SM Energy Company — Q2 2010 Form 10-Q
Business context and reporting period. Unaudited results cover the three and six months ended June 30, 2010. SM Energy is a U.S. independent oil and gas producer. Its activity spans several U.S. basins, with 2010 drilling focused on oil- and liquids-rich projects and selected emerging plays.
Financial and operating performance
| Metric | Q2 2010 | Q2 2009 | Six months 2010 | Six months 2009 |
|---|---|---|---|---|
| Total operating revenues and other income | $211.7 million | $205.2 million | $571.8 million | $404.4 million |
| Net income (loss) | $18.1 million | ($8.3 million) | $144.2 million | ($95.9 million) |
| Diluted earnings (loss) per share | $0.28 | ($0.13) | $2.24 | ($1.54) |
| Net cash provided by operating activities | — | $270.2 million | $241.8 million | |
| Cash used in investing activities | — | $82.7 million | $199.4 million | |
| Cash used in financing activities | — | $187.8 million | $38.1 million |
All financial amounts are in U.S. dollars. Q2 production was 25.2 BCFE, or 276.4 MMCFE per day, down 11% year over year. First-half production was 50.9 BCFE, down 10%; management said output from retained properties was essentially flat after adjusting for divestitures. Q2 oil and gas production revenue before hedging was $185.2 million, versus $188.6 million; higher realized prices were offset by lower volumes. For the six-month period, that revenue rose 7% to $400.7 million.
Operating profit was $4.56 per MCFE in Q2, up from $4.29, and $5.08 per MCFE for the first half, up from $4.14. Production expense per MCFE was $1.79 in Q2 versus $1.75 and $1.84 for the first half versus $1.87. G&A per MCFE rose to $1.01 from $0.64 in Q2 and to $0.96 from $0.61 for the first half; DD&A and asset-retirement accretion per MCFE increased to $3.17 from $2.49 in Q2 and to $3.10 from $2.87 for the first half.
Cash capital expenditures were $304.6 million in the first half. Sale proceeds from oil and gas properties were $248.0 million. Cash and cash equivalents were $10.2 million at June 30, 2010. Working capital was negative $111.2 million, compared with a deficit of $87.6 million at year-end 2009. Long-term debt was $271.2 million, consisting of convertible notes net of discount; the revolving credit facility had no balance at quarter-end. Total long-term debt had been $454.9 million at December 31, 2009, including $188.0 million drawn on the facility. The company reported $677.5 million of available borrowing capacity as of July 28, 2010.
Material changes versus comparable periods
- First-half net income benefited substantially from $128.0 million of divestiture gains, mainly from sales of Wyoming and North Dakota properties. The stated estimated gains were approximately $65.1 million and $50.4 million, respectively, subject to post-closing adjustments.
- First-half 2010 operating results also included a $33.9 million noncash benefit from remeasurement of the Net Profits Plan liability, compared with a $20.8 million benefit in first-half 2009. The liability was $136.4 million at June 30, 2010.
- Lower production volumes reflected prior-year reduced investment and asset sales, especially in the Rocky Mountain region. Higher commodity prices lifted realized prices and helped offset the volume decline; first-half net realized prices were $7.88 per MCFE versus $6.62.
- First-half production expense decreased 11% to $93.5 million, while G&A increased 41% to $48.9 million. No proved-property or materials-inventory impairments were recorded in first-half 2010, compared with $153.1 million and $11.3 million, respectively, in first-half 2009.
- Operating cash flow increased 12% year over year. Investing cash use was lower principally because of asset-sale proceeds, despite higher capital spending; the company used financing cash to repay credit-facility borrowings.
Outlook, commentary, and risks
- Management raised its 2010 capital-investment forecast to $871 million from $725 million, citing successful drilling results, higher industry costs, and increased partner activity and infrastructure spending in the Eagle Ford. The company planned to fund most 2010 spending from operating cash flow and asset-sale proceeds, with the credit facility funding the balance; it did not expect to access public equity or debt markets for the rest of 2010.
- Management anticipated sequential production increases in Q3 and Q4 2010, but the filing does not provide a clear full-year production target. It planned to emphasize oil and rich-gas projects, add activity in the Granite Wash and Williston Basin, test the Niobrara further, and continue Haynesville drilling. Management noted natural gas price pressure from supply and demand conditions and expected possible upward pressure on operating costs as industry activity increased.
- Hedges covered approximately 5 million barrels of oil, 46 million MMBtu of gas, and 2 million barrels of NGLs as of June 30, extending into 2013. Hedging supports cash-flow stability but can limit gains or produce losses when market prices move above contract terms. The hedge portfolio was a net asset of $13.7 million at June 30, versus a net liability of $80.9 million at year-end 2009.
- The company entered a Haynesville carry-and-earning agreement under which a third party committed $91.3 million for drilling and completion costs in return for specified acreage and well interests; SM Energy received an initial $45.6 million.
- Natural-gas gathering and transportation commitments create volume-delivery and deficiency-payment exposure. One ten-year commitment requires 100 Bcf, with disclosed undiscounted outflows of $18.0 million. A separate agreement entered July 2 could require up to $154.7 million in aggregate deficiency payments if no gas is delivered.
- The credit facility matures July 31, 2012, and convertible notes can be put to the company in 2012. Management believed it could extend or replace the facility and address the notes, but those outcomes are not assured. At June 30, the company reported compliance with covenants; its credit-agreement debt-to-EBITDA ratio was 0.64 and current ratio was 3.03.
- Risks include commodity-price volatility, drilling and reserve uncertainty, service-cost inflation, hedge counterparty and financing exposure, and potential regulation of hydraulic fracturing, greenhouse-gas emissions, and oil-and-gas operations. The filing also discusses possible new derivative collateral requirements and possible changes to tax deductions affecting the industry.
- The company was awaiting a $5.5 million tax refund tied to its 2006 return and expected the related audit to conclude in Q3 without material adjustments. It reported receiving $22.9 million on July 20, 2010, from a separate carryback claim. Divestiture sale prices remained subject to post-closing adjustments; some proceeds were restricted for potential like-kind exchanges.
Important facts for investors to verify
- Whether the revised $871 million capital program is executed as planned, particularly Eagle Ford partner drilling and related infrastructure spending, and whether anticipated production increases materialize.
- Final post-closing adjustments to the Wyoming and North Dakota sales, use of restricted Section 1031 proceeds, and the resulting tax and cash impacts.
- Delivery performance, deficiency-payment exposure, and realized economics under the gas gathering and transportation agreements, especially the separate potential $154.7 million liability.
- Hedge volumes, contract prices, settlement effects, and counterparties’ credit quality as market prices change; also monitor possible regulatory changes to derivatives and collateral requirements.
- Sensitivity of the $136.4 million Net Profits Plan liability to commodity prices and discount-rate assumptions, and the effect of its cash payments on future liquidity.
- Available borrowing capacity, covenant headroom, and refinancing or repayment plans ahead of the 2012 credit-facility maturity and convertible-note put date.