Good day and thank you for standing by. Welcome to the SM Energy’s 2021 Financial and Operating Results and 2022 Operating Plan Q&A call. [Operator Instructions] Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Jennifer Samuels, VP of Investor Relations. Please go ahead..

Thank you. Good morning and thank you for joining us for our question-and-answers call. To answer your questions today, we have our President and CEO, Herb Vogel and CFO, Wade Pursell. As always, I will remind you that our discussion today may include forward-looking statements and discussion of non-GAAP measures.

I direct you to Slide 2 of the accompanying slide deck, Page 8 of the accompanying earnings release and the Risk Factors section of our most recently filed 10-K and 10-Q, which describe risks associated with forward-looking statements that could cause actual results to differ. We will also refer to non-GAAP measures.

Please see slides 30 through 33 in the accompanying slide deck and Pages 15 to 23 of the accompanying earnings release for definitions and reconciliations of non-GAAP measures to the most directly comparable GAAP measures and discussion of forward-looking non-GAAP measures. Also, look for our 2021 10-K filed this morning.

With that, I will turn it over to Herb for a brief opening commentary..

Thanks, Jennifer. First off, I want to acknowledge the gravity of current events. Our prayers go out to the people of Ukraine. Oil and gas are central in geopolitics and SM Energy is positioned to maintain a sustainable long-term plan under a range of macroeconomic scenarios, while recognizing the importance of providing reliable, affordable energy.

Second, I would like to add some color regarding the oil production component of our guidance. Importantly, I will reiterate something we say every quarter. Production and the components of oil, NGLs and gas are outputs of our 3-year plan to optimize free cash flow.

Our 2022 plan is expected to roughly double free cash flow over 2021, delivering a highly attractive free cash flow yield. Two things are going on at the same time in the 2022 plan that impact our oil rates.

One, the increased allocation of capital to South Texas, 45% versus 35% of CapEx last year, moves the production mix to more natural gas and NGLs than in 2021 and two, we had unique orderly phasing of Midland completions last year and this year, which was the result of the Texas freeze in the first quarter of last year.

Some key points to keep in mind. We completed a total of 64 net wells in Midland in the second and third quarters last year. The subsequent two quarters, we complete 9 wells in the Midland Basin. The first year decline rate on new wells is approximately 75% to 80%. So, you will simply have a decline in Midland production in the first half of 2022.

New Austin Chalk wells will, on average, have a projected mix of 42% oil, 30% NGLs and 28% gas. The increased capital allocation in South Texas therefore contributes to higher gas and NGLs, changing the mix at the company level.

In addition, I will repeat Wade’s comment from yesterday that our 2022 capital spend includes a good portion of the capital for 20 wells in the Midland Basin that will not turn in line until early 2023. So, again, it’s timing that will affect the oil percent in 2022.

As we have demonstrated with actual well performance, the returns in our Austin Chalk compete with the Midland Basin. As shown in the deck, our 2021 Austin Chalk wells are expected to have an average 9-month payout per well. Development of the Austin Chalk is a sizable opportunity to build NAV and realize that value creation for shareholders.

Again, free cash flow is expected to roughly double year-over-year, because we have a highly efficient, high return operating plan where production is an output. Thank you. And I will turn it back to the operator to take our first question..

[Operator Instructions] And your first question comes from the line of Gabe Daoud with Cowen..

Thanks. Good morning, everyone. Just hoping we can maybe just dig in a little bit more on the guy.

I appreciate all the remarks last night and your comments just now, but just also just trying to get a sense of what’s baked in from a conservatism standpoint, whether it’s PDP downtime for offset fracs or just kind of how you handicap weather events or just trying to get a sense, because that first plus just given the improved Austin Chalk program obviously Midland wells getting better.

I would have thought even with the increase in Austin Chalk capital allocation that the oil volumes would have been a little bit better to what you had guided to.

So, could you maybe just give us a little bit of comfort around how much, if at all, conservatism is baked in the guide?.

Yes. Gabe. This is Herb. So we just have basically assumed normal events, normal performance. We don’t really do anything where we steer something in one direction conservative or aggressive in any way. It’s what our well performance is expected to be.

And then if we have outperformance like new completion design, it’s – we have had been very fortunate with those Midland-based wells on how well they have performed.

With normal weather and then we do assume a certain number of offset fracs from offset operators where we have to shut in and sometimes there is more, sometimes there is less and those can influence. So in the fourth quarter, there were less offset fracs from offset operators and that helped us. We also had really good weather in the Midland Basin.

So, those are really the key things, but we don’t do anything in terms of trying to be conservative or trying to be aggressive..

Okay. Thanks. That’s helpful. And then regardless of what the production output is as you mentioned, it is just at an output of your capital allocation framework. There is still a lot of free cash flow coming.

So, could you maybe just talk about once you get to your leverage targets, whether it’s the one-time net debt to EBITDA figure, which we think you kind of get there next quarter.

Could you maybe just talk about steps or use of free cash flow once you get there? Any thoughts around capital return to equity holders?.

Well, Gabe, I will start on this one and then I will hand it over to Wade, but I would just say we are just really pleased with how fast we have got to this point. We are way beyond our expectations.

We have got a tailwind with commodity prices, but just the performance of both the Chalk and Midland Basin has really enabled us to be at this point, much faster than we ever expected. And we are obviously thinking about what are the best means for return of capital to shareholders over time.

And I’ll turn it over to Wade to just give some thinking about it from our perspective..

Yes, sure. Yes. Good question. And I’ll just kind of reiterate a few guideposts that we laid out, I think, last quarter for the first time and then actually mentioned it again on the call yesterday. But as I mentioned, we are getting there quicker, which is very exciting.

But I think we mentioned that de-levering is really, really important to us, and we’re pleased how that’s going. We want to get down to 1x, but we also look at absolute debt is very important as well. So we said one in one basically, get down to 1x and $1 billion of absolute debt.

So as you mentioned, the 1x, assuming the macro hangs in there is coming pretty quick sometime around the middle of this year, probably.

And the $1 billion, I think I mentioned, looking at our forecast, just assuming the prices that we assumed, which are somewhat conservative compared to today’s strip, but it looks like something towards the end of this year or maybe early next year.

So it is on the horizon, and we will start – as we get close to that, we will start considering what the right options are. And that certainly includes a meaningful dividend or potentially buyback program. People love to ask which one of those – and I think it’s too early to declare which one of those we think would be the appropriate one.

I think stock valuation is a big factor in that compared to NAV at the time. So that would be a factor when we start contemplating those decisions.

Just to add color to that, if we were considering it today, I would – I think it would be – shouldn’t shock anybody to assume we might be leaning towards buyback, given our view of the stock valuation versus NAV, but that’s a theoretical answer today. I think it will be a more prudent answer when we get closer to reality..

That’s great color. And just before I go, so just to confirm, there is no difference in the way you issued or prepared ‘22 guidance versus years past, right? Thank you..

Same consistent approach..

Awesome. Thanks, guys..

Yes..

And your next question comes from William Howell with Stifel..

Hi, good morning, guys. Congrats on the quarter. My first question is on inflation. In the prepared remarks, you mentioned that you have about 15% inflation baked into well cost.

I’m wondering if you could talk a little bit more about where you’re seeing that? And how much efficiency gains are factored into that?.

Thanks, William. Yes, definitely, the topic of the year inflation. So you’ve probably seen that activity did ramp up to some degree last year. And what – when we look at the supply chain, we’re well positioned in terms of having availability of everything we need definitely through the first half, almost everything is locked in for us.

So we know what those cost increases are over last year, and we baked in that 15%. The areas where we’re seeing inflation, obviously, like diesel, clearly, with oil prices up, diesel prices are up. Steel prices are up.

Labor, trucking, those sorts of things, not as much on the drilling rig side or on the completion spread side if you run a continuous program and lock in the contract. But overall, we don’t know what the geopolitical events recently are going to do the supply chain. So that’s an unknown.

But we did bake in 15%, which seemed reasonable based on what we were seeing right at the year-end..

Okay, got it. Thank you. And my other question is the decision to allocate about almost half of the capital to South Texas.

Just talk a little bit more about the kind of long-term economics that you see there and how that stacks up against the Midland Basin?.

Yes. So that’s what we’re really pleased about. So we’ve shown over time, now we have 40 Austin Chalk wells producing.

And based on the results that we’re seeing in the commodity price environment we had at the end of last year, start of this year, that they are comparable returns, and we saw a big potential NAV addition from giving recognition for the Austin Chalk. So we’ve allocated 10% more of the capital to the Chalk than we had last year.

So we went from 65-35 to 55-45 to accelerate that recognition of the Chalk, and the returns are very comparable between the two. The commodity mix is somewhat different, but the returns are the same..

Okay, thanks..

Your next question comes from Zach Parham with JPMorgan..

Thanks for taking my question. Just a follow-up on the oil guide. Maybe could you talk a little bit about your base decline rate for oil as of year-end? Really just trying to reconcile that the 1Q guide and at the midpoint implies an 18% sequential decline in oil during a quarter when you’re still going to turn in line, I think, around 15 wells..

Zach, I think I heard your question there. So we showed in the slide deck that year-over-year, our base decline on a BOE basis is 38%. But the key here is that in the second and third quarter last year in the Midland Basin, we turned on 64 wells. In the fourth quarter, we turned on four. In the first quarter, we turned on five.

So those wells that start up in Q2 and Q3, they are on a 75% to 80% annual decline like normal unconventionals. So you’ll see a relatively rapid decline. While the base is at a certain decline, like 38%, those new wells are more rapid decline and since we don’t have a rate program, because of that freeze event last year.

That’s why you are seeing this dip in the first half of 2022. And then you will see it come back around. It’s really the quarterly phasing of oil in Midland wells versus the gassier NGL-rich Austin Chalk wells..

Got it. Thanks for that color. And I guess one just following up on Gabe’s question on cash return. You have got the one turn of leverage and $1 billion debt target out there for the balance sheet.

Do you want to reach both of those before considering cash return, or would you consider some level of cash return while also reducing leverage once you hit one of the targets?.

Yes. I would – good question. I would say, generally speaking, we want to reach both. We put them both out there as a target. It doesn’t mean once we reach one, and start approaching the second one, we wouldn’t start considering something in the meantime. I guess, is the way I would say that..

Got it. That’s helpful. Thanks..

[Operator Instructions] Your next question comes from Karl Blunden with Goldman Sachs..

Hi. Good morning. Thanks for the time.

I didn’t hear a lot of discussion about M&A, but with the balance sheet now in a better position, when does that come into consideration, if at all?.

Yes. Karl, thanks for the question. So the M&A, we have been pretty consistent over time, and we really don’t see any need for a change in our position there. So first of all, we are open to looking at some of the approaches, and we are open to considering an acquisition that makes sense.

And when we say it makes sense, what are we talking about really have to have really high-quality assets. So, the high returns that we have in our portfolio. We don’t want to diminish the portfolio or where you wouldn’t be able to drill the acquired acreage for several years out because the returns aren’t there.

Second, have to be comparable from a leverage standpoint, so not basically levering us up significantly. And then from an earnings standpoint, cash flow standpoint, it should be accretive. So, those are really our criteria, asset quality, not impeding us from a leverage standpoint and then helping us out on the cash flow standpoint, but we are open..

That makes sense. You outlined and reiterated this, a plan for about $1 billion of debt reduction, which is encouraging. When you think about the different parts to get there, you have a couple of different opportunities. You have some bonds due in 2025, some in 2026. Some of the ‘25 bonds have higher coal prices.

How do you go about prioritizing taking on high coupons versus paying high coal price? Just interested in how you do those NPV calcs internally?.

Yes. Sure. Great question. And you kind of outlined a summary of it. We will just kind of walk forward as we move through the year, generating free cash and take out the notes that make the most sense.

From a math standpoint, but also there is – I mean, obviously, I have mentioned in the past, the second lien notes, we have a high desire to get those out of the capital structure. So, they become callable in about four months. So, those are a target, but we will run math on that as we get closer.

The ‘25 unsecured notes, as we approach midyear, callable at – they get down to 100.9, I think we get to the middle of the year. And then moving on into this – the ‘26 is by the time you get those paid off. And you are towards the end of the year, they are callable at 102.

So, the math is – I think it’s always going to be compelling, and we are always going to have compelling options with the cash to get debt down to the level we desire to get to. Hopefully, that helps..

That’s helpful. Thanks very much for the time..

Your next question comes from Nicholas Pope with Seaport Research..

Good morning everyone..

Good morning..

Good morning..

I was hoping you could talk a little bit about Austin Chalk performance down in South Texas. And maybe really understanding how consistent the results have been. It feels like that’s been a knock on the formation across Texas and Louisiana in the past is kind of consistency and repeatability of performance.

And I guess, maybe what’s changed there? And how has performance kind of – what’s that spread look like as you kind of have a much bigger output of wealth?.

Yes. Nicholas, that’s a great question. And I will give you kind of a long answer to that. First of all, just starting with the consistency of the Austin Chalk across our entire position, we had 600 wells drilled to the Eagle Ford through the Austin Chalk, so we can map it extremely well. Then we have core.

And we also have done an enormous amount of science data, and we are going to get more science data. We have not yet optimized the completion. But when you look at our results, you have to consider two big factors. One is there is variation in the fluid quantity.

So, from the Northwest, it’s oilier and it gets progressively gassier and NGL-rich as you move east and south as it gets deeper and higher pressure. So, the variability there is going to be fluid-type variability, and that’s fine, very predictable. The other is the lateral lengths will vary.

And then what we really look at is the per 1,000 lateral feet performance. And there, it’s much narrow a P1090 than you would have seen from the Austin Chalk that I would have been developing in East Texas in the late 80s. So, a lot of people say, well, Austin Chalk and knock, it’s not predictable.

Well, here, it is actually quite predictable, and it’s the – properties are quite uniform compared to the days of old, which were more a fracture system that was unloading for the wells. Here, it’s much more consistent. I hope that helps..

Yes. That’s great, actually. I mean you guys have kind of outperformed my model for four quarters in a row. So, just trying to get a little understanding of how repeatable that is. I appreciate the time. That’s all I had. Thanks..

Thanks..

We have no further questions in queue at this time. I would now like to turn the conference back over to Herb Vogel, President and CEO, for closing remarks..

Okay. Thank you, Deb. And thank you all for joining us. Best wishes for the rest of the year..

And ladies and gentlemen, this does conclude today’s conference call. Thank you for your participation. You may now disconnect your lines..