SM

Business Context and Reporting Period

Company: St. Mary Land & Exploration Company (Note: Metadata referenced "SM Energy Co," but the filing text identifies the registrant as St. Mary Land & Exploration Company).

Reporting Period: Fiscal year ended December 31, 2005.

Business Overview: An independent oil and gas company engaged in exploration, exploitation, development, acquisition, and production of natural gas and crude oil. Operations are concentrated in five core U.S. regions: Rocky Mountain, Mid-Continent, ArkLaTex, Gulf Coast, and Permian Basin. The company focuses on building stockholder value through reserve growth and production increases, emphasizing a "drill bit" strategy over acquisitions.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Total operating revenues increased 71% to $739.6 million, driven by a 16% increase in production volumes and a 49% increase in average net realized prices (to $8.14 per MCFE).
• Profitability: Net income rose 64% to $151.9 million. However, this was partially offset by a significant $106.3 million expense related to the change in the Net Profits Plan liability, compared to $24.4 million in 2004.
• Reserve Growth: Proved reserves increased 21% to 794.5 BCFE. The PV-10 value surged 66% to $2.5 billion, reflecting both volume additions and higher commodity prices used in valuation.
• Debt Reduction: The company repaid all $37.0 million of borrowings outstanding under its revolving credit facility at the beginning of the year. As of year-end, no borrowings were outstanding under the credit facility.
• Acquisitions: Spent $87.8 million on acquisitions, primarily Agate Petroleum, Inc. ($40.0 million) and Wold Oil Properties, Inc. ($37.1 million).

Guidance, Outlook, and Risks

2006 Outlook

• Capital Budget: Total budget of $600 million, with $500 million allocated to drilling and $100 million to acquisitions. This represents a 42% increase over 2005 spending.
• Production: Management anticipates production in 2006 to be greater than in 2005.
• Costs: Expecting increased production expenses due to higher activity in the Rocky Mountain region, increased production taxes, and general inflation.

Management Commentary

Management emphasizes a shift toward growth through drilling rather than acquisitions. The company maintains a strong balance sheet with a low debt-to-capitalization ratio (15%). They have hedged a significant portion of anticipated future production through 2011 using zero-cost collars and swaps to manage price volatility.

Risks and Contingencies

• Commodity Price Volatility: Revenues and profitability are heavily dependent on oil and gas prices.
• Net Profits Plan Liability: The liability is highly sensitive to price assumptions and discount rates. A 10% change in prices could alter the liability by approximately $26 million.
• Regulatory/Environmental: Potential delays in the Hanging Woman Basin coalbed methane project due to water development plan approvals in Montana and sage grouse stipulations in Wyoming.
• Reserve Estimates: Reserve quantities are inherently imprecise and subject to change based on production history and commodity prices.

Investor Verification Checklist

• Net Profits Plan Liability: Verify the assumptions (discount rate, price forecasts) used to calculate the $136.8 million liability, as this is a significant non-cash expense driver.
• Hedging Strategy: Review the specific terms of the zero-cost collars and swaps entered in late 2005 to understand the price floors and ceilings protecting future cash flows.
• Capital Expenditure Execution: Monitor the ability to execute the $500 million drilling budget in 2006 given potential rig shortages and service cost inflation.
• Regulatory Approvals: Track the status of regulatory permits for the Hanging Woman Basin project, specifically regarding water disposal and environmental stipulations.
• Convertible Notes: Note the $100 million 5.75% Senior Convertible Notes due 2022, which are convertible at $13.00 per share and could impact share count if converted.