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SM Energy Trips on Eagle Ford Infrastructure, But Permian Holds Promise

Infrastructure constraints during the second quarter put a crimp in SM Energy Co.'s operated Eagle Ford Shale output, prompting the Denver-based company to divert some capital to the Permian Basin, where getting production to market is easier for the time being. And a steep drop in net income pummeled the Denver-based producer's shares.

The company's operated net production in the Eagle Ford averaged 207.1 MMcfe/d, a 16% increase from first quarter production of 178.3 MMcf/d. During the second quarter SM Energy ran six rigs on its operated Eagle Ford acreage with most drilling on multi-well pads. The completion schedule is weighted toward the second half of the year.

During the first half of 2012 the company completed 26 wells in the operated Eagle Ford program. Production in the second quarter was impacted by downstream pipeline curtailments in April and further constrained by continuing delays in the installation and start-up of new field production batteries on the third-party operated gathering system, the company said.

"These delays are being caused by later-than-expected deliveries of equipment resulting from increased industry demand. Based on the current schedule for delivery of midstream equipment, the company now expects to complete 67 wells in 2012," the company said.

Wells Fargo Securities analyst David Tameron said in a note that while the company's Eagle Ford volumes were lower than the company had forecast, they were in line with what his firm was expecting.

Phillip Jungwirth, an analyst with BMO Capital Markets, wrote that while the Eagle Ford takeaway constraints are "disappointing," they are "a timing issue and [we] think the more important aspect is operated Eagle Ford results appear to be strong, with production up 16% quarter/quarter, which we view as solid growth considering only 26 wells were turned online in 1H12."

On Thursday, though, investors appeared to be focused on the short term where SM Energy was concerned. Shares had plummeted 15% by midday, breaching the stock's previous 52-week low of $43.12 to trade down to $39.44 before rebounding to close at $41.80, down nearly 12% for the day. Volume was about five times the norm.

SM Energy reported net income for the second quarter of $24.9 million (37 cents/share) compared to net income of $124.5 million ($1.86/share) for the year-ago quarter. Adjusted net income was $5.9 million (9 cents/share) compared to $61.1 million (91 cents/share) year-ago quarter.

Jungwirth wrote that the 9 cents earnings per share missed BMO's projected 14 cents and the Street consensus of 23 cents.

Earnings before interest, taxes, depreciation, depletion, amortization, accretion, and exploration expense were $213.7 million, down from $242.4 million for the same period of 2011. Revenues and other income for the second quarter were $304.4 million compared to $377.9 million for the same period of 2011, a 19% decrease.

Another disappointment was that during the second quarter SM Energy withdrew its sales package of Denver-Julesburg Basin assets from the market after receiving offers deemed to be inadequate. Accounting guidance required that the assets be recorded at the lower of cost or market when reclassified as "held and used," which resulted in a $28.3 million non-cash loss on divestiture activity for the quarter.

SM Energy also recognized an impairment of proved properties of $38.5 million, primarily related to its Haynesville Shale assets. It also recorded a charge to abandonment and impairment of unproved properties of $10.7 million, primarily related to an exploratory program in its Rocky Mountain region.

SM Energy reported quarterly production of 50.6 Bcfe, or an average of 555.7 MMcfe/d, which was within guidance and represented a decline from 50.7 Bcfe in the first quarter due to declines in dry gas producing areas and divestitures that were not fully offset by production growth.

Jungwirth noted that second quarter production growth was 2.3% below the 568.9 MMcf/d BMO was expecting and at the low end of the company's guidance. SM Energy cut its full-year production guidance to 573-593 MMcf/d from 601-620 MMcf/d due to the takeaway constraints in the Eagle Ford.

"While the Street is likely to focus on the negative combination of lower production and higher capex caused by temporary takeaway constraints in the Eagle Ford, we think from a valuation perspective the positive Permian [horizontal] Mississippian (Northern Midland Basin) results are the bigger story," Jungwirth wrote.

During the first half of 2012 SM Energy increased its acreage in the Permian Basin by 27,700 net acres and increased its development rig count in the basin to three. During the second quarter one of the rigs was focused on Mississippian Limestone development in the northern Midland Basin where the company has seen "encouraging results" with recent wells, it said.

SM Energy operated a rig in a recently acquired acreage block near Midland, TX, and completed a horizontal well in the Leonard Shale. The well is flowing back and a second well is being drilled. The company also completed a Bone Spring development well on acreage it holds in New Mexico and is drilling the second well of a multi-well program in that play. At the beginning of the third quarter, the company added a second rig to its Mississippian Limestone development program, increasing its total operated rig count in the Permian Basin to four.

"With investors giving SM no credit for this [Permian] acreage, we view [recent Permian well performance] having a larger impact than weak production caused by midstream, which has a minor impact on our net asset value," Jungwirth wrote.

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