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With U.S. natural gas prices still extremely low, one might wonder how some natural gas companies continue to generate solid profits. It's quite simple, really: The ones that are prospering are the ones drilling in the right areas.
Most of these companies have piled into a shale gas play known as the Marcellus, a vast formation that extends from southern New York to West Virginia and spans most of Pennsylvania, the eastern part of Ohio, and parts of Maryland, Virginia, and Tennessee.
The main reason the Marcellus is still profitable for many of these companies is its extremely low cost of production -- by many measures, the lowest of any shale gas play in the country. With that said, let's take a closer look at Cabot Oil & Gas (NYSE: COG ) , a Marcellus-focused oil and gas producer that continues to thrive despite depressed gas prices.
Cabot's solid second quarter
Houston-based Cabot recently wrapped up its best quarter ever from an operational and financial perspective. In the second quarter, the company grew its production to a record 95.2 billion cubic feet equivalent, or Bcfe, of which 90.7 Bcf was natural gas and 763,000 barrels were liquids, representing a 52% year-over-year increase in output.
The majority of that growth was driven by its robust performance in the Marcellus, where the company's current gross production is around 1.2 Bcf per day from 226 horizontal wells. Thanks to solid operational results, the company managed to boost its net income by 148% over the same quarter a year earlier and its discretionary cash flows by an equally impressive 109% year over year.
Cabot's solid economics
What makes Cabot's drilling program so successful is its extremely attractive cost structure, especially for its Marcellus wells. According to a study by Howard Weil, an energy investment boutique, Cabot's drilling F&D costs -- finding and development -- were among the lowest in its peer group and compared quite favorably even with its closest low-cost competitors in the Marcellus.
Last year, Cabot's drilling F&D costs came in at $6.28 per BOE, as compared with $5.88 for Ultra Petroleum (NASDAQOTH: UPLMQ ) , $5.48 for Range Resources (NYSE: RRC ) , $3.53 for EQT (NYSE: EQT ) , and an impressive $3.13 for Consol Energy (NYSE: CNX ) . In fact, Cabot's typical Marcellus well generates a whopping 120% return even at a 10%-15% differential at current prices, according to the company's CEO, Dan Dinges.
In addition to having industry-leading low break-even costs, Cabot continues to make progress through efficiency gains. In the second quarter, the company reduced its average number of drilling days (from spud to total depth) to just 14 days, down from an average of 16 days last year. Importantly, the company achieved the reduction despite drilling longer laterals during the second quarter.
More good times ahead?
Going forward, the good times look likely to keep rolling for Cabot, especially as infrastructure constraints in the Marcellus ease up over the next year and a half. Though Cabot had an exceptional second quarter, it could have been even better if all its wells had been producing. As of the end of the second quarter, the company had a backlog of 37 Marcellus wells, which were either waiting to be completed or waiting on a pipeline.
But as new gas pipelines come online over the next several months, this backlog should fall dramatically. To capitalize on this expected improvement in infrastructure, the company recently added a sixth rig in the Marcellus. While the new rig won't have any impact on 2013 production since the associated wells won't be turned in line until 2014, it still gives the company a nice catalyst for ramping up growth next year.
The bottom line
Overall, I think Cabot presents an attractive opportunity for investors with a two- to three-year time horizon. Not only does it offer solid upside potential from a recovery in gas prices, but it also has limited downside thanks to its extremely low cost structure and dominant position in the Marcellus. Though the stock has run up significantly in recent months and currently trades at around 19.3 times cash flow, I still see reasonable value at its current price of around $38 a share.
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