Former Growth Darling's Domination Continues

Since discovering the Fayetteville Shale in 2003,

Through a series of acquisitions--including two transactions with Chesapeake and asset purchases from WPX and Statoil--Southwestern now controls close to 800,000 net acres in the Marcellus and Utica shales of Pennsylvania and West Virginia, making the company one of the region's largest leaseholders. Its acreage spans the dry and wet gas windows of the Marcellus and Utica and should help to diversify its hydrocarbon mix in the years ahead; we forecast companywide liquids production increasing to 13% by 2018, from essentially nothing in 2013. Southwestern's best Marcellus and Utica acreage is economically profitable at gas prices below $3 per thousand cubic feet, which implies that the Fayetteville has now assumed the role of marginal play in the company's portfolio. Ongoing drilling results should shed more light on the longer-term potential of this acreage, including the Upper Devonian formation. We forecast production across the Marcellus and Utica to increase to 3.3 billion cubic feet equivalent per day by the end of 2018, with 60% from the dry gas northeast Pennsylvania Marcellus and the remainder from the company's liquids-rich and dry gas acreage across southwest Pennsylvania and West Virginia. Volumes should largely keep pace with firm transportation arrangements.

Southwestern's New Ventures program is responsible for identifying growth opportunities. Among them are 460,000 net acres targeting the Lower Smackover Brown Dense as well as 600,000 net acres across Colorado targeting formations in the Sand Wash and D-J basins. Testing continues across these exploratory projects.

Assets Support a Narrow Moat Asset quality is the biggest determinant of competitive position in exploration and production and is measured along three dimensions: resource potential (the number of available drilling locations and the amount of recoverable hydrocarbons at each location), per-unit production costs (which takes into account royalties, leasehold outlays, drilling and completion costs, lifting expenses, and taxes), and realized prices (which are affected by the mix of oil versus gas as well as regional differentials). We rate Southwestern positively along each of these dimensions and accordingly assign the firm a narrow Morningstar Economic Moat Rating. Southwestern's midstream assets, which we expect to generate average returns on capital north of 15% throughout our forecast period, also support its moat.

Southwestern holds more than two decades of drilling opportunities across the Fayetteville and Marcellus shales, which are characterized by fairly low operating and development costs. As an early mover and sizable operator in each of these plays, Southwestern benefits from reasonable royalty rates, blocked-up lease positions, and established relationships with takeaway partners. Additionally, the firm's decision to internally develop services and midstream capabilities, especially in the Fayetteville, has helped keep costs low and has given the firm more control over the pace of development. While we don't incorporate into our analysis any future benefit from the firm's New Ventures investments, successful development of one or more of these prospects could help diversify the firm's production mix and provide a nice boost to economics.

We estimate Southwestern's fully loaded cash break-even costs to be around $2.70 per mcf, using the likely mix of production between the Fayetteville and Marcellus in 2015 (48% and 52%, respectively). We expect this break-even point to trend down modestly as Marcellus activity ramps up. We forecast adjusted returns on invested capital of approximately 8% through 2017 (thanks in part to the sizable acquisition spending in 2014), jumping to around 20% in 2018 once our midcycle prices of $90 per barrel West Texas Intermediate oil and $5.40 per mcf natural gas kick in. This compares with an average adjusted ROIC of 14% for 2010-14, during which realized prices averaged $4 per mcfe (versus $3.05 per mcfe from 2015 to 2017 and $4.85 per mcfe in 2018).

We don't anticipate any meaningful deviation from the firm's current playbook, which includes aggressive development of its low-cost Marcellus acreage, continued drilling across its mature Fayetteville position, and ongoing exploration within its oily prospects, as well as continued buildout of its profitable midstream segment. However, the likelihood of natural gas and oil price weakness for a few more years and the potential for midstream bottlenecks in Pennsylvania and West Virginia could damp returns.

Energy Prices Source of Risk As with most E&P firms, a sustained and significant drop in natural gas and oil prices would hurt Southwestern's profitability and reduce cash flow available for growth. Given the firm's relatively high leverage levels (estimated to be 2.8 times debt/EBITDA at year-end 2014 thanks to sizable acquisition spending, which compares with an average of less than 1 times over the previous five years), the firm could be forced to curtail activity or sell off assets to shore up its balance sheet if prices remain low for an extended period. Additionally, any pullback in drilling activity by Southwestern's third-party gathering customers could have an impact on performance in the midstream segment, which we expect to account for 10%-25% of firmwide EBITDA going forward. Other risks include midstream constraints, especially in the Marcellus; regulatory headwinds; uncertainty regarding future federal tax policy; and disappointing results from the firm's various oily prospects.

Stewardship Is Exemplary Southwestern's management team has generally taken good care of the firm's shareholders over the years, employing a conservative returns-focused approach that has helped minimize franchise risk and shareholder dilution while profitably increasing production and reserves. We applaud management's decision to take the lead on critical elements like midstream and services and give it credit for establishing low-cost positions in areas outside the Fayetteville, including the Marcellus and a handful of oily prospects. Combined, we think these moves position the company for continued strong performance in the years ahead.