Southwestern's Growth Slows, but Huge Inventory Remains

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 more than 750,000 net acres in the Marcellus and Utica shales of Pennsylvania and West Virginia, making the company one of the region's largest leaseholders. Southwestern's acreage spans the dry and wet gas windows of the Marcellus and Utica and should help to diversify the firm's hydrocarbon mix in the years ahead; we forecast companywide liquids production increasing to 10% by 2019, up 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 assumed the role of a 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 3.2 billion cubic feet of equivalent per day by the end of 2019, with 71% 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 304,000 net acres targeting the Lower Smackover Brown Dense and 376,000 net acres across Colorado targeting formations in the Sand Wash and D-J Basins. Testing continues across these exploratory projects.

Trading at a Deep Discount to Our Fair Value Estimate Our $31 fair value estimate is based on our five-year discounted cash flow model and an assessment of trading multiples, comparable transactions, and longer-term resource potential. We don't assign any value to Southwestern's prospective plays at this point, although we would consider incorporating them into our assessment of fair value once more information becomes available. We assume Southwestern's midstream cash flows are valued similarly to a group of publicly traded midstream limited partnerships.

We forecast aggregate net production of 2.7 bcfe/d in 2015, 2.9 bcfe/d in 2016, and 3.2 bcfe/d in 2017, representing a 14% compound annual growth rate over 2014. In the Fayetteville, we forecast volumes declining from 1.4 bcfe/d in 2014 to 1.1 bcfe/d in 2017. In the northeast Marcellus, we expect production to reach 1.4 bcf/d by the end of 2017, up from 770 mmcf/d at the end of 2014, supported by increased drilling activity and ongoing infrastructure buildout in northeast Pennsylvania. Across the southwest Marcellus (which includes the Utica and Upper Devonian formations), we project volumes to reach 930 mmcfe/d by the end of our forecast period. In the company's midstream segment, we expect gathering volumes to closely track Southwestern's production growth, reaching 3.5 bcfe/d by 2019. We forecast EBITDA of $1.6 billion in 2015, $1.6 billion in 2016, and $2.1 billion in 2017, driven primarily by production growth as well as a modest improvement in natural gas and oil prices. We expect Southwestern's midstream segment to account for 15%-25% of the firm's EBITDA over this period.

Asset Quality Brings a Narrow Moat The competitive advantage of E&P firms largely stems from the quality of their assets. In particular, we consider the rates of return of wells drilled on the company's acreage as well as the number of potential drilling locations remaining. The former depends on the productivity of the well as well as the cost of drilling and operating it. Hydrocarbon flow rates are primarily a function of the underlying geology, but the company's completion methodology will also have an impact. Typically, more-aggressive completion techniques will boost productivity but at a greater cost; management will seek to optimize these variables to maximize return. Other factors influencing the cost of a well include drilling cost, royalty rates, leasehold outlays, production taxes, and lifting expenses.

Asset quality 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 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 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 Southwestern's production mix and provide a nice boost to economics.

We estimate Southwestern's fully loaded cash break-even costs to be around $2.85 per mcf, using the likely mix of production between the Fayetteville and Marcellus in 2015 (40% and 60%, respectively). We expect this break-even point to trend down modestly over time as Marcellus activity ramps up.

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 in 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.

Extended Period of Low Prices Could Hurt 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 its relatively high leverage (estimated to be 2.7 times debt/EBITDA at year-end 2015 thanks to sizable acquisition spending, compared with an average of 1.3 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. Other risks to keep an eye on 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.

Southwestern's recent spending spree on energy resources in Appalachia and Colorado weakened the balance sheet relative to a historically strong condition, with adjusted June 2015 debt/reserves, debt/EBITDA, and debt/capital ratios of $0.42 per mcfe, 2.8 times, and 34%, respectively, compared with trailing five-year averages of $0.28 per mcfe, 1.3 times, and 26%. Considering current natural gas and oil futures prices, we expect continued tightness in the firm's credit metrics through the end of 2015. Despite minimal product price hedging beyond 2015, Southwestern's low-cost structure should enable the firm to remain profitable over the next few years even if natural gas and oil prices remain depressed.

Stewardship Is Exemplary Southwestern's management team has generally taken good care of shareholders over the years, employing a conservative, returns-focused approach that has helped minimize franchise risk and shareholder dilution while profitably expanding 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. We think these moves position the company for continued strong performance in the years ahead.

Southwestern's directors and officers own 1% of the outstanding common shares. Executive compensation appears reasonable and includes a mix of base pay, bonuses, and performance-based, long-term incentives.