Z-Note: Southwestern Energy – Strong Production, Good Cost Control, & A Potential Acceleration In The Shale

(SWN) reported $0.28 vs consensus of $0.29. Revenues were light as well but production was above the midpoint of guidance. So first we have a slight top line miss based on price. Second, cash operating costs were better than expected but the DD&A rate was just over the top end of guidance. This means the slight bottom line miss is at least a high quality one based on price and is more importantly, non cash in nature, which is a lot easier to forgive for an analysts than a miss based on volumes.

• 2Q07 Production: 284,000 Mcfepd, towards the upper end of prior guidance of 274,700 to 285,700.

• Fayetteville Shale gross production hit ~ 200,000 Mcfgpd as of July 28, up from 155,000 at the end of April.

Fayetteville Shale Is Moving From Science Project To Efficient Manufacturing Operation.

• Net Production increased to 10.7 Bcf or 118 Mmcfgpd in the second quarter.

• SWN has participated in 303 wells to date (246 horizontal) in 33 pilot areas.

• Performance has varied from areas with initial production of 4+ Mmcfgpd to some with IPs below 1 Mmcfgpd. SWN plans to focus on the higher return areas for the remainder year drilling longer horizontal laterals and completing most wells with slickwater fracs which have proven to be most successful here after trying numerous combinations of stimulation.

• Longer laterals cost more... Cost per well was up to $2.9 mm vs 2.6 in 1Q but laterals increased in length from 2,100 to 2,500 feet on average.

•  ...But they're sinking them faster. Average drilling time fell to 18 days from 20.

• ...and the last 10 wells drilled had IPs averaging 2.6 Mmcfgpd with several >4.

• ...expect to participate in 400 wells. The combination of longer laterals and slickwater fracs concentrated on the sweet spots of the play could yield further upside to estimates.

Conventional Arkoma production continues to rally. 2Q production reached 6 Bcfe (66 Mmcfepd). Ranger anticline wells dipped 1Q to 2Q.

East  Texas Production Appears To Be Flattening Out. The final and for now largest wedge of SWN production has been sliding but the most recent quarter shows only a 1% decline quarter to quarter and they plan to accelerate rig activity in the second half here.
Guidance Unchanged. Production guidance remains unchanged from levels issued in the 1Q press release: 107 to 110 Bcfe (293 to 301 Mmcfepd), the mid point of which equates to 50% YoY growth.
Operating Costs Better Than Anticipated:

• LOE/Mcfe was better than expected. Expected to average $0.82 to $0.87/Mcfe for the full year. Came in at $0.73, down a penny from 1Q levels. They maintained their LOE guidance.

This kind of says it all

• G&A / Mcfe was a touch high as the company continues to staff up quickly in the Fayetteville division.

Strong Hedge Position In Place For 2007 & 2008.

So in summary, you're left with a company that just grew volumes by 13% sequentially and 57% YoY while coming in at the top end of the guidance range, beat cash operating cost guidance and has a strong chance of beating 2H07 volume guidance as it focuses on the sweet spots in the Fayetteville. Combine this with the fact that over 70% of expected gas volumes for 2007 and over 60% of 2008 (my conservative ballpark on volumes) are hedged at well over $7 per Mcf and the fact that the stock has been sliding with gas prices since its last conference call and you see just a few of the reasons why I like the name long term. We'll save the massive (11Tcf) shale reserve potential reasoning for another day.