SM Energy Company

Moat: 2/5

Understandability: 3/5

Balance Sheet Health: 3/5

SM Energy is an independent oil and gas company engaged in the acquisition, exploration, development, and production of oil, gas, and NGLs, primarily in Texas.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

SM Energy is an upstream energy company, focusing on oil and gas exploration and production. This makes it subject to the cyclical nature of commodity prices and dependent on its operational efficiency.

Business Overview

SM Energy is an independent oil and gas company, which means that they are not integrated with other parts of the energy business like refining or distribution and therefore dependent on the price of the commodity itself. They engage in the exploration, development, and production of oil, gas, and natural gas liquids (NGLs).

Revenues are derived from the sale of these commodities. SM’s operations are primarily in the Midland and South Texas regions.

Revenue Distribution

  • Oil, Gas, and NGLs Production: The company’s primary revenue source is the sale of oil, natural gas, and NGLs. Revenue from the three segments are highly intertwined because of the exploration process.

    • In 2023, Oil revenue was 51.8% of total revenue, NGL revenue was 13.5%, and natural gas was 34.6% of total revenue.

  • Marketing: SM Energy Company also receives revenue from the marketing of their production.

    • In 2023, marketing and other accounted for 1.3% of total revenues.

  • Geography: Operations are concentrated in the Permian Basin in West Texas (Midland Basin and Delaware Basin) and in South Texas.

The oil and gas industry is known for its high capital intensity, competition, and vulnerability to commodity price swings. Prices are set on global markets, but production, exploration, and acquisition costs are specific to a company’s operation.

  • Cyclicality: Oil and gas prices are subject to cyclical swings driven by global supply and demand, economic activity, and geopolitical events. This creates considerable earnings volatility.
  • High Capital Intensity: Developing and operating oil and gas fields requires substantial capital investments, making access to capital critical.
  • Intense Competition: The industry is highly competitive, with many players seeking to discover, develop, and produce oil and gas.
  • Regulation: The industry faces significant regulation related to environmental protection, production limitations, and safety.
  • Technology: Technological innovation is essential for improving efficiency, reducing costs, and increasing production. Innovation happens rapidly in this sector, so companies must adapt often.

What Sets SM Energy Apart?

  • Geographic Concentration: The company’s focus on the Permian Basin and South Texas allows for operational efficiencies and specialization in those regions.
  • Well-Positioned Assets: SM Energy has established a position in high-returning oil-producing regions.
  • Hedging Program: SM Energy uses a hedging program to protect some of its revenues from price volatility, allowing them to smooth out fluctuations in their cash flow.
  • Focus on returns and efficiency They try to keep the cost of extracting oil and gas very low.
  • Debt Management SM Energy Company has been working on keeping debt at manageable levels.

Financial Analysis

SM Energy’s financials are highly impacted by changes in commodity prices. Therefore, when you analyze a company like this, you must adjust to that.

Profitability and Margins

  • Revenues: Revenue fluctuates depending on the prices of the commodities. Revenues have steadily increased YOY from $1.79 billion in 2020 to $3.41 billion in 2022, but declined to $2.94 billion in 2023.
  • Profitability: The company’s net profit margin was 22% for the full year 2023 and 30% for the quarter ended September 30, 2023, so even though revenues declined from 2022 to 2023, they were still profitable.
  • Operating expenses The average opex for the year is around $87/boe. The company also continues to improve the efficiency of its drilling operations by producing more per well.

Liquidity and Capital Resources

  • Cash Position: The company had total cash of about $492 million at the end of Q3 2023.
  • Debt: They are working towards reducing debt and have around $1.9 billion outstanding. The company has significantly improved its balance sheet compared to just 5 years ago, so there is clear improvement on the debt management front.

Earnings Call Insights

  • Management has focused heavily on returns and cash flow generation, rather than simply maximizing production volume. They have been reinvesting back into the company.
  • They are actively working on their debt reduction targets.
  • Management is expecting high growth in the next few years.
  • They believe there are still more opportunities in the Permian Basin to reduce well cost per boe and increase production.
  • They have been working towards reducing their carbon emissions.
  • Management believes they have a strong inventory of high-quality low-cost locations.
  • They are focusing on cost control and efficiency gains.

Moat Analysis

Moat ratings are a qualitative judgment about a company’s ability to generate value over a long period. They indicate how easily a company’s economic position can be challenged.

  • 1/5 Moat: SM Energy has a limited economic moat. Their competitive advantage is primarily based on geographic proximity to high-producing basins and their operational efficiencies, which they are actively pursuing.
  • Why? While access to the Permian Basin is valuable, they do not control a large area. They have to continue investing a lot of money for exploration and maintenance. All their competitive advantages can easily be replicated by competitors. They are a commodity producer, so differentiation and the formation of a brand are very difficult.
  • Economic moats are based on:
  • Network economics: SM Energy does not have any network economics, where a product or services value increases with the number of people using it.
  • Intangible assets: The company’s brands, patents, or regulatory licenses are not strong enough to defend against competition.
  • Switching costs: It is very easy for consumers to switch providers of oil and gas.
  • Cost advantages: SM Energy has only operational advantages, nothing that can lead to a sustainable cost advantage.

Risks to the Moat and Business Resilience

Moats are not set in stone, they can erode, and new threats can emerge. A sound analysis includes an assessment of vulnerabilities.

  • Commodity Price Volatility: The primary risk is the fluctuation of oil and gas prices, which directly affects revenues and profitability.
  • Geopolitical Risk: Supply of oil and gas can vary due to geopolitics. Also, regulations can change at any time and severely hamper future growth.
  • Operational Risks: Like any mining-related business, there is always some degree of operational risk, and a lot of money is spent for maintenance of the existing assets.
  • Competition: Intense competition can drive down prices and reduce margins, especially if new entrants introduce better processes and technologies.
  • Limited Diversification: As of now, almost all of their operations are in Texas. This does not provide much diversification.
  • Transition to renewables: The transition towards greener sources of energy could potentially hurt the demand and future prices of oil and gas.
  • Management risks Changes in management or strategy could negatively affect the company’s performance and investor confidence.
  • Increased operating expenses Increased costs to obtain and produce oil and gas could greatly diminish profits

Understandability

  • 3/5: Understanding an energy company requires some degree of familiarity with commodity markets, geographical operations, and financial statement analysis, making it somewhat complex.
  • Why? While their core business of exploration and production is not incredibly difficult to understand, their financials can get complex and fluctuate a lot due to commodity prices, which can be confusing to newer investors. Further, they have debt, leases, and hedges that are difficult to analyze.

Balance Sheet Health

  • 3/5: The balance sheet is getting better, as the company continues to focus on debt reduction, but it is still important to keep a close eye on this.
  • Debt: The debt is still quite large relative to the size of the business and a debt-laden company is exposed to high volatility because of the cyclical nature of the industry. However, this debt is being actively reduced.
  • Current ratio: Current assets are about 2.3x the size of their current liabilities so they are more than capable of handling them
  • Liquidity: The cash position is decent with around $492 million in cash.
  • Debt-to-equity ratio: Debt-to-equity has reduced and is now around 0.8x, however, they need to manage their debt further to solidify their financial position.

Conclusion

SM Energy is a company in a difficult industry that still manages to generate a profit and has been focusing on increasing returns. It remains a highly volatile business because of its commodity pricing. They have to continually acquire new locations to continue production. They are making a conscious effort to improve operational efficiencies and their balance sheet, which should lead to more stable long term operations. While they do have some competitive advantages, it can easily be imitated. Therefore, the company needs to be viewed with constant scrutiny to protect the interests of an intelligent investor.