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Southwestern Energy's (SWN) assessment effort in the Brown Dense oil play continued to capture the lion's share of analysts attention during the company's Q2 conference call. While SWN's 563,000-acre position in the Brown Dense is impressive, the evaluation results to date have been unconvincing. As Southwestern has now switched to drilling two vertical tests in the over-pressured area, there is little chance that a conclusion regarding the operational and economic viability of the play can be reached soon (unlikely in 2012).

The Brown Dense still remains an at-the-money option, and if the initiative ends up unsuccessful, the potential $300 million exploration write-off is a minor cost relative to SWN's $11 billion market cap and the possible upside from the play. In the meantime, natural gas fundamentals and SWN's progress in its core dry gas operating areas, particularly the Marcellus, are more significant, in my opinion, to the underlying stock value than the New Ventures. At least for the time being.

As The Industry's Lowest Cost Shale, The Marcellus May Play The Defining Role For SWN's Competitiveness As A Dry Gas Producer

As of year end 2011, Southwestern had 187,000 net acres in Northeast Pennsylvania. Of those, only 6,200 net acres were held by production and the undeveloped acreage position had an average remaining lease term of 2 years. The average royalty interest was just 13% and the average acquisition cost was approximately $1,077 per acre.

(click to enlarge)

(Source: Southwestern Energy August 2012 Investor Presentation)

Key Takeaways From SWN's Marcellus Update

The Q2 operating update shows strong well results and further validates the thesis that a substantial portion of the company's Marcellus acreage has excellent productivity and will likely yield better economics than the Fayetteville. As a result, with time, the Marcellus may take over from the Fayetteville as the primary growth engine in SWN's portfolio (while the Fayetteville has the risk of ending in the economically marginal category).

  • The first operated wells in the Range Trust and Price areas re-confirm that SWN's Susquehanna acreage may be as good as the company's Greenzweig acreage in Bradford County where all of SWN's operated drilling activity had been initially concentrated.

  • The production growth remains restrained by the lagging infrastructure. It looks like the Bluestone gathering line will now be operational in the fourth quarter (several months behind schedule due to permitting delays). The production should build up rapidly from that point as SWN will be bringing to sales a significant backlog of wells. In my estimate, the 2012 operated production exit rate may exceed 350 MMcf/d (gross) if SWN is able to put online all the 60 wells it has planned for the second half of the year. Infrastructure constraints and slow permitting remain the key obstacles to the development in the Marcellus. SWN is no exception. Optimistically, at the current drilling pace, it may take the company a year to fully work off its well backlog.

  • A close look at the updated well production profiles (see the picture and discussion below) leads to conclude that at least some of SWN's 20 long-lateral wells will likely have EURs greater than 10 Bcf, consistent with the results from other operators in the area. This should translate into acceptable returns even at $3 natural gas, in my estimate.

Operating Details

As of June 30, SWN's gross operated production in the Marcellus was 166 MMcf/d from 41 wells, mostly in the Greenzweig area (along the Stagecoach pipeline). In July, the additional compression at Greenzweig contributed to the production increase to 200 MMcf/d (as of August 2).

  • In the Price area (southern Susquehanna County), two wells were put on production in May and were producing at a combined rate of 10 MMcf/d at June 30, without compression, into TGP 300 pipeline.
  • In the Range Trust area (northern Susquehanna County), SWN flow tested three wells (currently shut-in; should be put to sales in Q4 once the Bluestone line is operational). The wells were only flowed for a short time period to avoid flaring and showed strong performance in the initial 5-day flowback period. SWN's productivity calculations for all three wells indicate that Greenzweig-type performance should be expected.

In the second half of the year, SWN is targeting to put on production 60-plus wells (one and a half times the number of wells SWN currently has on production). The largest step up is expected with the DTE Energy's 250 MMcf/d Bluestone high pressure gathering line becoming operational. This should allow SWN to put almost 100 MMcf/d of production to sales from its Range Trust acreage where the company is currently drilling with its three rigs.

In its press release and investor presentation, SWN provided an updated chart which shows the company's recent long-lateral (greater than 12 stages) wells sustain extended production plateaus with flow rates in the 6-7 MMcf/d range.

(click to enlarge)

(Source: Southwestern Energy August 2012 Investor Presentation)

While longer operating histories will be needed to make reasonably reliable EUR estimates, the extended plateau production profiles indicate potentially very strong wells. CEO Steve Mueller reconfirmed that some wells "certainly have some large EURs." He further commented on the well decline profiles:

…We are keeping the draw down across the perforations at a certain level. And that will limit the total rate of the wells and will make them look flat… Some of these wells are so strong that either we haven't had to put compression out there yet, or we haven't turned the compression on because it goes straight into the line, which acts like a choke and lets it stay pretty fairly flat.

...We certainly have some wells in the Greenzweig area in Bradford County that match up with anyone else's wells that are out there from a productivity standpoint. It's just the way we're producing them may be a little different than some of the other operators are doing it.

Economics

Despite the remarkable productivity of the Marcellus wells, the dry gas economics remain challenging for the majority of operators even in this area (perhaps with the sole exception of Cabot Oil & Gas (COG)). Return estimates vary by operator but converge in the 20%-30% rate of return range for a 10 Bcf well at $3 gas, assuming well cost of $6.0-$6.5 million, 4,900 ft lateral, and 15 frac stages. Range Resouces (RRC), Chesapeake Energy (CHK), Talisman Energy (TLM), Anadarko Resources (APC), Ultra Petroleum (UPL), and several others operate in reasonable proximity to Southwestern acreage.

Source: Marcellus Assets May Sustain Southwestern Energy's Future Competitiveness