Southwest Energy (NYSE: SWN) was one of the constituents of my article on the best in-depth analysis of small cap E&P companies. Seeing that it had no positive earnings in 2020 and 2021, when prices were exploding, I eliminated it from the recommendation at the very beginning. Here I dive deeper into its operations and financials to understand why this company, despite having a solid foundation and good operating metrics, has not returned anything to its investors over the past 5 years and this trend will- it will continue in 2022.
Presentation and status of the company
SWN is an E&P company focused on natural gas production. On average, 85% of its production volumes come from natural gas production, 12% to 15% from natural gas liquids and tiny percentages from crude oil. It produced 1015 billion cubic feet of natural gas in 2021, of which 883 came from their legacy assets and 132 came from their recent acquisitions in the Haynesville area. The two acquisitions made by SWN in 2021 were financed by a combination of cash and SWN equity, with equity representing the majority of the value of the transaction. As a result, equity has been diluted by 40% (each share now represents 60% of the share represented in 2020). Management provided a production forecast of approximately 1.5 trillion cubic feet of natural gas in 2022, of which approximately 12% will be natural gas liquids, maintenance capital expenditures of $1.9 billion to $2 billion and a target debt of $3.0 to $3.5 billion. That brings their total cash spend in 2022 to around $3.8 billion for minimum goals. The interesting point here is that management has already hedged 1381 bcf of natural gas and 16 MMBbls in 2022 (2021 production was 31 MMBbls) in the form of short fixed price swaps, 2-way collars, 3-way collars and short call options. . This means that revenues from 92% of natural gas production are prefixed and risk free. Additionally, with the way natural gas prices are moving today, it is easy to estimate which region of SWN coverage will fall into.
Based on the latest published financial report, the company is highly leveraged with 55% of its assets being paid for by pure debt (current + non-current) and equity supporting only 21.5% of its total assets. They have negative working capital and cash flow from core operations ($1,363 million) was just enough to meet their capital expenditure needs ($1,032 million) to drill and complete wells. . Of the $5,234 million of long-term debt, $4,229 million of debt is fixed interest rate obligations, making SWN’s interest expense stable. Over the last 6 years, their G&A expenses have decreased by around 45% while their natural gas production has increased by 1.29 times. However, their operating costs, which should closely follow the growth in production volumes, have doubled over the same period. The crux of the matter is that the company’s operations have become more inefficient as production volumes have increased.
SWN will not generate enough cash in 2022
Forecasts given for 2022 called for maintenance capital expenditure of $1.9 billion and a target natural gas production volume of approximately 1.5 trillion cubic feet. However, given the increase in demand for natural gas due to evident events around the world, it would not be surprising if management changed strategy to maximize production volumes. Still, assuming the forecast holds in 2022, SWN needs $3.8 billion in cash to meet its minimum targets. The money needed to reach the target debt is purely mathematical and does not warrant any further research into it. The maintenance capital expenditure figure requires review and verification as it is an indication.
Clay Carrell, EVP & COO, commented on the fourth quarter 2020 earnings call that
We currently have five rigs running and three completion teams.
and also clarified an analyst’s question about the trend of platforms in 2021 which
Yes. So it will look like the capital profile that I talked about where the first three quarters, capital spending will be flat, the first half of the year, I would say, is close to that average of five and three. And as you go into the third quarter, there will be a slight reduction, and then the fourth quarter will be a bit more of a reduction in activity.
During the fourth quarter 2021 earnings call, Clay Carrell said
We anticipate an average of 12-13 rigs with 5-6 completion crews across our asset base with 8-9 rigs and 3-4 crews in Haynesville.
In 2021, SWN drilled and completed 78 wells with a capital expenditure of $882 million. This represents an expenditure of approximately $11.30 million per well and an average of 15.6 wells per drilling crew. Extrapolating this performance to 2022 brings their projected drilled wells to 203 wells and capital expenditures of $2,293 million. We can therefore safely assume $2.3 billion in capital expenditures, at a minimum, for 2022. Please note that these capital expenditures do not include the expenditures SWN will need to make to complete its 43 DUC wells in 2022.
This brings the projected cash requirement to $4.2 billion for SWN to meet its debt and capital expenditure targets.
Now that the 2022 cash requirements are verified, we can check if SWN will be able to make that much money. As mentioned earlier, SWN has covered 1381 bcf of production in 2022. Last reported gas prices are $4.56/MMBtu (EIA) and with the way things are going it would be safe to assume that natural gas prices will remain at a higher level during the year. SWN hedged its production at different price points, the highest being calls sold at $3.14/MMBtu. Obviously, whoever bought these calls will exercise their options and SWN will earn revenue at $3.14/MMBtu. Thus, SWN’s confirmed revenue in 2022 is approximately $5.0 billion from all hedges, natural gas, NGLs and crude oil.
For the remaining natural gas production volume, I took $4/Bcf as the average spot rates in 2022. This translates to total revenues of $5.55 billion.
Although SWN maintains a negative working capital, I assume that it would still require an additional $100M for additional production volumes in 2022. Operating expenses are approximately $1.15/Mcf of production, from G&A stable and $150 million for restructuring and other taxes. . Based on these assumptions, EBIT is approximately $2.53 billion, and assuming a 21% tax, CFO generated is estimated to be approximately $2.45 billion, which is far from their needs.
It is clear that the cash requirement for 2022 will not be met by the CFO alone. Either the revolving credit or the bonds will have to be lifted. If management is determined to reduce debt, the bonds cannot be lifted, leaving only one option in management’s hands.
A point to note is that the revenue calculations above are actually the sum of accounting revenue plus the gain/loss on the realized derivative. Thus, their removal from the cash flow equation is already taken into account.
Comparison with peers
The company is not a favorite among investors, mainly because it has poor stock returns. The total returns for the last 5 years, 3 years and 1 year were -30.22%, 14% and 32% respectively. The chart is shown below, and relative to its performance peers (read note below), SWN has consistently remained the worst performer across all time horizons.
During the fourth quarter earnings call, management said it expects to be able to return capital to investors in 2022. However, I don’t believe SWN will have enough cash on hand. it spends on target debt reduction and targeted capital spending in 2022.
Currently, SWN is the cheapest cash flow generator among its performance peers (as seen in the chart above). Normally, one would expect this gap to close and an opportunity for the investor to make a profit. But, for that to happen, SWN’s financial performance must evolve with the industry. SWN’s strategy of ensuring that its expenses are covered by the use of derivatives will not, however, bridge this gap. Ensuring that the business will generate enough cash to cover expenses is good and safe, but safer investments do not generate good returns due to their very nature of predictability.
No return in sight for the moment
Management gave enthusiastic advice and a very high financial target for the year 2022. Cash flow from operations will not meet their cash requirements for 2022. At this point the following comment in their filing 10- K seems far-fetched.
In 2022, we expect to continue to generate free cash flow from operations, net of changes in working capital, in excess of our planned capital investments, and we intend to use this free cash flow to pay off our debt.
Although stocks are the cheapest among its peers, SWN has left a lot of money on the table in 2022 due to its hedging. Simply put, SWN is out of luck. Beyond the current conflict, one thing is certain, countries would try to end their dependence for energy needs on both a single type of energy and a single source of energy. The result will be increased competition between energy sources, creating an even greater challenge for companies like SWN.
Based on current industry dynamics, SWN shares are not a buy for me. SWN management has the option to change strategy this year and maximize its production volumes so that it can sell its excess volumes at higher spot market rates. This could be a challenge to the hypothesis.
Note: The set of peers to be compared is a subset of the SWN’s choice of performance peers for executive compensation. Management uses these companies (and others) to benchmark their performance to calculate their performance share unit awards. These companies were shortlisted by me based on their natural gas production as a percentage of their production, to represent companies heavy on natural gas production.