SM Energy: Nearly $400 Million In Projected 2H 2023 Free Cash Flow (NYSE:SM)

SM Energy (NYSE:SM) reported strong Q2 2023 results with production around 5% above its initial expectations. This has allowed it to boost its full-year production guidance, while also improving its guidance around costs. I had already assumed that SM would do fairly well in terms of 2023 production, but it is exceeding my expectations.

In combination with stronger commodity prices, I now believe that SM can generate close to $400 million in free cash flow during the second half of 2023. It also managed to repurchase 2.55 million shares during Q2 2023 at an average price of under $27 per share.

I now estimate SM’s value at approximately $46 per share at long-term $75 WTI oil and $3.75 NYMEX gas.

Strong Production Results

SM previously expected to average 146,000 to 148,000 BOEPD in Q2 2023 production, with an oil cut of 42% to 43%. It ended up averaging approximately 154,400 BOEPD (42% oil) in production during Q2 2023, around 5% above the midpoint of its original guidance. SM noted that Austin Chalk well performance exceeded expectations, and it also benefited from the build-out of oil handling facilities that allowed it to bring large pads online without as much curtailing of production.

SM’s strong performance has allowed it to make some positive revisions to its full-year guidance. It now expects to average 147,000 to 152,000 BOEPD (43% to 44% oil) in 2023 production, up from prior expectations for 144,000 to 150,000 BOEPD (43% oil). Approximately 20% of the increased production guidance is due to its Reliance acquisition, while the remainder is due to factors such as its well outperformance and reduced production curtailments.

SM has also reduced its 2023 capex budget by $50 million, helped by cost deflation, while its LOE is also expected to be $0.50 per BOE lower than originally thought.

Acquisitions

SM announced an acquisition of 20,000 net acres in the Midland Basin for $93.5 million in cash ($90.6 million after purchase price adjustments and closing costs). This acreage was acquired from Reliance Energy and is mostly located in Dawson County, with a small amount of the acreage spilling over into northern Martin County.

SM noted that the Reliance assets were producing approximately 1,250 BOEPD (90% oil). Reliance’s production came from 30 vertical wells and 8 horizontal wells, with the horizontal wells targeting the Dean and Middle Spraberry formations.

Reliance claimed 51 gross undeveloped locations in the Dean and Middle Spraberry formations. This may translate into approximately 46 net locations in those formations given Reliance’s average 90% working interest across that acreage. SM claims the Dean and Middle Spraberry locations can breakeven (with a 10% discount rate) at under $50 oil.

Reliance also indicated that its assets were expected to generate $21 million in cash flow over the next 12 months (from March 2023). This was at lower commodity prices than current levels, so SM may be able to generate around $23 million in cash flow from the producing assets over that 12 month period.

The decline rate from the producing wells seems pretty high though, with the roughly 2 million BOE in PDP reserves being under 5 years of current production levels.

The purchase price for the Reliance assets seems reasonable, with net undeveloped locations being valued at under $1 million each, after adjusting the purchase price for the value of the current production.

In addition to the Reliance acquisition, SM has also added another 2,800 net acres to its separate mystery position in the Midland Basin. SM acquired 6,300 net acres in that area in Q1 2023, but has not disclosed the exact location as it seems to be stealthily adding to its position there. It paid around $1,600 per net acre for its Q1 2023 acquisition, but did not disclose the cost of the additional 2,800 net acres.

Updated Outlook For 2H 2023

I now expect SM to average around 150,500 BOEPD (44% oil) during the second half of 2023.

At current strip (including roughly $81 WTI oil) for the second half of the year, this would allow SM to generate $1.267 billion in revenues after hedges. SM’s 2H 2023 hedges have negative $5 million in estimated value, with positive value natural gas hedges and generally negative value oil hedges.

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With SM’s improved guidance for costs, this results in a projection that it can generate $393 million in free cash flow during the second half of 2023.

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Some of this free cash flow is likely to go towards more share repurchases. SM Energy repurchased another 2.55 million shares during Q2 2023 for $68.7 million, at an average price of $26.95 per share.

Notes On Valuation

At this point in time I have not changed my expectations around long-term (after 2023) commodity prices from $75 WTI oil and $3.75 NYMEX gas. However, the rise in near-term oil prices (along with its cost savings) still benefits SM’s cash flow. As a result of the improved 2023 free cash flow expectations, its improved cost structure and repurchasing shares at a relatively low price, I have increased my estimate of SM’s value to approximately $46 per share, up from $43 per share.

Conclusion

SM Energy exceeded expectations for production in Q2 2023 and made positive revisions to both its full-year production and cost guidance. It now looks capable of generating nearly $400 million in free cash flow in the second half of 2023 at current strip prices.

SM also repurchased another 2% of its outstanding shares in Q2 2023 at a favorable average price of under $27 per share. Although its share price is near $40 now (and not as much of a value as when I looked at it in May), I still believe it has some remaining upside with an estimated value of $46 per share.