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Southwestern Finds Shales More Pliable Than Utilities

Southwestern Energy Co. has proven itself in the Fayetteville Shale and is now successfully poking holes in the Marcellus. However, it hasn't been as adept at getting utility gas buyers to put pen to long-term supply contracts.

As U.S. gas production grows, local distribution utilities that once might have been skeptical about the strong supply outlook from shale plays now look like wallflowers lingering in the spot market, reluctant to strike long-term supply deals until there's more clarity on price direction.

A recent report from the Bipartisan Policy Center and the American Clean Skies Foundation said the growth of shale gas production "reduce[s] the susceptibility of [natural] gas markets to price instability." With a more stable price horizon, the report urged state utility regulators and industry to consider making greater use of longer-term supply contracts (see Shale Daily, March 23).

But the unfinished paperwork continues to pile up on desks at producers such as Southwestern.

"We've talked to almost every major utility in the country," Southwestern CEO Steve Mueller said during an earnings conference call Friday. "We have contracts or beginnings of contracts on our desks from almost every major utility in the country...The big issue is, is the gas price going to go up or down in the near future, and when would they sign a contract and what that price would be."

Mueller compared the contracting stalemate with utilities to a static mergers and acquisitions (M&A) market. "The only time M&A works is when everyone agrees on the direction of the price. Right now, in general, we don't quite agree on the direction of which way gas price is going...

"If you were to have asked me in December, I would have guessed that both our company and the industry would have had some [long-term utility supply] contracts signed by now...[I]t may be the fall when we start seeing the storage a little more obvious that you start seeing contracts being signed...[W]e're comfortable that the power generators are going to be using more gas; they're right now using more gas."

Asked for a gas price forecast, Mueller put on his salesman's hat: "From a contract negotiation standpoint, this thing's going up and going up fast."

Perhaps that will one day be true of gas prices; right now it seems to only apply to production.

Southwestern natural gas and oil production totaled 115 Bcfe in the first quarter, up 28% from 90.0 Bcfe in the first quarter of 2010, and included 101.1 Bcf from the company's Fayetteville Shale play, up from 75.5 Bcf in the first quarter of 2010. The company updated its production guidance for the remainder of 2011 due to the strong performance from its Fayetteville Shale and Marcellus Shale operating areas.

Revised total gas and oil production guidance for 2011 is 483-491 Bcfe, an increase of about 20% over 2010 production (using midpoints). Of total expected production in 2011, 425-435 Bcf is expected to come from the Fayetteville Shale.

"Our first quarter financial and operating results have exceeded our expectations despite lower natural gas prices," Mueller said. "Our production continues to grow, and we increased our guidance for the rest of the year to take into account our first quarter results and the strong results we are continuing to see from both our Fayetteville and Marcellus drilling programs.

"Our all-in cash operating costs of $1.30/Mcfe for the first quarter of 2011, which include lease operating expenses, general and administrative expenses, taxes other than income taxes and net interest expense, remain some of the lowest in our industry. As we look ahead, we are excited about moving to more development drilling in the Fayetteville Shale, increasing our activity in Pennsylvania and drilling our first wells on some new ideas we have been working on over the past two years."

Including hedges, Southwestern's average realized gas price in the first quarter was $4.12/Mcf, down 24% from $5.42/Mcf in the first quarter of 2010. Hedging activities increased average gas price by 44 cents/Mcf during the first quarter, compared to an increase of 55 cents/Mcf during the same period in 2010. As of April 27 Southwestern had hedges in place on notional volumes of about 161 Bcf of its remaining 2011 gas production at a weighted average floor price of $5.27/Mcf, the company said.

Disregarding the impact of hedges, the average price received for gas production for each of the first quarters of 2011 and 2010 was about 43 cents/Mcf lower than average New York Mercantile Exchange settlement prices.

Due to faster drilling times in the Fayetteville than previously budgeted Southwestern increased its capital program for 2011 to about $2 billion, up from $1.9 billion. The increase will result in about 30 additional wells drilled in its Fayetteville, Southwestern said.

"What we're working on and we're planning on is staying conservative," Mueller told financial analysts. "We don't know what's going to happen. Certainly rig count hasn't come off as much as we would have liked, so we have concerns about the near term. But I think we have the same kind of positive outlook that the forward curve does. When you start looking out [to] '13, '14, where it's popped up, that's the discussions we're having with [utilities]. They would like to go back to the forward curve of a month and a half ago, and we like the forward curve now."

Southwestern spent about $468 million on its exploration and production business during the first quarter, including $330 million on the Fayetteville Shale, $52 million in Appalachia, $41 million in East Texas and $41 million in new venture areas.

In the Fayetteville during the first quarter Southwestern placed 137 operated wells on production, all of which were horizontal wells fracture stimulated using slickwater fracks. At March 31, the company's gross production from the Fayetteville was about 1,725 MMcf/d, up from about 1,330 MMcf/d a year ago.

Southwestern is running 18 drilling rigs in the play, including 11 that are capable of drilling horizontal wells and seven smaller rigs that are used to drill the vertical portion of wells. During the first quarter Southwestern horizontal Fayetteville wells had an average completed cost of $2.8 million, average horizontal lateral length of 4,985 feet and average time to drill to total depth of 8.4 days.

Fayetteville wells placed on production during the first quarter averaged initial production rates of 3,231 Mcf/d, down 7% from rates of 3,472 Mcf/d in the fourth quarter of 2010, primarily due to locational differences in the mix of wells and higher line pressures in certain parts of its gathering system where wells were brought online during the first quarter.

The two biggest areas of cost pressure for Southwestern in the Fayetteville right now are casing/tubulars and pumping services. The company has contracts for pumping services that will keep it protected from cost hikes for a while, Mueller said. Casing and tubulars are more costly due to Japanese steel coming off of the world market, he said.

In its Appalachia operations Southwestern has participated in 21 wells in northeast Pennsylvania, of which 14 were successful and seven were in progress at the end of the first quarter. Producing wells are all operated Marcellus Shale wells in the Greenzweig area in Bradford County. Net production from the area was 2.8 Bcf in the first quarter of 2011, compared to 0.8 Bcf in the fourth quarter of 2010.

In the Greenzweig area Southwestern currently places several wells on production from a single pad simultaneously. Three wells that were placed on production last October are producing at an average gross rate of 6,276 Mcf/d per well, while three wells placed on production in November 2010 are producing at an average gross rate of 4,315 Mcf/d per well, and three wells placed on production in February are producing at an average gross rate of 5,816 Mcf/d per well.

In mid-April the company placed three additional horizontal wells on production in Pennsylvania at a gross rate of 4,000 Mcf/d per well while awaiting the installation of production tubing, which will allow higher producing rates.

Analysts at Tudor, Pickering, Holt & Co. Securities Inc. greeted the Marcellus production news enthusiastically with a upgrade on Southwestern to accumulate. "Marcellus wells are freaking strong and steadily walking higher with time. We're thinking 40-plus Bcfe Marcellus production in 2012," TPH said in a note Friday.

The company is in the "last innings" of an audit of its midstream business going back three years. Next will be a decision on what to do with the assets "from a strategic standpoint." That decision is expected in the second half of this year.

Southwestern reported first quarter net income of $136.6 million (39 cents/share), compared to net income of $171.8 million (49 cents/share), for the prior-year period. Results were lower primarily due to a 24% decrease in average realized gas prices, partially offset by "significant growth" in production volumes, the company said.

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