Description

Idea:  Short Southwestern Energy (SWN) to $15/share

Thesis:  The declines in natural gas prices over the last 6 months have made drilling for dry natural gas uneconomic.  Producers have responded to these price declines by drilling oil projects or projects rich in natural gas liquids (these liquids are typically worth about 50% of what a barrel of oil sells for and as such track oil prices more closely than gas prices – at least for now).  These oil and wet gas properties are very profitable (single well IRRs of 30% - 100%) and have bailed out the E&P companies from their legacy dry gas assets.  Most major companies made this shift during 2010 and 2011.  One company, SWN, remained wed to a legacy gas asset that turned the company from nothing into an $11bn market cap powerhouse.  It continued to invest in this dry gas asset last year (the Fayetteville shale) and will spend 65% of its E&P budget on the Fayetteville this year.  SWN has gone from a well-run growth story with a premium valuation to a destroyer of capital with a premium valuation.  SWN has no way out in the next two years which should be a sufficient window for the stock to decline by 50% where it will still be priced at levels that would only be justified by a 100% increase in natural gas prices from today’s $2.3/mmbtu level.

Analysis:  Analyzing an E&P company typically requires a detailed knowledge of all projects that the company is working on since any single project could have enough optionality in its reserves to make a major impact on the valuation of the entire company.  In the case of SWN, there are only two development stage projects.  The first, the Fayettville shale, is 87% of the company’s reserves and will consume 67% of the company’s E&P development budget this year.  The second development stage project is a dry gas asset in the Marcellus shale that is superior to its Fayetteville asset, but due lack of infrastructure, equipment and personnel, the company can only allocate 32% of its development budget to this project.  The Marcellus project  accounts for 6% of the companies proved reserves.  The remaining 6% of proved reserves are in two even worse dry gas properties that will only receive 1% of the development budget this year.  In addition to these development stage projects, SWN has three exploration projects in which it will invest $177 million this year on top of its $1,644 million development budget.  Early reports from these efforts are poor and SWN cut 20% of its funding to these projects in its 2012 budget.  So, in the case of SWN we are fortunate in that we can just analyze the Fayetteville asset to determine the fair of the company (since 87% of its reserves and the bulk of its CAPX are going into this project).  The Marcellus project is economically slightly superior to Fayetteville, but not much since it too is dry gas (alas, SWN did not manage to get leases in the wet gas portion of the Marcellus).  The development projects are far in the future and not showing enough promise to justify any valuation at this point.  For the detail oriented I’ve included SWN’s reserve and CAPX data in the following two tables.

 2011 Proved Reserves by Category and Summary Operating Data      

                               Fayetteville Marcellus E. Texas        Arkoma New Ventures        Total

Estimated Proved Reserves:

Natural Gas (Bcf):

Developed (Bcf)           2,689                  172          220          173                         -               3,254

Undeveloped (Bcf)      2,415                  170          27             21                           -               2,633

                                 5,104                  342          247          194                         -               5,887

Capital Investments

(in millions)                   Actual 2011     Forecast 2012

Fayetteville Shale          $ 1,347             $ 1,100

Marcellus Shale                   332                   526

New Ventures                      201                   177

Ark-La-Tex                            76                     18

Midstream Services              161                  193

Corporate & Other                  90                    91

Total                             $ 2,207            $ 2,105

The Fayetteville Asset:  The Fayetteville was a decent dry gas asset, but not even the best out there.  The following link contains a pretty good overview article with some data on the Fayetteville relative to other basins and shows the Fayetteville in last place.  http://seekingalpha.com/article/449951-driving-down-the-cost-of-production-natural-gas-companies-can-still-make-money.  We can get everything we need from the company annual report though.  The key to valuation is the reserve report.  From last year’s 10-k, we find:

For those who aren’t familiar with E&P accounting.  What this table says is that company has over 3 trillion cubic feet (TCF) of producing natural gas reserves whose future cash flows will be worth over $4bn at a 10% discount rate.  The other 2.6 TCF of undeveloped locations are only worth $600mm because of the drilling capital required to generate the cash flows.  The key to this is the gas price assumption though.  From the 10-k again:

“”Prices used by Southwestern are based on the 12-month unweighted arithmetic average of the first-day-of-the-month price for each month in the period January through December 2011. For oil volumes, the average West Texas Intermediate posted price of $92.71 per barrel is adjusted by field for quality, transportation fees, and regional price differentials. For gas volumes, the average Henry Hub spot price of $4.12 per MMBTU is adjusted by field for energy content, transportation fees, and regional price differentials. All prices are held constant throughout the lives of the properties. The average adjusted product prices weighted by production over the remaining lives of the properties are $92.21 per barrel of oil and $3.72 per MCF of gas.”

So, this $4.8bn valuation for SWN is based on $4.12 per mmbtu average natural gas price in 2011 and as we can see from the table above it is barely profitable (based on a 10% discount rate) for SWN to drill wells due to the low value on the proved undeveloped reserves.

Now gas prices are $2.30 per mmbtu and SWN is dumping another $1.1bn into drilling wells in 2012.  In their last conference call, they say they plan to “cherry pick” their best well locations and those should be profitable at $3.00 per mmbtu gas.  Either way they, are going to generate very poor returns on capital this year and in the shale drilling business, this year is all that really counts since shale wells have an 60% first year decline in production – see the following figure for a typical Fayetteville well.

                       [FOR SOME REASON MY CHART SHOWING DECLINE CURVES WON'T PRINT HERE]

This shows that by year 4 the well has produced 50% of the gas it will ever produce.  However, this well probably produces 40% of its economic value in the first year.

One interesting exercise would be to guess what SWN’s reserves are worth at $2.30/mmbtu gas.  Without running a complete reserve report, I can’t answer that, but I can put some goal posts on the answer.  A very high goal post, would be to use their current cost structure to determine the total future cash flows of their developed reserves.  SWN says it has $0.45/mmbtu of transport costs, lease operating costs in 2011 were $0.84/mmbtu, G&A was $0.27/mmbtu and taxes other than income taxes were $0.11/mmbtu.  That means that right now SWN is netting $0.63/mmbtu.  And this is before the massive production declines set in if they stop drilling and all of their escalate massively on a per mmbtu basis.  So, right now, our high goal post for SWN valuation is about $2bn UNDISCOUNTED.  The low goal post is to use all the OPEX embedded in their reserve report above which is about $4.5bn over the life of the wells and use their $1.85/mmbtu netbacks for revenue.  This goal post gives us a valuation of $1.4bn UNDISCOUNTED. 

While that exercise is interesting, everyone knows that someday gas prices are going to go back up so they bid the stock up based on that optionality.  Let’s be really charitable and use the reserve report that says the company is worth $4.8bn on a PV10 basis at almost 100% higher gas prices and then let’s multiply that by 1.5 because the market doesn’t really want a 10% rate of return, it wants a 7%.  So SWN is worth $7.5bn at 100% higher gas prices, but we have to take out their $2.3bn in debt so we get to $5bn.  And SWN is in the process of investing $1.6bn of that value today at rates of return far below 10%.

Adjusted EPS:  What about good old Adjusted EPS?  Investors like EPS even though it is inappropriate for all but the largest and most stable E&P companies.  Investors really like SWN’s EPS since they are valuing the company at 17.7x 2011 EPS as compared to a valuation of 10x and 8x for Exxon Mobile and Chevron respectively.  Well what about 2012 EPS?  Analysts think it is going to be $1.50/share on average making it worth 21.3x 2012 EPS estimates.  Is SWN going to earn $1.50 in 2012?  The low estimate on the street is $0.90/share or a valuation of 35.6x 2012 earnings.   Let’s see if that is in the ballpark.

Well SWN says it is going to produce 560 billion cubic feet of natural gas this year at $2.30/mcf less $0.45/mcf transport fees means that $1,036mm in E&P revenue.  Now, being a conservative bunch they did hedge 265 bcf of this gas at $5.06/mcf so they’ll get an extra $728mm in revenue from their hedges which will fall to $499mm in 2013 and $0 thereafter.  So 2012 E&P revenue = $1.75bn and going south in future years.  Plus I’m going to add another $150mm in gathering revenues from their 3^rd party clients (which was last year’s revenue even though I think 3^rd party volumes will be down this year since no one besides SWN is drilling in the Fayetteville anymore).

On the cost side, SWN has some complexities to its accounting since it owns its own gathering system and uses that system for its own use as well as transporting gas for others.  So, just to make it easy I’ll use 2011 expenses and escalate Lease operating expenses, depreciation, and taxes other than income by 12%.  They also doubled their debt this year so I’ll add an extra $45mm in interest expense.

Revenue = $1.9bn

Lease Operating Expense = $270mm

G&A = $160mm

Depreciation = $788mm

Taxes other than Income = $73mm

Operating Income = $609mm

Interest Payments = $110mm

Less Capitalized Interest = -$70mm

Pretax Income = $569mm

Taxes = $224mm

Net Income = $345mm

Shares outstanding = 350mm

So EPS = $0.99

So, let’s just say 2012 EPS = $1.00 if natural gas prices stay where they are.  That means SWN is valued at 32xEPS versus 10 for XOM which has massive exposure to oil versus natural gas.  And by the way if gas prices go back up to $4/mmbtu and SWNs hedges roll off their EPS would be coincidentally about the same $1.00/share.  And what happens if SWNs hedges roll off and gas prices only go up to $3/mmbtu?  They earn $0.00/share.   Is that really possible?  No, even they would probably stop investing in their crappy asset after a couple of years of earning nothing and do some financing to acquire a large asset that’s actually productive.  So what’s $1/share normalized EPS worth?  At 15x EPS with a deservedly significant premium to XOM (this is me laughing right now), that would be $15/share or about $5bn – very similar to the reserve valuation above (again assuming $4/mmbtu gas – recall it was far lower if gas prices don’t rebound from here for several years).

Natural Gas Prices:  That is the $64,000 question.  What are they going to be this year?  What are they going to be next year?  Well, if we have a recession, I’d venture to say they won’t go up a lot from here.  What if the Bernanke can continue to engineer our faux recovery for another few years?  Well, in that case we’ll have even more activity in the E&P space.  Yes, dry gas rig count is dropping off the face of the earth, but all those rigs are going to oily shales and wet gas plays and every rig is drilling faster than it did the year before as the industry learns to drive up efficiency.  It is impossible to project how much gas supply will come online from these oily plays to offset declines in dry gas plays but every single play (even the bakkan) produces dry gas along with its liquids.  I don’t have energy to pull together all the stats right now, but the eagleford has gone from no gas to tons of gas in the last two years and people are drilling the crap out of the wetter sections of the Marcellus where well IRRS approach 100% even at $3.00/mmbtu gas (versus 5% for our friends at SWN in the Fayetteville).

We do know that gas storage is 50% higher right now than it has ever been in the last 5 years and that we are probably going to run out of storage capacity before the injection season ends and that means that people will be getting $0.00/mcf for their gas when pipelines curtail service not $2.30/mcf.  So, I’m eminently comfortable assuming $2.30/mcf until this winter – you can cover the short right around election time if you want.  However, I think it is a good bet that the production from the wetter shales keeps a lid on prices for several years to come and SWN just gets worse and worse as its hedges roll off.

Book Value:  Why risk holding this into next year when we could have a really cold winter and gas prices could jump?  Again, I ask jump to where?  $4/mmbtu?  As I said above, it is still only worth $15/share once its hedges roll off.   Back to Book Value which many value investors like.  SWN reported book value of about $11.40/share at the end of 2011.  Many E&P companies are trading at 2-3x book value.  Since this company has crappy assets, we could assign a price target of 2x book value or $23/share.  But we all know this is ultimately a commodity biz especially in natural gas where there is a domestic market with no international oil price umbrella.  Historically this industry generates a 9% return on equity.  What’s that worth?  1.5x book value?  $16/share?  Here’s the good part though.  E&P accountants have a concept called the ceiling test where every year they look at the value of company’s reserves and see if book value exceeds that value and if it does, they make the company write down its assets resulting in a hit to book value.  This book value does not come back later until it is earned back in the normal course of generating income.  I think SWN will report an asset impairment charge of around $1.75bn next year when it publishes its year end financials.  This, along with its $1.00/share EPS will result in actual 2012 earnings of -$4.00/share reducing book value to more realistic $7.40/share.

Technicals:  Everyone likes to look at technicals when shorting.  During the last 6 months, SWN has fallen 10% while the S&P has risen 20% - not bad for a stock with a 1.14beta.  There is price ceiling about 7% higher than today’s price where you can place a stop if you like.  The stock is also about 10% above its multi-year low right now, so you could wait till it breaks through that on the downside….

Catalyst