Description

SM Energy is in a far better position today than it was five years ago and it should be more than a double from the current share price.  Production and reserves are both higher, net debt has been more than halved, and free cash flow is in positive territory.  Capital discipline has also vastly improved as has management's commitment to return excess free cash flow to shareholders as highlighted by its $500 million buyback authorization.  Yet despite all of its operational and financial progress over the last few years, its stock price has been more than cut in half from its June 2022 highs and remains below its 2018 highs when it was nearly 3x levered on a net debt/adjusted EBITDAX basis, had lower production and reserves, and was decidedly free cash flow negative (and had yet to crack the code in the Austin Chalk).  Talk about disrespect!?!

For those not as familiar with this company, SM is an E&P focused on the Midland Basin in the Permian and the Eagle Ford and Austin Chalk plays in South Texas.  It has roughly 82k net acres in the Midland Basin including its RockStar assets in Howard and Martin Counties and its Sweetie Peck assets in Upton and Midland Counties.  The Midland Basin represented 56% of SM’s total production in 2022 and will command the majority of its 2023 CapEx budget of $1.1 billion.  SM expects to average three rigs and one completion crew this year in the Midland with activity focused on highly economic oil-rich intervals such as the Spraberry and Wolfcamp.  Meanwhile, its South Texas assets consist of 155k net acres located in Dimmit and Webb Counties where 2023 activity will focus primarily on the Austin Chalk.  Two rigs and one completion crew are slated for this play in 2023. 

After a decade of outspending cash flows in a desperate push to keep pace with the double-digit production CAGRs of other Permian E&Ps and appease growth-oriented investors, the plunge in oil prices and harrowing decline in its stock price to below 1/sh in March 2020 forced a much-needed strategic rethink for the company.  Going forward, free cash flow would take clear priority over the disastrous growth for growth’s sake mentality of the past.  Flat production effectively became the new up not only for SM but the rest of the industry.  This strategy arguably worked to perfection for SM through early June 2022 as its stock price leapt by over 50x from its March 2020 nadir on the heels of a rise in oil prices to over $120/bbl, which fueled robust FCF and significant debt reduction.   

Fast forward to today, and we see that spot oil prices have retreated by 38% while SM’s stock price has declined by 52% since June 2022, or nearly double the 27% decline in the S&P Oil & Gas E&P Index (XOP).  Yet, longer-term oil prices as indicated by the futures market, the bigger driver of net asset value, have declined at a far more measured pace since last June and remain above $65/bbl through December 2026.  Amazingly, SM presently trades at under 0.54x on an EV/YE 21 PV-10 basis (current EV is $4.37 bil. while YE 21 PV-10 was $8.16 bil. and reflected $66.56/bbl oil and $3.6/Mmbtu nat gas) and 0.36x YE 22 PV-10 (which is less relevant given that it reflected $93.67/bbl oil and $6.36/Mmbtu nat gas).

The bottom line is that SM is only pricing in low $50s/bbl oil and $2.5/Mmbtu nat gas going forward, both of which look conservative.  We’ve already seen the Saudis and OPEC attempt to draw a line in the sand at $80/bbl with their unexpected production cuts announced earlier this month, not to mention the fact that the US government hopes to begin refilling its SPR later this year around $70/bbl.  Thus, there’s plenty of support for oil prices at present levels.  Meanwhile, nat gas prices have cratered thus far in 2023 on an unseasonably warm winter and an outage at the Freeport LNG facility.  However, Europe is still desperate as ever to cut ties with Russia, which should ultimately buoy today’s depressed nat gas prices down the road assuming weather is a bit more cooperative. 

SM is not waiting around for investors to realize that it has permanently changed its stripes and remains grossly undervalued.  Instead, it has ramped up share repurchase activity from 0.45 million shares in Q3 22 to 0.91 million in Q4 22 and 1.4 million in Q1 23, taking advantage of its sizable discount to NAV and retiring over 2% of its outstanding shares in the process.  SM’s more sustainable production trajectory is one that not only extends its inventory position in both the Midland and Auston Chalk to roughly a decade but one that should also deliver far more attractive levels of free cash flow along the way.  In fact, it is trading at a free cash flow yield of nearly 14% based on consensus 2023 free cash flow of roughly $450 mil.  This is a stock that should be trading a lot closer to its June 2022 highs than under $27/share despite all the macroeconomic and commodity price uncertainty.  In our view, there’s over 100% upside from current levels.

Catalyst

- Value will out