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We are maintaining our long-term Neutral recommendation on Louisiana-based Stone Energy Corporation (SGY - Analyst Report).

Stone Energy has a multi-year inventory of drilling prospects with a special emphasis on its growth areas in Appalachia, the Rockies and the Deep Gas/Deepwater in the conventional shelf. These are likely to add to revenues in the coming quarters. However, we remain cautious on the company due to its lowered production forecast for the third quarter due to Hurricane Isaac that affected GoM in early September.

The company has an extensive capital project inventory and is generating surplus cash flow with no bank debt. Although Stone Energy aims to apportion the capital across its portfolio, the focus will be on the Gulf of Mexico (GoM) shelf as well as the Marcellus region. Currently, Stone Energy is favorably positioned in the industry with widespread high yielding inventory.

Stone Energy announced it has drilled 11 wells and commissioned 19 wells in the Mary field in Marcellus in the first half of 2012, and expects this figure to go up to 24 by year-end 2012. The wells are currently producing 45 million cubic feet per day (MMcfe/d) versus 20 MMcfe/d at year-end 2011. The liquids-rich onshore Marcellus wells provide ample cash flow potential for the company. It will also help to augment production going forward as it is expected to contribute 25%-30% of the company’s total output by year-end 2012.

The company’s Gulf operations are back on track and its U.S. land activities (additional Marcellus results, deep onshore exploration results, and Alberta Bakken results) are also significant tailwinds. Importantly, year-end reserves are expected to grow with the success in the Pompano field, Appalachia and the Marcellus Shale programs.

During the second quarter, the known limits of the second well at La Cantera/LaPosada onshore deep gas discovery — where Stone Energy holds a 35.4% working interest — was extended. The company expects net production of 14-18 million cubic feet per day (MMcf/d) of wet gas and 250-350 barrels of condensate by year-end 2012. These are expected to be positive catalysts for the company’s future growth.

A number of opportunities in new well production like Apache Corp. (APA - Analyst Report) operated Parmer well in Wideberth prospect and continued activity in the La Cantera prospect, including drilling which commenced in the third quarter at the Pounder well in Ship Shoal 113, could significantly improve revenues. Further, permits for the Phinisi, and Floyd prospects along with the interests purchased in Pompano and Mica fields in the GoM from BP Plc (BP - Analyst Report) and Anadarko Petroleum Corporation (APC - Analyst Report) has placed the company favorably.

However, growing exploration exposure to the mature, low reserve life and capital intensive GoM shelf is expected to aggravate Stone Energy’s risk profile. Other risks faced by the company are changes in government regulations, dependence on individual well performance, possibility of unsuccessful.

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