HAROLD KORELL - SOUTHWESTERN ENERGY - (SWN)
CEO Interview - published 03/11/01

DOCUMENT # LAW214

HAROLD KORELL, President and CEO of Southwestern Energy Company, was appointed to his present position in May 1998. He joined the company in April 1997 as Executive Vice President — Operations and Chief Operating Officer. From 1992 to 1997, he was employed by American Exploration Company where he was most recently Senior Vice President — Operations. Earlier he was Executive Vice President of McCormick Resources and held various managerial positions with Tenneco Oil Company, culminating as Vice President, Production. A graduate of the Colorado School of Mines with a BS in Engineering, he began his career with Mobil Oil Corporation.

Sector: Oil & Gas Drilling & Exploration

TWST: Can you bring us up to date on what has happened with the company over the last year?

Mr. Korell: From an overall standpoint, we’ve had a really successful year. We’ve focused the last three years on putting together a great team of people in our E&P business, as well as putting together an inventory of projects to drill across our three focus areas. We had good success with the drill bit in the year 2000, and replaced 196% of our production with new reserves. Of course, gas prices being at the level that they were at, it’s a good environment from an economic standpoint. Also, our finding and development cost was $0.99 per Mcfe in the year 2000. We had one negative thing happen to us, which is something that we don’t like to talk about a lot. We lost on appeal this Hales class-action lawsuit. That judgment came down on June 22, 2000, and we paid $110 million in that judgment which caused our debt to go up for the year. We had a year of very good news on the fundamentals of the company, but bad news on something we had very little control over — which was the outcome of that lawsuit. But, all in all, we ended the year with a lot of momentum.

TWST: What is the mix of business today between oil and gas?

Mr. Korell: As you know, we have two primary businesses. We have one main business that is the exploration and production business. We also have a natural gas distribution company that operates in the northern part of Arkansas. That was the business from which this company was founded some 70 years ago. But today, 90% of our capital spending is going into exploration and production. Just to give you an idea, 75% of our cash flow comes out of our exploration and production business, while the utility is a stable cash generator and an earnings generator. But our primary line of business and growth area is with exploration and production.

TWST: Where are you looking in drilling?

Mr. Korell: We have three primary areas. The sort of bread-and-butter/low-risk part of our portfolio is in the Arkoma Basin that straddles the Oklahoma and Arkansas state line. We, as a company, have been drilling there since the mid-1940s. It provides pretty predictable results for us. We have a completion rate of about 70% of our wells there, and it generates a nice stable cash flow. The second part of our investing is in the Texas/New Mexico area — specifically, the Permian Basin and in East Texas. It’s a combination there of both exploration and development drilling and infill drilling in our East Texas Overton field. That’s our medium-risk/medium-potential area. Then our other area of focus, which really gives us the upside, is in South Louisiana. In fact, four out of our last five wildcats have been successful there. We have some real positive momentum from our exploration down there, but generally speaking, you would consider it our higher-risk/higher-potential area.

TWST: I guess the generally-held opinion is that the US has been drilled out. Why are you being so successful in finding new sources here?

Mr. Korell: It’s an interesting thing and I can’t quote you the exact time and date. But there was a time around the turn of the century, where people thought that everything was pretty well found also. Of course, we have greater technology today than we had then. But I think the fundamental thing that allows us to still be able to successfully play the E&P game in the lower 48 is that we are relatively small. We have 380 Bcfe of reserves. For companies like the super-majors and majors, they can’t afford to focus on these opportunities because they wouldn’t have the impact on their bottom line. There are lots of opportunities left around and, in fact, one of the opportunities is that the majors are not pursuing them. For companies our size, using the technology that we have available, which is second to none, and the people resource that we have, we’re able to develop very economic investments in the lower 48.

TWST: What are the plans for this year and next in terms of your drilling program?

Mr. Korell: Our capital program will be around $75 million for E&P for 2001. Roughly, that will be split with about a third going to the Arkoma, a third going to Texas/New Mexico, and a third going toward exploration in South Louisiana. About 75% of our E&P capital will go to the drill bit, which is a high percentage and works well for us. Overall, we’ll drill about 120 wells in the year 2001. About 50 of those will be in the Arkoma, 25 more or less in the Permian, probably 10-15 in Overton and nine wells in South Louisiana.

TWST: Will you be looking in any other areas or is that going to be it for the foreseeable future?

Mr. Korell: Our focus will be in those three areas this year. We’ll keep our eye out for new opportunity areas, but given our high debt level, our focus this year is on being able to fund this capital program, which is a larger program than we did in 2000, from our cash flow. With the remaining part of our free cash flow, we intend to target paying down debt and improve our balance sheet, which is levered-up due to that lawsuit that we lost and the borrowing that we had to do.

TWST: What was the genesis of the lawsuit?

Mr. Korell: It was a class-action lawsuit brought by some lawyers for royalty owners in the Arkoma Basin. There was a gas contract that existed and was written in 1978, back when there were price controls on natural gas. They were claiming that they were not paid the appropriate price for the gas during a part of the term of that contract, which expired in 1998. We don’t think we should have lost. I won’t go into everything we’ve said publicly, but we don’t think we got a fair trial. We fought that for a year and a half and we put up with that black eye until the appeal was over in June of last year and we lost. It’s one of those things that you lose and you’re not happy about it, but you have to gut up and go on.

TWST: What are you anticipating for gas prices over the next year or two in order to justify your programs?

Mr. Korell: Two different questions there. One is what do we need to justify our capital program? The other is, what do I think gas prices are going to be? Our program works at $2.50 gas, so gas price is not an issue there. We could invest more capital if we were not paying down debt. As far as gas prices go, I don’t think there’s anything magic about it. I imagine that gas prices are probably going to be above $4.00 for the next two or three years. The fundamentals seem to be there, and the demand side of the gas equation is so strong. The real question, I think, is what will the supplier response be from the drilling that is taking place now. It’s an interesting question, but prices are sure good right now. There is a lot of built-in demand just for power generation that’s coming on — that’s the major growth element from the demand side. I suppose if you had a tremendously hard-landing in the economy, or if things turn down sharply or depending upon the response on conservation measures, you could see the price fall some. It’s a really tough question. But it’s very good for us to have these prices high like they are right now, because we’re going to be able to pay down a lot of debt. But the economics of our projects certainly work at a much lower gas price.

TWST: What kind of growth should investors expect from you over the next two or three years?

Mr. Korell: We’re targeting annual growth of reserves and production over a multiple-year period of 10%. That may not sound like a lot, but that’s the target we have primarily with the drill bit. That doesn’t include any acquiring. A lot of the companies that talk about having 20%-30% growth rates are having to go and buy reserves in order to accomplish it, for the most part. Maybe some much smaller companies can have higher growth rates, but conceptionally, of course, everything depends on the capital program. If we weren’t paying down debt, as we are right now, we could grow faster because we would have more free cash flow to put back into our projects. I think our real story is value per dollar invested which, from a shareholder perspective, we should do very well in this period.

TWST: How quickly can you pay down your debt?

Mr. Korell: This year we think that we’ll pay down between $40-$70 million of debt. We ended the year of 2000 at about $400 million of debt. We’ll take a pretty good cut at our debt this year.

TWST: You mentioned acquisitions. Does the debt-heavy balance sheet keep you out of the acquisitions game?

Mr. Korell: It makes it a difficult thing to do. We can’t use debt to do acquisitions, per se, and it’s a tough time to use our stock because our stock price is not at a very elevated level relative to our peers. That’s because of our debt level, and the fact that a lot of people still remember this lawsuit and are wondering how we’re going to come through it. But we’re going to come through it fine.

TWST: How do you feel about the value that the market is currently putting on your stock?

Mr. Korell: Almost by any of the valuation methodologies — price-to-cash flow or earnings or enterprise value to EBITDA — we feel like we’re undervalued. For example, on a price-to-cash flow comparison to some of our peers, we trade at about a multiple of 3 times. Our peers are looking at maybe a multiple of 5 times. If we were to trade at a 5 multiple on our 2001 cash flow, we’d be above $20 a share and here we are at $10. There is an opportunity there, and there’s opportunity as the market pays more attention to us as we move our debt downward. I think that there is an opportunity for our multiple to expand.

TWST: Have you just been held back because of this lawsuit?

Mr. Korell: For about a year and a half, more or less, it was really hard to get people interested in our company because of that over-hang. Then there was the over-hang of, “Oh, they incurred $110 million of debt to pay that off. How are they going to live through that?” And the way that we planned to do that was to pursue the sale of our utility company. But as we went into that process, we did not really get the level of offers, in terms of dollars, that we thought were acceptable. Some good fortune came along in that gas prices went up. So we went ahead and hedged about 80% of our expected gas volumes for the year 2001 to be able to fund our capital program and ensure that we could pay down, as I mentioned earlier, a pretty substantial amount of debt this year. So now we can hold on to the utility asset because it’s a cash generator and an earnings generator. We weren’t really compelled to have to sell it at some price we didn’t want to.

TWST: But if somebody came around and made the right offer, they could own it?

Mr. Korell: We’d have to see what that offer was. Some of the players whom we might have liked to have in the process, were not in the process. So, you know, things can change.

TWST: When you sit down and talk to investors today, what other questions are they asking? What is their key concern?

Mr. Korell: The first question that you tend to get are the general questions, like “What are your expectations for commodity prices?” They are very interested in that. There are a lot of momentum players who want to move in and out of the industry. They also want to know what our hedging strategy is, and once they look beyond that, they want to understand our E&P program and why we think we can add value. Then they analyze the whole story of the right people doing the right things and our strategy areas. We really believe in the areas that we’re in. Our people, both on the E&P side of this company and on the utility side, but particularly on the E&P side, have proven themselves in the last three years with our results in finding costs and production volumes. Our balanced investment portfolio has enough low-risk in it from the Arkoma Basin that it allows us to take a swing at the fence with some of these South Louisiana exploration activities. Some companies don’t have the flexibility to do that. They also want to talk about valuation and then you get into this value thing. They can see the upside, but I think they also want to know can we really pay down this debt. And there is the opportunity. If you’re looking at companies on the basis of enterprise value to EBITDA, then for every dollar of debt that you pay down, there is the implied increase in your market cap. Various people look at things in different ways, but those would be the kinds of questions that we get.

TWST: If you were sitting down with some potential investors today what two or three reasons would you give them to go out and buy your stock?

Mr. Korell: The first one that I emphasize, and it’s a soft issue, but it’s the right people doing the right things. This is a hand-picked group of intrinsically-motivated people that I brought on board here in 1998. Our focus has been on putting together prospects to drill, not on acquiring. Many people in the industry are focused on acquiring and financial engineering. I believe that if we’re opportunistic on acquisitions, we will be able to do some small acquisitions in our focus areas, but we’re primarily focused on adding value through drilling. I think the balance of our investment portfolio would be the second thing: The Arkoma, the medium-risk Permian and the higher-risk/higher-potential of South Louisiana. Then the valuation would be the third thing. We’ve been sort of overlooked for a period of time. If you go back prior to 1998, the company had very poor results for three years in E&P, so everyone quit looking. Then we had the Hales lawsuit, which I think really deadened it some more. But now as people look at three years’ worth of E&P activity, they’re going to see a company that knows what its doing. We need to move our multiple up to our peer level. Therein lies a real opportunity from a shareholder’s viewpoint on the appreciation of the stock.

TWST: Is there anything else we should have touched on?

Mr. Korell: The only other thing would be, and we point this out when we meet with people, we’ve got a low-cost structure. We have a high cash flow per unit of production relative to a lot of household names. That means our cash flow is pretty strong. We’re going to have a solid cash flow no matter what the price environment unless it drops very low. We have the cash both to service our debt and fund our program. So cash flow is not something to worry about with us and hasn’t been.

TWST: Thank you. (TM)

HAROLD KORELL
 President & CEO
 Southwestern Energy Company
 2350 North Sam Houston Parkway East
 Suite 300
 Houston, Texas  77032
 (281) 618-4700
 (281) 618-4757 - FAX
 www.swn.com
 e-mail: irelatio@swn.com

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