Bakken Update: SM Energy's High Gas Production Is A Worry Going Forward

| About: SM Energy (SM)

SM Energy (NYSE:SM) missed EPS estimates of 50 cents/share, coming in at 48 cents in Q1 of 2012. Although it missed, production and costs were all within guidance. Given the lower price of natural gas, SM is allocating 95% of its drilling and completion capital to liquids projects. SM has done a very nice job of keeping costs in check. It came in at the bottom end of guidance on DD&A, and was well below guidance on its LOE. Both of these numbers, especially DD&A, have been high with respect to companies operating in the Bakken.

SM's production is still 56% gas, but it is growing quickly and expects a 50/50 split between gas and liquids by 2014. This growth is predominantly from the Eagle Ford, Bakken/Three Forks and Granite Wash. SM is increasing its usage of pad drilling, which should continue to aid in cutting costs. The company estimates this will be $500000 to $600000/well on a three well pad.

SM's top play is the Eagle Ford. It has 149000 net acres in its operated program, with a majority located in the rich gas window. SM has anticipated a frac stage cost decrease in 2012. An estimated savings of 20% is anticipated year over year. This will be used to increase frac density and increase production/well. Drilling costs should also decrease as well. SM plans to decrease the number of rigs in its operated Eagle Ford play from 6 to 5, due to an increase in pad drilling.

Efficiencies will allow for a decrease in rigs without a loss in production or number of wells drilled. Keep in mind, its operated program is 56% gas as opposed to about 29% in its non-operated acreage. Its non-operated Eagle Ford acreage saw a 9% increase in production quarter over quarter. This was accomplished after a sale of 12.5%, which shows the strong growth generated by Anadarko (NYSE:APC).

SM has some very good acreage in the Bakken. It has 15000 net acres at the Bear Den prospect, in northeast McKenzie County. It also has an additional 37000 net acres in Raven, which is also in McKenzie County but further west. These two areas should produce very good wells going forward. Here are some of its more recent well results:

  1. Nora 13-9H: Had an average oil production of 648 Bo/d over the first 111 days of production (Poe Field)
  2. Leiseth 1-24H: Had an average oil production of 726 Bo/d over the first 90 days of production (Poe Field)
  3. Stepanek 1-18H: had an average oil production of 250 Bo/d over the first 132 days (Elk Field)
  4. Hauge 13-21H: had an average oil production of 448 Bo/d over of the first 95 days (Ambrose Field)
  5. Wolter 13-23H: had an average oil production of 501 Bo/d over the first 112 days (West Ambrose Field)
  6. Dahl 4-27H: had an average oil production of 509 Bo/d over the first 123 days (West Ambrose)

All of these wells did better than I thought, except for the Stepanek well which must have had some issues given its low production rate. All of these wells are long laterals, with only one that wasn't completed with a 20 stage frac. Given the low number of stages, it would seem SM is doing a very good job of completing its wells. The first two wells are in Poe Field, which has had excellent well production in both the Bakken and Three Forks pay zones. Its Divide County wells are quite good, and focus on Three Forks production. Divide wells are $1.5 to $2 million cheaper than other areas.

This could be why Magnum Hunter (MHR) purchased Baytex's (NYSE:BTE) non-operated acreage in the area. SM is adding a rig for a total of four in the second quarter of 2011. Although there has been no official announcement as to where, it could be assumed it will be deployed in the Bear Den as it is the best acreage. It is also increasing its participation non-operated wells. Not only is SM getting better production per well, it is also improving proficiencies. As it ramps its pad drilling, zipper fracs will continue to save time and money.

Its total Bakken focus area is 87000 net acres. SM's total acreage is 202000 net acres, but most of the non-focus area is held by production. I would also note, it does have acreage in Billings County, which in a recent lease sale garnered $5000/acre. SM is currently marketing some non-operated acreage for monetizing. It has no plans to sell operated acreage already HBP.

On a side note, SM also is having success in the Granite Wash and has three rigs running. It has deployed one well in the Permian and Niobrara. I like its position in these areas, but focus will continue to be the Eagle Ford, and Bakken.

Commenting on natural gas liquids pricing, propane and ethane prices are down. Although lower, it would seem the tape is quite strong especially with respect to propane. Ethane is 48% with propane 25% of natural gas liquids production. Prices should continue to improve, but right now demand has waned somewhat. Even if prices continue downward, it would not affect rate of return much.

SM Energy is a good company with a very good balance sheet. It has seen a much improved production per well without increasing the number of stages. Decrease costs will be pushed into well completions to increase the number of stages, which should improve production going forward. Its Divide County wells have been a big surprise, and it sounds like these wells will also improve. Although SM is not targeting its Billings County acreage, this could be one of its better areas, given the very good results coming from the Pronghorn.

I am a little worried about its high natural gas production. I don't think we will see natural gas prices at $4 until late next year. This is just an estimate, but it will take time for the decrease in natural gas drilling to affect supply to the extent needed to push prices higher. On a positive note, I do think the price has bottomed. I would tread lightly here in the short term, but SM is probably a very good long term buy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: This is not a buy recommendation.