on that. So we've been really watching what makes sense to do, and the first principle we came up with, as we look at return of capital scenarios is having sustainability to it, that an investor can look at us and say, okay, they're doing this for return of capital. How long can they do that? Is that something we can do for 10 years? We show 13 years of inventory. Can we do it for the life of the inventory? So that's our focus. So we're looking, obviously, at fixed dividends. Buybacks, if we feel our NAV is really low, buybacks may make sense at points in time. We're looking at variable dividends, and there we look at some of the peers and some have done a promise of a certain percentage of free cash flow that goes to variable dividends and some have done it more ad hoc as they develop, build up cash on the balance sheet that they would put one in. And then a couple have gone for growth. And we see all those, and we say, okay, well, what really is something that somebody could look at us and say, yes, those guys can sustain it. That makes sense from a return standpoint. These returns are phenomenal that we have right now. So we've got all those in the mix, and we're not committing ourselves yet. We think it's prudent to wait, watch, and then when we get to our objective, then we can come out with something and just know it'll be well thought through, it'll make a lot of sense, and it'll be sustainable.

Got it. Thanks, Herb. Maybe just jumping over to cost inflation, which has been a big topic within the industry. What are you seeing on the cost inflation currently? What are your expectations for the back half of the year?

Okay. Zach, that's very topical. I'd say the question de jure. Let me just go -- stock back a little ways. So we're now getting the costs that are starting to exceed the 2019 levels. So we had some great deflation in 2020-2021. We really benefited. It really helped our free cash flow plus the commodity price tailwind. And nobody likes inflation. There's a lot of inflation, obviously. So we look back at what we did. And really, in the fourth quarter last year, we said, let's look at 2022 and as we get into the budget and we finalize it in January, what's it really look like? And at the front end of the year, we didn't see much inflation. We had a lot of our services locked in. We didn't see much inflation, but we knew some of our service contracts would expire during the year. And at the back end of the year it would be greater. All in, we said 15% on average. So that would be less than 15% of the first half of the year, more than 15% in the back half of the year. So that was the normal thing. So every year we do this. We do a midyear capital review. So we go through all our projects, we see how have they done, what's the capital environment, what services have we updated our locked-in prices on, and what are those levels at. And pretty much now we've locked in everything for 2022 that we can. We're actually into 2023 and locking those costs in. So we haven't completed that update. Should be done here shortly, but I just reflected on some of the peer numbers that we've seen. And so we said 15%. Some of our peers said 10%. They probably did it -- called it a little bit early. Now you're seeing -- and this is -- you got to really watch the starting point. So if you started at fourth quarter 2021 and we said 15%, our peers that do it on that same basis, they're saying it's 20% to 25%, okay? So now we had a lot of services locked in, like sand is a great example where we have a long-term contract. We're less exposed. We feather our rigs so that there's a lot that's locked in. But if we just took the peer number, so just doing a back-of-the-envelope calculation. If you said it was going to go up on us by 5% to 10% on a USD 750 million capital budget, that would be USD 38 million to USD 75 million. So that's what we said -- well, that's the way I look at it. That's my exposure on the inflationary aspect for the late in the year. And we'll look -- we're looking right now, and we'll see what that actually looks like. Whether we're consistent with the peers, better than the peers, that's kind of the expectation. There's one other aspect I should mention, too. We have a track record of running faster than expected. So, obviously, our teams are motivated and incentivized to do better than they did the year before. We go into a budget cycle, we never assume more efficiency than the year before, but we have a track record of doing things fast. That means drilling faster, completing faster. So in the current environment, it's really important to keep your crews running. So we're going to look at, okay, are we running ahead of schedule. Does that say we should continue to run some crew for a couple more weeks where they would finish early rather than letting them go? That's really smart in the current environment where services are really being tied up. So we're looking at that dimension also.

Got it.

That's kind of a longwinded answer to that one, Zach.

No, no, that's great color. And I guess it's still early. You talked about more than 15% inflation is what you've factored in the back half of the year. Still early, but what are your expectations for '23? What are you seeing now? Is that an additional 10% inflation, or just any color you have on what costs might look like in '23?

Yes. Zach, so we're in the midst of contracting services well into 2023. We don't have really color on that. I could say, yes, it's more than 2022 that the cost will be greater than 2022. But what level of increase, I think it's premature for us to say. We'll really get into that in September-November. Right now it's '22 and then how does the back end of the year look, and then we'll get into '23 as we get into that budget cycle.

Got it. And one on the operational front. You mentioned in your presentation, you'll tested up to 8 intervals in the Midland Basin, and you talked about some frac barriers that allowed you to come back and get some of those zones after you developed the core. Can you just give us a little more color there? What do you need to develop all at once and what zones can you come back and get later?

Okay. So, I'll tell you, we've been pretty programmatic over time. We have an enormous database of our own wells. We've drilled over 550 wells in the Permian. We have a database of 1,600 where we do data trades with offset operators. So we have a pretty good understanding of which intervals are working in which areas and what are the parameters, the detailed technical parameters that drive that better performance. And one of those is the frac barriers. So we have that core development area where those 3 zones that we're developing, and we know those are great returns. Then in our program we've slipped in a number of different wells in the other intervals, so we get longer-term track record on them. In some cases, we'll put a single well in there, so it's unbounded. So you have to make assumptions on what spacing will work. And in some cases, we put 2 right alongside each other, so we get half bounded wells, and we can see what the performances of those. So you're going to see us continue to do that, and you'd see inventory additions from those. And those will be both over at Sweetie Peck and over on our RockStar acreage. And we also have some drill-to-earn acreage in the center of the basin where it's just a really prudent way to look at things. But it is a big database, and it grows. It's a continually -- it's a learning process all the way through. And long laterals make a big difference, and we're able to do that because it's the same acreage. So we hold that acreage. We don't really have to pay extra on most of the intervals at all, so.

Good. Thanks, Herb. I've got a few more questions, but happy to open it up to the investors in the room if anyone has questions.

Herb, just to follow up on that last point on the upside zones with the Wolfcamp D and Leonard and the other zones. To what extent do you have those included in the 13-year inventory? Or to what extent -- is there any way you can quantify the upside there?

Yes. I don't have that at hand. There's a little bit in there generally where we've drilled and neighboring area, but further away where in some cases it's closer to where peers are, those would not yet be in inventory. So there's probably a little bit bled-ins, some zones with more than others. So some have very little in inventory. If we've only drilled 1 or 2 wells, we're not going to have much in inventory. If we've drilled like Middle Spraberry, we'd have more where we've drilled a lot more.

I'll go ahead and ask another. The Austin Chalk, some of the wells have been a little bit variable, but they're getting more consistent over time. How repeatable do you think those results are? And maybe, could you just detail the inventory that you have there and what could that ultimate inventory look like on your position?

Okay. Yes. Zach, so I'll just give a little history on the Austin Chalk on how we got there. In 2018, we made an effort, we'd been developing the Eagle Ford there. We had close to 600 wells at the time. We said, okay, what's the full potential of the acreage? We really put it to our geoscience team, which is just a phenomenal team. They're the ones who open up Howard County, they're the ones who opened up the Austin Chalk. They proposed a well going down all the way to 16,000 feet vertically, and we looked at every single interval all the way down to 16,000 feet. And we tested a couple of those intervals, and in that process, we saw the Austin Chalk potential that it kind of overlooks -- all these years, 600 wells we drilled through the Austin Chalk, so we had all this data on the Austin Chalk. Then the team said, we need to core this thing. It looks really good in this area, and we cored it, and we found 2 excellent landing zones. So our first wells were in a deeper landing zone in the Austin Chalk, and those performed really well. They were better economics than the Eagle Ford, but they weren't quite at the Permian level. And then when they looked closely at the core, they said, well, this other landing zone actually it's higher permeability, it's thick, especially on the northwest it's really thick. And so they proposed drilling a well. And that well, I just remember real well, was a December of 2019 we started flowing that well back, and it was a phenomenal well. Returns were outlandishly good. So we said, okay, this is better. So then we started looking at that interval landing zone, and we did a number of wells, and the economics were superior. And then we looked at staggering between the 2 intervals and we were able to add a lot of value from staggering in the areas where the Austin Chalk was really thick. So when I say 400 wells of inventory, there's assumptions on relatively wide spacing, single layer in some parts of our acreage, and in other acreage, it's staggered between the 2 landing zones and in the thick intervals. And then the phase behavior is it's very oily, 80% liquids to the northwest, and then it gets down to 1/3, 1/3, 1/3 between oil, gas and NGLs over to the east. But then it gets drier gas to the south. And we're really not going to that southern are, but there's potential to add there also. So what we're focused on is first was delineation, then -- well, landing zone, delineation, and then spacing. And we've done enough spacing pilots to feel pretty confident in our 400-well inventory, and we know where the upside is. Not that we're necessarily going to go after that right away. But we know it exists. So that's a longwinded answer on that one, but I'm excited because it's been basically an addition to our inventory at no land cost. Didn't have to do an acquisition. It was just organically developed, and it's the same team that came up with Howard County that was deemed as too far east before in the Midland Basin, and then look what it did for us. So I'm counting on more from them. And then they have a -- I've got a shelf behind my desk of potential plays that they want to pursue, and we're going to be prudent about pursuing those for additional inventory.

Great. That's good color. Yes.

Just wondering how in shale 3.0 low to single digit type production growth, how this world has changed your view on M&A, especially being a SMID-sized operator where growing organically meaningfully will take a longer time low to single?

Right. Yes, we get asked that quite a bit, and we've been really consistent in the answer on that one. So the first I'll just start with the quality of our inventory is really high. I showed those slides and if you look at that SMOG, for example, and then our returns, they are really standout compared to our peers. So the first thing is, we would consider -- we're agnostic. If somebody wants to take us out or if we see somebody that looks really valuable to us, if they want to take us out, we got to make sure we get our value for the shareholders. If we are looking at somebody, their quality of inventory has to be comparable to ours, or we have to be able to see a way where we can get similar returns, which sometimes is a technological difference, which we are well prepared to look at. Second is it's got to be free cash flow or EBITDAX accretive. Otherwise, why would you do it? Third is from a debt standpoint, previously we said it's got to help us out on the leverage standpoint when we were more highly levered. Now it's just got to be within our objectives of being below 1x levered. So the world's changed on the leverage side from a year or 2 ago. And then finally, there's got to be some industrial logic. There's great to get G&A reduction, but there should be something that makes sense from an industrial sense on why you would put 2 companies together. So that's another angle. So that's really the story for M&A from our perspective. And on the A&D buying from a private, right now there's pretty big bid/ask spread from high strip to somebody with a more running a mid-cycle price for undeveloped acreage. So it is harder to see transactions there. From the M&A where publics, they are floating roughly the same rates. That you can see. It's more open than the straight A&D markets. So long answer again.

Herb, we are running short on our time here, but thank you for your presentation, your answers to these questions today, and thanks to SM for being a supporter of our conference.

Okay. Great. Thanks, Zach. Appreciate it.