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Independent natural gas operator Southwestern Energy Co. reported third-quarter 2012 earnings of 38 cents per share, exceeding the Zacks Consensus Estimate by 6 cents mainly on higher production. The quarterly result, however, declined 24% from the year-earlier profit of 50 cents. The underperformance was primarily due to the drop in natural gas prices.

Third-quarter revenue declined 10.6% to $685.8 million from the year-ago level of $767.3 million. The revenue also lagged the Zacks Consensus Estimate of $661.0 million.

Production and Realized Prices

During the reported quarter, the company’s oil and gas production grew nearly 12% year over year to 144.3 billion cubic feet equivalent (Bcfe) – almost entirely gas – driven by the Fayetteville Shale operations. Production from Southwestern’s Fayetteville Shale play increased 10.5% to 123.6 Bcfe from the year-earlier period.

The company’s average realized gas price, including hedges, dropped almost 21.0% to $3.40 per thousand cubic feet (Mcf) from $4.30 per Mcf in the year-ago period. Oil was sold at $99.67 per barrel, up 12.8% from the year-earlier level of $88.35 per barrel.

Segmental Highlights

Operating income for the Exploration and Production (E&P) segment dropped more than 36.4% year over year to $145.4 million in the third quarter. The decrease was due to lower gas price realization as well as increased operating costs and expenses related to higher production, partially toned down by the increased output level.

On a per-Mcfe basis, lease operating expenses were down to 79 cents versus 86 cents in the prior-year quarter. On the other hand, general and administrative expense per unit of production was down by 16% year over year to 21 cents.

The Midstream Services segment’s operating income jumped 13% to $75.5 million in the third quarter from $66.8 million in the year-earlier quarter. The increase was driven by an improvement in gathering revenues related to the Fayetteville and Marcellus Shale plays.

Capex and Debt

The company’s total capital expenditure in the quarter was $470.4 million, of which $421.2 million was invested in E&P activities and $32.2 million in the Midstream segment. Southwestern planned for a total capital expenditure of $2.1 billion for the year.

As of September 30, 2012, long-term debt stood at $1,695.3 million, representing a debt-to-capitalization ratio of 34.3% (versus 32.2% in the preceding quarter).

Hedging

As of September 30, 2012, Southwestern had approximately 67 Bcf of its remaining 2012 expected gas production hedged at an average floor price of $5.16 per Mcf. It has hedged approximately 186 Bcf of its 2013 expected gas production at an average floor price of 5.06 per Mcf.

Guidance

Earlier, Southwestern had issued production guidance for 2012 in the range of 560 Bcfe to 570 Bcfe. The outlook represents a 13% increase over the 2011 level.

Our Take

Southwestern’s industry-leading holdings in Northern Arkansas’ Fayetteville Shale play offer some of the highest quality natural gas discoveries in North America in recent years. Marcellus and Fayetteville shales also hold ample opportunity for newer natural gas discoveries.

We see the company as well positioned for production growth given its streamlined cost structure, upcoming drilling programs in the Fayetteville and Marcellus shales, and a wide acreage in its New Ventures, especially in the Brown Dense play.

However, we remain apprehensive about the weak natural gas scenario in the U.S. given the continued oversupply and low demand. This will likely hurt the company’s as well as other natural gas companies like Chesapeake Energy Corporation’s performance in the near term.

Other risk factors include weaker-than-expected commodity prices, technological failures and the lack of a diversified asset base.

The company holds a Zacks #2 Rank (short-term Buy rating). We maintain our long-term Neutral recommendation on the stock.

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