Investors in Southwestern Energy (NYSE:SWN) have finally received some good news after a long time of continued struggles.
The company has been listed for a long time and between the 1970s and 2000, shares were essentially trading at around a dollar. The company was a major beneficiary of the emerging shale revolution as shares rose to $40 in 2008 and while incurring some volatility, still traded at same levels in 2014, the year in which oil prices started cracking.
Ever since it has all been downhill as shares fell to level in the $3s in recent weeks. A relative strong fourth quarter and upbeat guidance for 2018 made that shares jumped 20% from the lows towards $4.50 per share, warranting a review of the situation.
Southwestern produces (mostly) natural gas in three areas being the Northeast Appalachia, the Southwest Appalachia and the Fayetteville Shale. Each of these shales have different profiles, as discussed next.
The Northeast Appalachia is the smallest region, containing little over 190,000 net acres. It produces 395 Bcf, making it the greatest production asset of the company, responsible for 44% of total production. The 4.1 Tcf in reserves represent 28% of total reserves.
The Southwest Appalachia contains 290,000 net acres and has the largest reserves with 7.0 Tcf, nearly half of total reserves. Production comes in at 183 Bcf, about 20% of total production.
The Fayetteville shale is by far the largest with over 900,000 net acres. Reserves of 3.7 Tcf represents a quarter of total reserves as production of 316 Bcf is equivalent of a little over a third of total production. Most of the company´s drilling locations can be found in the Southwest Appalachia, as most of the Northeast Appalachia has already been explored. The Fayetteville has a relatively low number of drilling locations at current prices, but this increases rapidly if prices move higher as these assets have higher break-even prices.
The total company produces 897 Bcfe with total proved reserves of 14.8 Tcfe, for a reserve life of 16.5 years. While the company has a sizeable debt load, it does not have a liquidity crisis at all coming up. The first sizeable bond payment is only coming up in 2022, giving the company a lot of time to address the situation.
Repayments of the loans are furthermore ¨supported¨ by a pre-tax PV-10 valuation of $5.8 billion. This value has been growing as economic reserves have been growing quite impressively in recent years, despite falling prices. The improved economics in terms of exploration and production makes that economic reserves are growing, despite falling prices.
The company produced 897 Bcfe in 2017, a 2.5% increase from the year before. Fourth quarter production came in at 239 Bcfe, marking a more than 18% increase compared to the year before. Production has been growing in the Appalachia, although it was down in the Fayetteville. 89% of production is in the form of natural gas, so that is the key determinant of revenues.
Problematic is that Henry Hub prices averaged at $3.11 in 2017, yet Southwestern is selling its gas at a significant discount of between $0.75 and $1.00 across the different regions. The company recorded revenues of $3.2 billion, although this includes a billion dollars in no margin marketing revenues, with product revenues coming in closer to $2.2 billion.
The company reported operating earnings of $731 million in 2017, as no significant items have a big impact on these results (such as hedges) being accounted for at a lower point in the income statement. This seems to suggest that the business is solidly profitable, but there are some caveats to that observation.
The massive impairments recorded on the assets made that depreciation charges only came in at $504 million for all of 2017 while capital investments totalled $1.15 billion. This suggests that net capital investments of $646 million pretty much eat up all of the operating earnings, leaving just $85 million left. This cash is not sufficient to pay the $239 million interest bill, before even leaving anything for shareholders.
The good thing is that the business still has $916 million in cash at hand, offset by $4.4 billion in (long-term) debt, for a $3.5 billion net debt load. Based on adjusted EBITDA of $1.25 billion, leverage ratios at 2.8 times sound reasonable, but it is clear that the business is not economical at this point in time.
While oil prices have been relatively firm as of late, the same cannot be said for natural gas prices. In fact, the contrary is the case. Having averaged at $3.10 in 2017, they have now fallen 13% to $2.70 at the moment. As the company is realising about $0.75-$1.00 lower than market prices, that makes that realisation falls steeper than the headline prices, assuming that the discount at which the company sells its gas remains the same.
That creates a revenue headwind of about $300 million versus the 2017 results, which creates even more headaches for the business. The good news is that 70% of 2018 production is hedged just below $3 already, which makes the headwind much less pronounced.
There is some good news as well, being the fact that the current capital spending budget is greater than necessary to keep production flat. The company is upping the 2018 capital budget to $1.15-$1.25 billion at the midpoint, a $50 million increase from the 2017 budget. This budget should be sufficient to grow production to 930-965 Bcfe in the coming year, up near 6% at the midpoint of the guidance. Unfortunately, no maintenance capital spending budget has been outlined, as that would make it easier to estimate the realistic break-even point of the business at this point.
Taking Action, Appeal Might Lure
In early February, the company announced that it is exploring strategic options, which are centred around the Fayetteville Shale E&P assets and related assets in the area as well. Shares hardly reacted to the announcement, in part because no valuation has been attached to the asset, as that will be key. The current PV-10 value awarded to the asset stands at $2.0 billion.
A potential deal would be great in terms of reducing debt and cutting the break-even point of the business, but has drawbacks as well as it would reduce the footprint a great deal: cutting production by 35% and reserves by 25%.
While the company is taking the right actions, I think that growing production in this low price environment is not necessarily the best action. What is clear is that the valuation of the firm at large depends on two major events, both not under control of management. The sale of the Fayetteville assets will be very indicative for the valuation of the firm at large, as I am very anxious to learn about that potential valuation, although this divestment process is still in very early stages.
Such a move will reduce financial stress on the company further and improve the profitability of the company. The other big determinant is of course the future of natural gas prices, which remains a big guess as the better economics makes that marginal production kicks in way earlier than in past years, especially if cheap drilling money continues to be around.
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