Good day, and thank you for standing by. Welcome to SM Energy's 2021 financial and operating results and 2022 operating plan Q&A call. At this time, all participants are in a listen-only mode. To ask a question during this time, you will need to press star one on your telephone keypad. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Jennifer Samuels, VP of Investor Relations. Please go ahead.
Thank you. Good morning, and thank you for joining us for our question and answers call. To answer your questions today, we have our President and CEO, Herb Vogel, and CFO, Wade Pursell. As always, I will remind you that our discussion today may include forward-looking statements and discussion of non-GAAP measures. I direct you to slide 2 of the accompanying slide deck, page 8 of the accompanying earnings release, and the Risk Factors section of our most recently filed 10-K and 10-Q, which describe risks associated with forward-looking statements that could cause actual results to differ.
We will also refer to non-GAAP measures. Please see slides 30-33 in the accompanying slide deck and pages 15-23 of the accompanying earnings release for definitions and reconciliations of non-GAAP measures to the most directly comparable GAAP measures and discussion of forward-looking non-GAAP measures. Also, look for our 2021 10-K filed this morning. With that, I will turn it over to Herb for brief opening commentary.
Thanks, Jennifer. First off, I want to acknowledge the gravity of current events. Our prayers go out to the people of Ukraine. Oil and gas are central in geopolitics, and SM Energy is positioned to maintain a sustainable long-term plan under a range of macroeconomic scenarios while recognizing the importance of providing reliable, affordable energy. Second, I would like to add some color regarding the oil production component of our guidance. Importantly, I will reiterate something we say every quarter. Production and the components of oil, NGLs and gas are outputs of our three-year plan to optimize free cash flow. Our 2022 plan is expected to roughly double free cash flow over 2021, delivering a highly attractive free cash flow yield. Two things are going on at the same time in the 2022 plan that impact our oil rates.
One, the increased allocation of capital in South Texas, 45% versus 35% of CapEx last year, moves the production mix to more natural gas and NGLs than in 2021. Two, we had unique quarterly phasing of Midland completions last year and this year, which was the result of the Texas freeze in the first quarter of last year. Some key points to keep in mind. We completed a total of 64 net wells in Midland in the second and third quarters last year. The subsequent two quarters, we complete nine wells in the Midland Basin. The first-year decline rate on new wells is approximately 75%-80%. You will simply have a decline in Midland production in the first half of 2022.
New Austin Chalk wells will, on average, have a projected mix of 42% oil, 30% NGLs, and 28% gas. The increased capital allocation to South Texas therefore contributes to higher gas and NGLs, changing the mix at the company level. In addition, I will repeat Wade's comment from yesterday that our 2022 capital spend includes a good portion of the capital for 20 wells in the Midland Basin that will not turn in line until early 2023. Again, it's timing that will affect the oil percent in 2022. As we have demonstrated with actual well performance, the returns in our Austin Chalk compete with the Midland Basin. As shown in the deck, our 2021 Austin Chalk wells are expected to have an average nine-month payout per well.
Development of the Austin Chalk is a sizable opportunity to build NAV and realize that value creation for shareholders. Again, free cash flow is expected to roughly double year-over-year because we have a highly efficient, high-return operating plan where production is an output. Thank you, and I will turn it back to the operator to take our first question. Deb?
Ladies and gentlemen, if you would like to ask a question, you can press star one on your telephone keypad. Your first question comes from the line of Gabe Daoud with Cowen.
Thanks. Morning, everyone. I was hoping we can maybe just dig in a little bit more on the guide. I appreciate all the remarks last night and your comments just now, but just trying to get a sense of, you know, what's baked in from a conservatism standpoint, whether it's, you know, PDP downtime for offset fracs or just kinda how you handicap weather events or just trying to get a sense because at first blush, just given, you know, the improved Austin Chalk program, obviously, Midland wells getting better, I would have thought even with the increase in Austin Chalk capital allocation, that the oil volumes would have been a little bit better to what you'd guided to. Could you maybe just give us a little bit of comfort around how much, if at all, conservatism is baked in the guide?
Yeah, Gabe. This is Herb. We just have basically assumed normal events, normal performance. We don't really do anything where we steer something in one direction conservative or aggressive in any way. It's what our well performance is expected to be, and then if we have outperformance, like new completion designs, you know, it's we've been very fortunate with those Midland Basin wells on how well they've performed with normal weather. We do assume a certain number of offset fracs from offset operators, where we have to shut in. And sometimes there's more, sometimes there's less, and those can influence. In the fourth quarter, there were less offset fracs from offset operators, and that helped us. We also had really good weather in the Midland Basin. Those are really the key things. We don't do anything in terms of trying to be conservative or trying to be aggressive.
Okay. Thanks, Herb. That's helpful. Then, regardless of what the production output is, as you mentioned, it is just at an output of your capital allocation framework. There's still a lot of free cash flow coming. Could you maybe just talk about, you know, once you get to your leverage targets, whether it's the 1x net debt to EBITDA figure, which, you know, we think you kinda get there next quarter, could you maybe just talk about steps or use of free cash flow once you get there? Any thoughts around capital return to equity holders?
Well, Gabe, I'll start on this one, then I'll hand it over to Wade. I would just say we're just really pleased with how fast we've got to this point. We are way beyond our expectations. We've gotten a tailwind with commodity prices, but just the performance of both the chalk and Midland Basin has really enabled us to be at this point much faster than we ever expected. We are obviously thinking about what are the best means for return of capital to shareholders over time. I'll turn it over to Wade to just give some thinking about it from our perspective.
Yeah, sure. Yeah, good question. I'll just kinda reiterate, you know, a few guideposts that we laid out, I think, last quarter for the first time, and then actually mentioned it again on the call yesterday. As Herb mentioned, we are getting there quicker, which is very exciting. I think we mentioned that, you know, de-levering is really important to us, and we're pleased how that's going. We wanna get down to 1x , but we also look at absolute debt is very important as well. We said one in one, basically. Get down to 1x and $1 billion of absolute debt. As you mentioned, the 1x , assuming the macro hangs in there, is coming pretty quick.
You know, sometime around the middle of this year, probably. The $1 billion , I think I mentioned, looking at our forecast, just assuming, you know, the prices that we assumed, which are somewhat conservative compared to today's strip, but looks like something toward the end of this year or maybe early next year. So it is on the horizon. We'll start considering, as we get close to that, what the right options are, and that certainly includes meaningful dividend or potentially buyback program. People love to ask which one of those, and I think it's too early to declare which one of those we think would be the appropriate one.
I think stock valuation is a big factor in that compared to NAV at the time. That would be a factor when we start contemplating those decisions. You know, just to add color to that, if we were considering it today, I think it shouldn't shock anybody to assume we might be leaning toward buyback given our view of the stock valuation versus NAV, but that's a theoretical answer today. I think it'll be a more prudent answer when we get closer to the reality.
Thanks, Wade. That's a great color. Just before I go, so just to confirm, there's no difference in the way, you know, you issued or, you know, prepared 2022 guidance versus years past, right? Thank you.
Same consistent approach.
Awesome. Thanks, guys.
Your next question comes from William Howell with Stifel.
Hey, good morning, guys, and congrats on the quarter. My first question is on inflation. In the prepared remarks, you mentioned that you have about 15% inflation baked into well costs. I'm wondering if you could talk a little bit more about where you're seeing that and how much efficiency gains are factored into that.
Hey, thanks, William. Yeah, definitely the topic of the year, inflation. You've probably seen that, you know, activity did ramp up to some degree last year. When we look at the supply chain, we're well-positioned in terms of having availability of everything we need, definitely through the first half. Almost everything's locked in for us, so we know what those cost increases are over last year, and we baked in that 15%. The areas where we're seeing inflation, obviously, like diesel. Clearly with oil prices up, diesel prices are up. Steel prices are up. Labor, trucking, those sorts of things. Not as much on the drilling rig side or on the completion spread side if you run a continuous program and lock in the contracts.
Overall, we don't know what the geopolitical events recently are gonna do to the supply chain. That's an unknown. We did bake in 15%, which seemed reasonable based on what we were seeing right at the year-end.
Okay, got it. Thank you. My other question is on the decision to allocate almost half of the capital to South Texas. Can you talk a little bit more about the kinda long-term economics that you see there and how that stacks up against the Midland Basin?
Yeah. That's what we're really pleased about. We've shown over time now we have 40 Austin Chalk wells producing. Based on the results that we're seeing in the commodity price environment we had at the end of last year, start of this year, that there are comparable returns. We saw a big potential NAV addition from getting recognition for the Austin Chalk. We've allocated 10% more of the capital to the chalk than we had last year. We went from 65%-35% to 55%-45% to accelerate that recognition of the chalk. The returns are very comparable between the two. The commodity mix is somewhat different, but the returns are the same.
Great. Thanks.
Your next question comes from Zach Parham with JPMorgan.
Thanks for taking my question. Just a follow-up on the oil guide. You know, maybe could you talk a little bit about your base decline rate for oil as of year-end? You know, really just trying to reconcile that, the 1Q guide that at the midpoint implies an 18% sequential decline in oil during a quarter when you're still gonna turn in line, I think around 15 wells.
Hey, Zach, I think I heard your question there. You know, we showed in the slide deck that year-over-year, our base decline on a BOE basis is 38%. The key here is that in the second and third quarter last year in the Midland Basin, we turned on 64 wells. In the fourth quarter, we turned on four, and in the first quarter, we turned on five. Those wells that started up in Q2 and Q3, they're on a 75%-80% annual decline like normal unconventionals. You'll see a relatively rapid decline. While the base is at a certain decline, like 38%, those new wells are on more rapid decline.
Since we don't have a ratable program because of that freeze event last year, that's why you're seeing this dip in the first half of 2022, and then you'll see it come back around. It's really the quarterly phasing of oily Midland wells versus the gasier NGL rich Austin Chalk wells.
Got it. Thanks for that color. I guess one, just following up on Gabe Daoud's question on cash return, you've got the one turn of leverage and $1 billion debt target out there for the balance sheet. You know, do you wanna reach both of those before considering cash return, or would you consider some level of cash return while also reducing leverage, once you've hit one of the targets?
Yeah, I would. Good question. I would say, generally speaking, we wanna reach both. We put them both out there as a target. It doesn't mean once we reach one and start approaching the second one, we wouldn't start considering something in the meantime, I guess, is the way I would say that.
Got it. That's helpful. Thanks a lot.
If you'd like to ask a question, please press star one on your telephone keypad. Your next question comes from Karl Blunden with Goldman Sachs.
Hi, good morning. Thanks for the time. Didn't hear a lot of discussion about M&A. With the balance sheet now in better position, when does that come into consideration, if at all?
Yeah. Karl, thanks for that question. You know, the M&A, we've been pretty consistent over time, and we really don't see any need for a change in our position there. First of all, you know, we're open to looking at somebody approaches, and we're open to considering an acquisition that makes sense. When we say makes sense, what are we talking about, really? It has to have really high-quality assets. The high returns that we have in our portfolio, we don't wanna diminish the portfolio or where you wouldn't be able to drill the acquired acreage for several years out, 'cause the returns aren't there.
Second, have to be comparable from a leverage standpoint, so not basically levering us up significantly. Then from a earnings standpoint, cash flow standpoint, it should be accretive. Those are really our criteria, asset quality, you know, not impeding us from a leverage standpoint, and then helping us out on the cash flows standpoint. We're open.
That makes sense. You outlined and reiterated this plan for about $1 billion of debt reduction, which is encouraging. When you think about the different parts to get there, you have a couple different opportunities. You have some bonds due in 2025, some in 2026. Some of the 2025 bonds have higher call prices. How do you go about prioritizing, you know, taking on high coupons versus paying high call prices? Just interested in how you do those NPV calcs internally.
Yeah, sure. Great question, and you kind of outlined a summary of it. We'll just kind of walk forward as we move through the year generating free cash and, you know, take out the notes that make the most sense from a math standpoint. Also, you know, now, obviously, I've mentioned in the past, you know, the second lien notes, you know, we have a high desire to get those out of the capital structure. They become callable in about four months. Those are a target. You know, we'll run math on that as we get closer.
You know, the 2025 unsecured notes, as we approach mid-year, callable at 100, you know, they get down to 100.9, I think, when we get to the middle of the year. Then moving on into this, you know, the 2026 notes, by the time you get those paid off, we're always gonna have compelling options with the cash to get debt down to the level we desire to get to. Hopefully, that helps.
Yeah, that's helpful. Thanks very much for the time.
Your next question comes from Nicholas Pope with Seaport Research.
Morning, everyone.
Morning.
I was hoping you could talk a little bit about Austin Chalk performance down in South Texas, and maybe, you know, really understanding how consistent the results have been. It feels like that's been a knock on the formation, you know, across Texas and Louisiana in the past, is kinda consistency and repeatability of performance. I guess maybe what's changed there and how has performance kind of. What's that spread look like as you kind of have a much bigger output of wells?
Yeah, Nicholas, that's a great question, and I'll give you kind of a long answer to that. First of all, just starting with the consistency of the Austin Chalk across our entire position. You know, we had 600 wells drilled to the Eagle Ford through the Austin Chalk, so we can map it extremely well. Then we have core, and we also have done an enormous amount of seismic data, and we're going to get more seismic data. We have not yet optimized the completion. But when you look at our results, you have to consider two big factors. One is there's variation in the fluid quality, so from the northwest, it's oilier, and it gets progressively gassier and NGL rich as you move east and south, as it gets deeper and higher pressure.
The variability there is going to be fluid type variability, and that's fine, very predictable. The other is the lateral lengths will vary. What we really look at is the per 1,000 lateral feet performance. There it's much narrower, a P10/P90, than you would have seen from the Austin Chalk that I would have been developing in East Texas in the late 1980s. A lot of people say, "Well, Austin Chalk, you know, it's not predictable." Here it is actually quite predictable and it's the properties are quite uniform compared to the days of old, which were more a fracture system that was unloading for the wells. Here, it's much more consistent. I hope that helps.
Yeah, that's great, actually. I mean, you guys have kind of outperformed my model for four quarters in a row. Just trying to get a little understanding of how repeatable that is. I appreciate the time. That's all I had. Thanks.
Sure. Thanks.
We have no further questions in queue at this time. I would now like to turn the conference back over to Herb Vogel, President and CEO, for closing remarks.
Okay. Thank you, Deb, and thank you all for joining us. Best wishes for the rest of the year.
Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation. You may now disconnect your lines.