Southwestern Energy (SWN -0.14%), the Houston-based independent energy producer, reported solid first-quarter financial results on Thursday. Let's take a closer look at some important highlights from the quarter and why the company's improving cash flow and massive opportunity in Colorado's liquids-rich Niobrara shale bode well for its future.

Photo credit: Chesapeake Energy.

First-quarter highlights
Southwestern reported record adjusted net income of $231.4 million, or $0.66 per diluted share, for the first quarter, up 58% from $146.0 million, or $0.42 per diluted share, in the year-earlier period. Operating revenues came in at $1.11 billion, up from $0.73 billion in the first quarter of 2013. The sharp year-over-year improvement in earnings was due largely to strong production growth and sharply higher average realized natural gas prices.

Southwestern's first-quarter oil and gas production came in ahead of guidance, surging 23% year over year to a record 182.0 Bcfe. This growth was driven almost entirely by the company's Marcellus shale operations, where output surged nearly 150% year-over-year to 58 Bcf. Including hedges, the company realized an average gas price of $4.19 per Mcf during the first quarter, up nearly 23% from an average price of $3.42 per Mcf in the year-earlier quarter.

At the same time, Southwestern maintained its position as one of the lowest-cost operators in the industry, with a first-quarter all-in cash operating cost of $1.36 per Mcfe. While that's up meaningfully from $1.18 per Mcfe in the first quarter of 2013, investors shouldn't be too worried. That's because the increase is due largely to higher natural gas prices and accelerated activity in the Marcellus, which resulted in higher lease operating expenses and higher taxes as expected.

Improving cash flow with protected downside
As a result of impressive growth in production and higher gas prices, Southwestern's E&P segment saw its operating income double from $176 million to $352 million in the quarter, while operating cash flow surged 45% year over year to a record $617 million. That easily exceeded the company's first-quarter capital spending of $542 million, allowing it to generate $75 million in free cash flow during the quarter.

Stronger cash flow generation helped the company reduce its long-term debt from $1.95 billion as of year-end 2013 to $1.83 billion as of the end of the first quarter. As a result, Southwestern's debt-to-total book capitalization ratio improved to 32%, down from 35% as of the end of last year, and is expected to improve to 28% to 30% by year-end 2014 at current strip prices.

Southwestern is also attractively hedged, with 349 Bcf, or roughly 61%, of its remaining 2014 expected natural gas production hedged through fixed price swaps at an average price of $4.35 per Mcf. This not only provides considerable downside protection but also leaves some room for the company to benefit if gas prices exceed expectations over the remainder of 2014.

Huge potential upside in Colorado
Even though Southwestern's biggest driver of production growth over the next few years will be the Marcellus, which accounted for 32% of companywide volumes in the first quarter, up from 16% a year earlier, the company's liquids-rich acreage in northwest Colorado's Niobrara shale and eastern Colorado's Denver-Julesburg, or DJ, Basin could prove crucial in augmenting this growth.

To get a better understanding of the commercial potential of these assets, the company expects to begin a drilling program in June that will entail drilling four vertical test wells and one horizontal well in the Niobrara. The five wells will target a 400-foot section in the play's rich condensate oil window. Southwestern also plans to spud its third well in the DJ Basin in May, as well as test two additional exploration ideas this year that it has not yet disclosed.  

Success at either of these locations in Colorado could be a game changer for Southwestern, providing a big potential boost to margins and cash flows because of the higher margins associated with liquids-rich drilling. Investors should watch carefully for any announcements regarding the company's progress in these plays, including details about resource estimates, development costs, expected returns, and other material information.

Investor takeaway
Though Southwestern's growth from its core Fayetteville asset has slowed in recent years, its Marcellus operations have picked up the slack and should account for an increasing share of companywide production, EBITDA, and cash flow in the years ahead.

With more than a decade's worth of drilling inventory across the Marcellus and Fayetteville, the company is on track to deliver profitable production growth in the low double digits over the next few years. And that's not including the huge potential upside from its liquids-rich prospects that could result in significantly higher growth in production, margins, and cash flow.