Is This Shale Play Bad News for Southwestern Energy?

Houston-based Southwestern Energy (NYSE: SWN  ) is primarily a natural gas producer, with core assets located in the Marcellus shale of Pennsylvania and the Fayetteville shale of Oklahoma and Arkansas. Despite depressed natural gas prices over the past few years, the company has been able to generate strong profits and cash flow due largely to its superior asset base and extremely low operating costs.

But despite the company's strong growth prospects in the Marcellus, roughly three quarters of its reserves are located in the Fayetteville shale, where drilling is less profitable and capital efficiency appears to be declining. Could this be a reason for concern?

Strong recent performance
Over the past three years, Southwestern's finding and development costs have averaged just under $1.50 per Mcfe, which is better than most of its low-cost peers. Only  Ultra Petroleum (NYSE: UPL  ) , whose three-year average F&D costs were just over $1 per Mcfe, Range Resources (NYSE: RRC  ) , which spent a little under $1 per Mcfe, and Cabot Oil & Gas (NYSE: COG  ) , which had F&D costs of $1.20 per Mcfe, had lower three-year average F&D costs than Southwestern.

Thanks to these low operating costs and solid production growth, the company reported record second quarter adjusted net income of $189.7 million, up 108% year-over-year, and record discretionary cash flow of $492.6 million, up 39% year-over-year. Total production grew 17% year-over-year, led by the company's Marcellus operations, which delivered year-over-year production growth in excess of 200% and 43% sequentially.

But output from the company's Fayetteville shale operations rose by just 1% sequentially and was more or less flat year-over-year. While this isn't necessarily bad per se, a closer look at the company's Fayetteville operations raises some concerns.

Trouble in the Fayetteville?
With nearly 915,000 net acres under its belt, Southwestern is one of the dominant players in the Fayetteville shale. Over the past few years, the company has done a great job in growing Fayetteville production, while keeping costs in check partly through using its own drilling rigs and developing its own midstream capabilities in the play.

But recent results point to declining capital efficiency. During the second quarter, average well costs in the Fayetteville rose from $2.1 million to $2.3 million, while average drilling days increased from 5.4 days to 6.2 days. To me, this suggests that the robust efficiency gains Southwestern saw in the Fayetteville over the past several years may not be repeatable.

Furthermore, Southwestern's finding and development costs in the play have spiked over the past couple of years. Last year, F&D costs in the Fayetteville more than doubled from 2011 levels, coming in at $2.53 per Mcf. And break-even prices in the play are now roughly $4 per Mcf, noticeably higher than in the company's Marcellus operations, where it can turn a profit with prices as low as $3 per Mcf.

It's not so bad...
To answer the question posed at the onset, Southwestern's sizable exposure to the Fayetteville shale, which is less economical than the Marcellus, is probably not a major cause for concern. For one, despite having drilled heavily in the Fayetteville over the past few years, the company still has a deep inventory of drilling locations left in the play.

And while its true that the majority of these wells will be less economical, requiring $4 per Mcf gas prices to generate a sufficient pre-tax rate of return, Southwestern estimates that it still has about two years worth of drilling inventory that can generate strong profits at $3 gas. Furthermore, the company has ample room to grow or curtail drilling in the play, given that most of its Fayetteville acreage is now held by production.

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