Southwestern Energy Company (SWN) is an integrated energy company primarily focused on the exploration for and production of natural gas. Southwestern is engaged in natural gas and crude oil exploration and production in the East Texas, Permian Basin, the onshore Gulf Coast, and is the leading operator in the Fayetteville Shale. The Company also has natural gas distribution activities in northern Arkansas and midstream activities located in Southwestern's core market areas however SWN’s E&P business generates approximately 95% of SWN’s operating income and EBITDA.

 

We believe the street is behind the curve on the value of SWN’s Fayetteville shale resource, the main value driver in the company.  This unconventional shale play has continued to surprise on the upside, just like the Barnett shale did.  In fact, we believe the street is two iterations behind the reality at SWN and is not even giving SWN credit for resource data it released last week, much less for the resource we believe will ultimately be quantified.

 

Simply, we believe SWN’s per well resource recovery will be higher than the currently announced 1.4 Bcf gross per well and it will be able to drill more than their estimated 7,000 wells the Street is currently discounting, and ultimately more than the 8,000 wells SWN just announced last week.

 

We believe SWN’s wells will ultimately average 1.75 Bcf gross per well and that the company will be able to drill 9,400 wells. Using these metrics we value SWN at $77.00 per share using the forward strip as a gas price and give it a floor valuation of $26.00 per share using $5.50 per mcf of gas.

 

SWN owns 887,000 net acres in the Fayetteville Shale. SWN assumes average ultimate production of 1.4 Bcf gross per well and 80-acre spacing. They assume a total of 8,000 drilling locations and an estimated gross ultimate recovery of 11.2 Tcf. Per well costs are currently approximately $2.2 million.

 

Below we examine both ultimate well recovery as well as number of drilling locations.

 

Well Recovery – Southwestern’s horizontal well performance is summarized in the table on page 17 of the presentation linked to here.

 

 

As the table illustrates, SWN’s typecurve is significantly above the 1.5 Bcf typecurve. As SWN has drilled more wells, their average well typecurve has moved farther above the 1.5 Bcf typecurve and closer to that of a 1.75 Bcf well. For this reason we think it is only a matter of time that SWN raises its publicly stated well EUR value to approximately 1.75 Bcf per well.

 

Number of Drilling Locations – SWN estimates it has 8,000 drilling locations on its Fayetteville acreage. During 2006, SWN has increased the number of potential wells from 5,000 to 7,000 to the current 8,000 wells. Using SWN’s published 80-acre well spacing, 8,000 wells uses approximately 72% of its Fayetteville acreage.

 

We believe SWN will ultimately use a higher percentage of its drillable acreage which will increase the number of drilling locations. The Fayetteville shale is a Mississippian-age shale that is the geologic equivalent of the Barnett Shale in north Texas. In the Barnett, the general rule of thumb is that 85% of the acreage is drillable while the remaining acreage is condemned due to karsting (where the shale has collapsed) or other geologic faults that make drilling impossible or economically unviable. Unlike the Barnett, however, the Fayetteville shale does not contain water-filled karsts which should result in a higher percentage of drillable acreage. Assuming that the Fayetteville has at least the same percentage of drillable acreage as the Barnett should yield approximately 9,400 drilling locations for SWN on 80 acre spacing.  SWN also holds 130,000 net acres in the Moorfield Shale (below the Fayetteville). While the initial well results are lower (1.2 mmcf/day) than the Fayetteville, we believe that SWN will ultimately develop this acreage which will had even more drilling locations.

 

In our valuation, we use two gas price estimates: a base price of $5.50 per mcf and a street estimate of $7.50 per mcf. To establish our base gas price we assume industry finding costs of $3.00 per mcf, lifting costs of $1.50 per mcf, and transportation costs of $1.00 per mcf. This price assumes E&P operators generate no profit on marginal capital projects. $7.50 per mcf is based off the NYMEX strip and assumes that E&P operators earn a decent rate of return on their marginal capital investments.

 

The following table gives our valuation ranges for SWN as well as our estimate on the Street’s valuation methodology.

           

	Street Old	Street New	Low	Target
Gas Price ($/mcf)	Strip	Strip	$5.50	Strip
SWN Realized Price ($/mcf)	$7.12	$7.12	$4.95	$7.12
F&D Cost ($/mcfe)	$1.75	$1.75	$1.75	$1.75
Production Cost ($/mcfe)	$0.70	$0.70	$0.70	$0.70
Discount Rate	10%	10%	10%	10%
Net Fayetteville Acres	887,000	887,000	887,000	887,000
% Assumed Productive	64%	73%	85%	85%
Well Spacing, acres	80	80	80	80
Number of Drilling Locations	7,000	8,000	9,400	9,400
Estimated per Well Reserves, Bcf	1.4	1.4	1.75	1.75
Total Fayetteville Potential	8.3 Tcfe	11.4 Tcfe	13.4 Tcfe	13.4 Tcfe
Cost Per Well, $MM	$2.2	$2.2	$2.2	$2.2
NPV of Fayetteville, per Share	$31.00	$36.00	$20.00	$62.00
NPV of Proven Reserves	$12.00	$12.00	$6.00	$12.00
Target Price	$43.00	$48.00	$26.00	$77.00

 

The following table shows our target price’s sensitivity to a range of gas prices from $5.50 - $8.00 per mcf.

 

 

 

Despite SWN’s recent run from a low of $28.22 in September to its current price of $38.27 on November 20^th, we believe the stock presents an excellent risk-reward opportunity. We believe the catalyst will come as SWN announces an increased number of drilling locations and well size.

 

Risks to the stock include escalating operating costs (SWN lowered its 2006 production growth target partly due to a shortage of crews and pressure pumping equipment), a prolonged decline in natural gas prices due to warm weather, and the Fayetteville Shale not materializing into the play we anticipate.