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Speaking at an industry conference in New York last week, Southwestern Energy's (SWN) CEO Steven Mueller laid out the company's operating plan in the Marcellus shale. Due to the sheer size of Southwestern's position in the Fayetteville, the company is often perceived as a single-asset stock. This may change in the near future. The Marcellus is quickly emerging as Southwestern's primary growth engine and will likely beat the Fayetteville in terms of return on investment. About a year and a half ago, Southwestern had zero production coming out of the Marcellus. At the end of last quarter, SWN had 166 MMcf/d of gross operated production from the area which the company expects to increase to over 300 MMcf/d already by the end of this year and to over 500 MMcf/d by the end of 2013. By 2017, SWN anticipates to be producing almost 800 MMcf/d out of the Marcellus.

Southwestern's Marcellus leaseholds are located in the northeast part of Pennsylvania. While the acreage is predominantly in the play's dry gas window, the remarkable productivity of the shale and relatively low drilling and completion costs make these wells economic even in a very low gas price environment.

Like in the Fayetteville shale, Southwestern entered the play early, following the initial success by Range Resources in the state's southwest corner in 2006 and 2007. Rather than compete with other operators for acreage in the "hot" part of the play, Southwestern leased acreage in the northeast corner of the state being one of the early entrants in that area. As a result, the company was able to put together close to 190,000 net acres at an average cost of less than $1,000 an acre and average royalty burden of just 13%.

The company's acreage is concentrated in four operating areas: the Greenzweig area in Bradford County, the Range Trust and Price areas in Susquehanna County, and the Lycoming County area.

(click to enlarge)
(Source: Southwestern Energy Presentation at Barclays' Energy Conference, September 2012)

To date, Southwestern has tested all four of its operating areas and estimates that about 120,000 acres of their 190,000 total will yield wells with 6 Bcf average EUR. Assuming 120-acre spacing, this translates in approximately 1,000 drilling locations. Those wells "work" in a sub-$3 natural gas price environment, according to the company. The remaining 60,000 acres are expected to yield wells with EURs in the 3-6 Bcf range, which would require a higher natural gas price to justify drilling.

The 6 Bcf average EUR estimate may in fact prove to be conservative which is understandable given the early stage of the delineation process and limited well performance history in those areas that have been restricted by the off-take pipeline availability. Indirectly, Southwestern hints to the fact that the EURs may have substantial upside by providing a well performance slide in its most recent presentations.

(click to enlarge)
(Source: Southwestern Energy Presentation at Barclays' Energy Conference, September 2012)

The chart shows four smooth "type well" curves, with the top one being a 10 Bcf type curve. The three sets of actual well performance graphs shown on the slide represent the three "generations" of wells in terms of lateral length and completion design. The bottom one is the first 2,700 ft. lateral completed by Southwestern with six frac stages. The upper two graphs are wells with 9-12 stages of fracs and 12 or more stages of fracs. The longest lateral that Southwestern has drilled so far is just over 5,500 ft. and has 19 frac stages. The graph implies that wells with nine or more frac stages are tracking type curves with 8+ Bcf EURs. This is not unexpected given that other operators in the area have reported multiple wells with 10-20 Bcf EURs. Southwestern indicates that the well cost in the Bradford/Susquehanna area is currently in the $5.5-$6.0 million range, also in line with other operators when adjusted for the number of frac stages. This translates in F&D cost of less than a dollar and solid returns even at the $3/Mcf price level, according to the company.

In his presentation, Steven Mueller confirmed that based on the early testing the quality of Southwestern's Susquehanna acreage looks comparable to the Greenzweig area:

"We have drilled wells in the Range area, and we have actually tested three wells there. These wells look very comparable to the Greenzweig. In the Price area, we have two wells on production at the end of the second quarter. They've averaged about 5 MMcf/d each, 10 MMcf/d total. Have been on production for about four months, five months, that period of time."

To date, the company has done most of its drilling in the Greenzweig where the existing Stagecoach pipeline has provided an off-take route. As gathering lines and processing facilities are getting ready to come online in other areas, Southwestern is ramping up its drilling program. The company started the year running two rigs in the Marcellus in the Greenzweig area. As the year progressed, SWN expanded its drilling activity to the Range Trust area in Susquehanna County. Today it has three rigs running, and the fourth rig will be added in October. By the end of the year Southwestern plans to have 90 wells on production, more than double the 40 wells it has on production currently. The rapid scale up is mostly the result of the Bluestone pipeline coming online later this year. The high-pressure gathering line will go through the Range Trust area and will provide off-take routes for Southwestern's production in Susquehanna County. The pipeline is in its final stages of construction and will be put in service in two phases. The first phase connects in the south to the Tennessee gas line which goes east-west just north of the Price operating area. The second phase will connect to the Millenium line in the north, just across the border in New York. The first phase is expected in service in late October, while the second phase should be completed in late November, according to Southwestern. Like many other operators in the Marcellus, Southwestern has accumulated a significant inventory of wells that are waiting on pipeline or completion. The company will start putting those wells on production once the pipeline connections become available.

Southwestern is also making progress in resolving pipeline access in its Lycoming County area. Southwestern's Lycoming County leases are just north of the Range Resources (RRC) and Anadarko Petroleum (APC) acreage in that area. In Lycoming County, the company has drilled three wells to date and should have five additional wells drilled by the end of the year (operating one rig in the area). The company's far western acreage block is now being tied in with a gathering line by Penn Virginia (PVA), the midstream provider, and Southwestern plans to put its wells on production in the next several months. In Lycoming County the wells are deeper and well costs are higher as a result, in the $6.5-$7.0 million range according to Southwestern.

Southwestern plans to limit its future drilling program to four rigs and projects that this should be enough to drill the roughly 1,000 wells that the company identifies as the most economic. With the four rigs, SWN expects to achieve the 800 MMcf/d production rate within five years. Thereafter, SWN plans to keep its production constant at around 800 MMcf/d for about seven or eight years and then let the production gradually decline.

Southwestern's rapid production ramp up in the Marcellus provides a real-time illustration of the structural change in the U.S. natural gas industry that is currently underway. Despite the seemingly sub-economic gas prices, operators in the most productive dry gas areas are demonstrating their ability to grow production at a remarkably fast pace. The infrastructure lag is concealing a sizeable production backlog which will find its way to the market in the next several quarters. The low natural gas price is the mechanism of displacing production in the less prolific areas. It may need to remain in place until the new equilibrium is achieved. This process may take more than just a few months. Southwestern is just one example illustrating this trend. Cabot Oil & Gas (COG) has just announced its new production record in the Marcellus of 750 MMcf/d and is on track to meet or beat the high end of its company-wide production growth guidance range of 35%-50% for the year. Range Resources, another leading Marcellus operator, will see its production grow this year by more than 35%.

This illustration does not lend much in support of a fast recovery in natural gas prices or the value of dry gas assets outside the productive sweet spots. My natural gas producer index includes: Chesapeake Energy (CHK), EnCana Corporation (ECA), Devon Energy (DVN), Southwestern Energy, Ultra Petroleum (UPL), EXCO Resources (XCO), WPX Energy (WPX), Cabot Oil & Gas, Range Resources, QEP Resources (QEP), Quicksilver Resources (KWK), and Forest Oil (FST).

Source: Southwestern Energy: Marcellus Production To Exceed 500 MMcf Per Day In 18 Months