Earnings Call Transcript - SM Q4 2020

Operator, Operator

Ladies and gentlemen, thank you for being here. Welcome to SM Energy's Q4 2020 Financial and Operating Results Question-and-Answer Session. I will now hand the conference over to our speaker today, Jennifer Samuels, Vice President of Investor Relations. Thank you. Please proceed, Ms. Samuels.

Jennifer Samuels, VP, Investor Relations

Thank you, Julianne. Good morning everyone and thank you for joining us. I hope you're all warm and safe. As always, allow me to quickly remind you that we may discuss forward-looking statements about our plans, expectations, and assumptions regarding future performance. These statements involve risks that may cause our actual results to differ materially from the results expressed or implied in our forward-looking statements. Please refer to the cautionary information about forward-looking statements in the earnings release, the IR presentation, and the risk factors section of our Form-10 K, which was filed this morning, all of which are posted to our website. Our discussion today may include discussion of non-GAAP financial measures that we believe are useful in understanding and evaluating our performance. Reconciliation of those measures to the most directly comparable GAAP measures and other information about these non-GAAP metrics are provided in our earnings release and IR presentation. Here to answer your questions this morning are President and CEO, Herb Vogel and EVP and CFO Wade Pursell. I will now turn it to Herb Vogel for some opening remarks. Herb?

Herb Vogel, President and CEO

Thank you, Jennifer. Good morning and thank you for your interest in SM Energy. Before opening up the call to your questions, I would like to say a few words to our Texas communities. With millions of Texans still without power, many without water, and many homes that have not had heat for days, the SM Energy community is certainly affected by these storms. Our focus is on the health and safety of our employees and doing what we can in our local communities. In South Texas, our regional gas processing plant was grateful Monday night as SM natural gas was moving and instrumental in keeping the plant open, enabling them to support power generation and keep many people's homes heated. In terms of implications to our first quarter production, certain weather-related issues continue as we speak and our team is responding with their best efforts. We will be assessing and quantifying the impact over the coming days. Now, let me turn it back to Julianne to open up for questions.

Operator, Operator

Thank you. Your first question will come from Scott Hanold from RBC Capital Markets. Please go ahead. Your line is open.

Scott Hanold, Analyst

Thanks. Good morning.

Herb Vogel, President and CEO

Morning.

Scott Hanold, Analyst

Can I ask you about the five Austin Chalk wells that you mentioned regarding wellbore issues and some deferrals? Can you provide more details and insights into what occurred there? Has this situation occurred previously in either the Eagle Ford or the Austin Chalk?

Herb Vogel, President and CEO

Yes, I can provide some details on that. We encountered a localized issue with five newly drilled Austin Chalk wells on two nearby pads in the northwestern section of our acreage that haven't been completed yet. On one pad, three wells experienced casing issues in their vertical sections above the Austin Chalk, but this is unrelated to the Austin Chalk Reservoir itself. Fortunately, we've enlisted service companies that successfully implemented a method to address the problem. In our planning, we anticipated the worst-case scenario of having to pre-drill up to three or potentially all five wells, which could result in an exposure of approximately 6 million to 10 million, or about 2 million per well. We felt it was important to mention this because it justified the production CapEx in the fourth quarter. However, there are no long-term impacts to worry about. We've drilled through this interval with around 600 wells in the past and only faced one issue prior to this occurrence, indicating that this is simply a local issue.

Scott Hanold, Analyst

Okay. When you refer to a local issue, can you clarify if it was related to something geological in that area or if it was more of an operational or service-related issue, whether it was a mistake or something else? Was it primarily geological?

Herb Vogel, President and CEO

No, it's a casing issue. It's quite localized, and we can navigate right through the problem area. We just need to ensure that we maintain integrity throughout that section.

Wade Pursell, EVP and CFO

Not geology.

Herb Vogel, President and CEO

That’s not geology.

Scott Hanold, Analyst

Got it. Okay. Understood. My follow-up question is regarding your allocation to the Austin Chalk next year. Can you provide some high-level insight into your thinking behind this decision, especially since you're seeing great returns in the Permian and performance and costs seem solid? Is the shift mainly due to the strong well performance and its expected contribution, or is part of it about wanting to do more delineation while staying within your budget range?

Herb Vogel, President and CEO

Well, Scott, first of all, these wells with what we can see are fully competitive with Permian with our co-developments there. And there is an element of wanting to demonstrate the Austin Chalk and how well it can do and what it can do for our inventory and our reserves. So, there's a component of delineation in the 2021 program, there's a component of development in there also.

Scott Hanold, Analyst

Understood. Thanks.

Operator, Operator

Your next question comes from Leo Mariani from KeyBanc. Please go ahead, your line is open.

Leo Mariani, Analyst

Hey, guys. I know this is probably a tough question to answer. But you have any indication if you could tell us about kind of downtime you're experiencing out in the Permian at this point in time and just based on your prepared comments. I got the sense that there was no disruptions in the South Texas access, so just wanted to clarify that. And I guess just the final point related to that on the guidance that you just came out with, does that already contemplate any significant first quarter 2021 weather disruptions in the full year 2021 guide?

Herb Vogel, President and CEO

Let me address your last question first. We have not included any weather-related impacts in our estimates. It's really a matter of deferral rather than a direct impact on the first quarter. Once we resume operations, we anticipate catching up. Specifically, the issue is with roads, which prevents sand trucks from getting through, leading to a shutdown of our frac operations. While most of our rigs are currently operational, some experienced temporary shutdowns. Additionally, production is affected when there's no electricity since pumps and compressors need to be shut down. However, production that doesn't depend on electricity can continue as long as the downstream systems are functional. Does that clarify things?

Leo Mariani, Analyst

Yes, that definitely helps. And again, it's the last part of South Texas, was that totally unaffected in South Texas, or is this just a West Texas problem, just trying to isolate that a little bit?

Herb Vogel, President and CEO

No, there's some problems within South Texas, the impacts don't seem as severe, but we're going to come back, we're going to look at everything once we're past this short-term bad weather event, even though it's significant, and see what the impact is, and then we'll be able to make an estimate, but when we shut these wells is simply a deferral really.

Leo Mariani, Analyst

Right. Okay. Well, that's definitely helpful. And then just with respect to the CapEx plan for the year here, I certainly saw the numbers, it looks like your first quarter CapEx was kind of a little bit higher, if we annualize that and kind of the full-year budget. Just wanted to get a sense, is there a plan to kind of have CapEx more on half weighted in 2021 as you can kind of look at the activity plan, what can tell me on that?

Herb Vogel, President and CEO

Yes, Leo, the original plan had front end loading to the first half of the year. So, not that major, but yes, there was front end loading. And now with frac spreads shut down, that obviously reduces our CapEx spending right now. And so we don't know exactly where we wind up until this event is over with.

Leo Mariani, Analyst

Got it. No, that makes sense. Just a quick follow-up on the South Texas asset. The question was sort of asked previously, clearly, there's an element of delineation here in what you're doing? Do you look at this asset now as something you see is very much core to the company, because I know a year or so ago, you guys were talking about potential divestment at some point, but obviously, the returns were very strong. So, it's kind of a divestment piece more off the table and really we see this as something that's kind of foundational, you can drill inventory on for years.

Herb Vogel, President and CEO

Yes, Leo, so the key thing is in late 2019, we're really more or less uncracked the code a little bit in the Austin Chalk down there. So, our perspective on the wells are improved and then we confirm that with the wells that were drilled in 2020, and we found that they were fully competitive with Permian. So, when I said we have a combination of delineation and development, we're really looking at development in areas where we know the returns could be very competitive with the Permian and then continue to delineate to expand the inventory. And that'll determine the extent of the core nature of it. But in terms of returns, it's a great asset.

Leo Mariani, Analyst

Okay. Thank you.

Operator, Operator

Your next question comes from Arun Jayaram from JPMorgan. Please go ahead, your line is open.

Arun Jayaram, Analyst

Good morning. Herb, could you share your thoughts on the long-term perspective of the 2022 plus plan? You've already mentioned some information regarding free cash flow, balance sheet implications, and reinvestment rates. Should we view the 2022 plan as one aimed at maintaining stable production levels, particularly in terms of oil and BOEs?

Herb Vogel, President and CEO

Yes, Arun, what we thought was very clear was the quality of our assets is so strong, the returns are quite good. And you see that our base production keeps outperforming. So, when we look at it, we could keep production flat to single-digit growing with less than 75% of a reinvestment rate. And I don't think people realize the quality of our assets, but now you're really starting to see it in our results with this transformation that's really taking place over the last three to four years.

Arun Jayaram, Analyst

Got it. Got it. So, longer term, reinvestment rate and flat to single-digit type growth opportunities over the long-term?

Herb Vogel, President and CEO

Exactly.

Arun Jayaram, Analyst

One housekeeping question is, in 2022 in South Texas, there were 21 completions and 39 wells drilled, which helped build some DUCs. In Midland, there were 72 completions and 55 wells drilled, indicating some reductions in DUCs. As we consider the 2022 mix, should we expect a slightly higher proportion in South Texas, or should we think more about a longer-term model?

Herb Vogel, President and CEO

Well, Arun, frankly, we run multiple scenarios, and we can change the capital allocation between the South Texas and Permian asset and in terms of the returns we get and the financials we get, we can get to pretty much the same level, with everything panning out that way. And so we can mix that between the two and get to the same end results is kind of the bottom-line. And so, one scenario here that we're using for this, this plan, and the only variation will be someone in oil percentage, one case to the other.

Arun Jayaram, Analyst

Got it. Got it. Okay. All right. Thanks a lot Herb.

Herb Vogel, President and CEO

You bet.

Operator, Operator

Your next question comes from Carl from Goldman Sachs. Please go ahead, your line is open.

Unidentified Analyst, Analyst

Hi, good morning. Thanks very much for the time. Question really focuses on the balance sheet; your bonds have had a very nice run from the middle of last year, as you think about what the optimal capital structure is going forward. I'd be interested in your thoughts and maybe this is more for Wade on the benefit of interest cost savings from adding second lien debt relative to the increased flexibility you have from issuing regular way high yield bonds. And then I guess one you want to that is there? Is there an element there around your discussions with your bank lenders that would suggest one approach or another approach?

Wade Pursell, EVP and CFO

Hey Carl, it's Wade. I believe there are many questions to address. Generally, I want to emphasize that our long-term plan aims to generate more free cash flow than our actual debt maturities from now through 2024. I have no doubt that using this free cash flow to reduce debt is beneficial for both shareholders and bondholders. This should be your baseline assumption moving forward. Regarding second lien debt, we have no interest in pursuing that option due to its higher costs and the idea of increasing debt at all. Our goal is to maintain leverage below two times within the next year and approach one time by 2025. Paying down maturities through free cash flow between now and 2024 is the main focus.

Arun Jayaram, Analyst

Certainly, I understand your point about the cash being sufficient to address the 2024 maturity on schedule. Considering this, as we enter a phase of cash generation, where do inventory acquisition or mergers and acquisitions rank on your list of cash priorities?

Wade Pursell, EVP and CFO

I want to make a comment about inventory before Herb adds his thoughts. It's exciting to recognize that we can discuss these metrics for the next five years without needing to replenish inventory during that time. We have a high return on inventory, which is highlighted in our presentations, extending beyond that period. So, during the years we're discussing, there's no requirement to increase our inventory, but I'll let Herb address our strategic approach. We manage inventory on a daily basis and there's potential for optimization. We're fortunate to be situated with our resources, and who would have predicted the current state of the Austin Chalk just a few years back? We anticipate organic inventory growth and we continue to engage in acreage trades to enhance our returns. This is our perspective; we are not compelled to take action because we have a significant inventory runway, particularly with our current reinvestment rates of only 75%. That's helpful. Thanks very much for the comments. And certainly when you look at the bond levels, it's pricing a whole lot of options that you have available to yourself. Thank you.

Operator, Operator

Your next question comes from Gail Nicholson from Stevens. Please go ahead, your line is open.

Gail Nicholson, Analyst

Good morning everybody. You guys made really good improvement on your DC&E costs in South Texas versus where you guys were previously modeling? Can you just talk about the drivers there?

Herb Vogel, President and CEO

So, Gail, this is Herb. The drivers are really just across the board reductions from the cost of our rigs, or cost of services associated with rigs, the sand costs are down, pumping services costs are down. That is key to this. And then that minute-by-minute efficiency again, so basically less runtime on each well, by pumping more stages per day, but it's really a combination of sector deflation and efficiencies.

Gail Nicholson, Analyst

Great. And then can you guys get some higher profit loading in the Midland this quarter? Can you talk about what you saw there, and also the fact that the higher profit loading even allowed even, you were even able to get your wall cost photo what you were previously anticipated with the higher profit loading?

Herb Vogel, President and CEO

So, regarding the profit loading, we experimented with some higher profit loading in the fourth quarter, but it wasn't a significant amount. Based on our results and those of others with high profit loading, we adjusted the profit loading assumption for 2021. As a result, we incurred some additional costs. We were operating at below $500 per lateral foot in the fourth quarter. As you can see, we reported this on 2021, and it reflects that higher profit loading.

Gail Nicholson, Analyst

What type of well uplift you anticipate seeing with the higher profit loading?

Herb Vogel, President and CEO

I'll show you once we've got a bunch of results to share with you.

Gail Nicholson, Analyst

Fair enough. And then just on the standpoint of with the significant amount of free cash generation, you guys have upcoming from the 2021 to 2025 timeframe, you talked about a kind of a lower hedge level really in the 2024 for outlook. Can you just talk about what is the appropriate target hedges level you guys would like to be in 2022?

Herb Vogel, President and CEO

That's a great question. We’ve indicated previously that our approach is closely linked to leverage. Historically, when we considered a leverage ratio around three times, our calculations suggested a hedging percentage around 75% for the upcoming year. If we gain confidence that we’re more in the two times range, then we would look at hedging closer to 50% as we near the year. Of course, if the market conditions shift, it might prompt us to be more opportunistic. Overall, we aim to manage the risk associated with our balance sheet, and if we're looking at a two times leverage, then a 50% hedge would be reasonable. As we continue forward and if we go below that leverage threshold, the hedging percentage would decrease accordingly.

Gail Nicholson, Analyst

Great. Thank you.

Herb Vogel, President and CEO

You bet.

Operator, Operator

Your next question comes from Tom Hughes from Wells Fargo. Please go ahead, your line is open.

Tom Hughes, Analyst

Yes. Thanks. And hey guys, congrats on the quarter. Wanted to see how you're thinking about development versus delineation results in the Chalk. Maybe if you could go into both spacing and productivity application?

Herb Vogel, President and CEO

Tom, so this is Herb. The way we'd line up that program, I think we show on the slide where we are drilling the Austin Chalk wells in 2021. So, are completing the 21 wells in 2021 and we also show where the existing wells are. So, that's really where you can see what looks more like development and what looks more like delineation when we're really stepping out. So, we have a combination there and that will be testing a number of different things with those different pad areas that we show on there.

Tom Hughes, Analyst

Okay. And as a follow-up, the changes made versus preliminary guidance indicate you're probably better set up for 2022 from a product production standpoint. So, as you slow activity into 2022, is it fair to assume you begin to eat into the DUC backlog to better match the rig base?

Herb Vogel, President and CEO

So, Tom, it's that year-end issue that always comes up. So, we've got well, so the work completing the wells in terms of CapEx during 2021 and then 2022 comes on and we turn a number of wells, I think it's about 10 wells on that we completed in 2021 at the start of 2022. So, it's real hard to lock down exactly what your drawdowns will be year-in, year-out. Overall, we're pretty flat in 2021. In 2022, overall, it'll be the same sort of thing where we're either going to be flat, or it'll just depend on what happens right near the end of the year or the start of the year.

Tom Hughes, Analyst

Okay. Thank you.

Operator, Operator

Your next question comes from Michael Scialla from Stifel. Please go ahead, your line is open.

Michael Scialla, Analyst

Yes, good morning guys.

Herb Vogel, President and CEO

Good morning, Michael.

Michael Scialla, Analyst

I want to get a little detail on your five-year plan or a sense of what would maybe cause you to deviate from the five-year plan, particularly in terms of prices, if you said you're going to hedge 50% of production from 2022 and beyond? What kind of price range would cause you to do anything differently than what you've laid out there?

Herb Vogel, President and CEO

Well, Mike, at pointing to the risk factors in the slides, so that's a really hard question to really pin down. We look at things and we constantly relook at our five-year and 10-year plan. And we say okay, given the circumstances there's things around gas relative to oil, or NGL, they're trading that can affect the how you go ahead and develop and where you develop. But there's no general answer, I can really give on that.

Wade Pursell, EVP and CFO

Regarding the hedging, I want to clarify that when we mention a 50% target, we're referring to a one-year period. We are not hedging 50% of all commodities for the next five years at this time. This approach informs our decisions as we approach the end of the year and move forward. Additionally, when prices rise significantly, costs tend to follow. Therefore, we prefer to maintain as much flexibility as possible in our strategy.

Michael Scialla, Analyst

I understand. You mentioned the challenges you faced with the Austin Chalk wells related to the casing issue. When can we expect to receive more incremental data on any new chalk wells that you would be willing to share with the investors?

Herb Vogel, President and CEO

The 21 completions will be coming in throughout the year, and these do not include the five related to the three that had issues. We will receive these over the course of the year, but we plan to wait a couple to three months after they come online before making any reports. You can expect to see updates probably late in the second quarter, followed by a quick succession of additional updates.

Michael Scialla, Analyst

I wanted to ask about the higher profit loading in the Midland Basin. Are we testing both the Wolfcamp and Spraberry formations? Looking at the state data, it seems that your 2020 vintage for Spraberry is performing better than previous wells. I'm curious if this aligns with your observations, considering Texas data can sometimes be misleading. Is this improvement due to higher profit loading or another factor?

Herb Vogel, President and CEO

Okay. Yes, that's a great question, Michael. That is not related to the profit loading. It involves detailed optimization of other completion factors and some spacing adjustments all combined. But yes, we do see improvement from 2017 to 2020, and our teams are focused on that. They are really motivated to keep the well performance increasing even as we co-develop nearly all those areas.

Michael Scialla, Analyst

Very good. Thank you.

Herb Vogel, President and CEO

Thank you.

Operator, Operator

This will conclude today's question-and-answer session. I would like to turn the call back over to Herb Vogel, President and CEO for closing remarks.

Herb Vogel, President and CEO

Well, thank you for your interest in SM Energy. Any questions, you know you can always contact Jennifer Samuels at the number shown in the deck.

Operator, Operator

This concludes today's conference call. You may now disconnect.