It's safe to say that the Marcellus has exceeded most expectations about production growth. In the first half of this year, output from the prolific shale gas play increased 50% year over year, according to Bentek Energy, an energy market analytics company.
Ironically, however, this supply growth has led to depressed regional prices that have proved a major challenge for the very same Marcellus producers that drove the surge in production in the first place. Let's take a closer look at what Cabot Oil & Gas (NYSE:COG), one of the largest gas producers in the Marcellus, is doing to combat low regional gas prices.
Low gas prices in the Marcellus
The collapse of regional gas prices in the Marcellus has been one of the biggest causes for concern among investors recently. In a nutshell, the combination of soaring production from the play and inadequate infrastructure has caused basis differentials to widen significantly. Last month, for instance, gas at a Pennsylvania trading hub known as TGP Zone 4-Marcellus traded for as little as $1 per Mcf, a more than $2 per Mcf discount to benchmark prices at Henry Hub.
Even Cabot, despite its industry-leading low costs of production, hasn't been immune to the impact of widening basis differentials. According to CEO Dan Dinges, the company's gas production during the month of July sold at an average $0.15 per Mcf discount to NYMEX futures prices on a pre-hedged basis. These types of heavy discounts for Marcellus gas have left regional producers scrambling to market their production profitably.
To alleviate this problem, Cabot is diversifying its transportation network through multiple pipelines while also pursuing a rigorous hedging program to mitigate its exposure to regional price volatility. In the company's second-quarter earnings conference call, Dinges explained the various measures Cabot is taking to accomplish these objectives:
"...We have pursued many different avenues, including: diversifying all multiple pipelines; firm transportation agreements; long-term sales agreements, that's our firm sales; investing in new projects like the Constitution Pipeline; and opportunistically hedging a portion of our production. All of this provides us diverse opportunities to maximize the value of this tremendous resource."
Cabot's gas marketing efforts
Cabot currently moves its production to market through three large interstate pipeline systems: Tennessee Gas Pipeline's 300 Line, which is owned by Kinder Morgan (NYSE:KMI), the Transco Gas Pipeline, owned by the Williams Companies (NYSE:WMB), and the Millennium Gas Pipeline, owned by affiliates of NiSource Inc (NYSE:NI), National Grid (NYSE:NGG) and DTE Energy.
Right off the bat, having access to three large interstate pipeline systems places Cabot in an enviable position. Not only do these pipelines provide the company with firm transportation contracts to move as much as 325 MMcf per day this year, all three of them recently wrapped up expansion projects and have announced plans to expand capacity in the future.
Furthermore, Cabot has an ambitious plan to more than triple its current capacity secured by firm transportation contracts by 2015, as it adds a number of additional pipelines to its existing transportation and marketing efforts. These include the Constitution pipeline, for which Cabot filed an application with FERC during the second quarter and expects the line to be in service by March of 2015, as well as the Iroquois Pipeline, the Tennessee Gas Pipeline's 200 Line, and the TransCanada Pipeline via Iroquois.
As these and other infrastructure projects come online over the next couple of years, Cabot expects to ramp up capacity secured by firm transportation contracts to 450 MMcf per day by 2014 and to a whopping 1 Bcf per day by 2015. The company also expects to nearly double its long-term sales contracts (defined as those between eight and fifteen years) between now and 2015, from 325 MMcf per day this year to roughly 615 MMcf per day in 2015.
The bottom line
These infrastructure improvements provide a very visible growth runway for Cabot, as well as other Marcellus producers, whose production potential has been severely hampered by infrastructure limitations in the play. Indeed, Cabot is so confident about the impact of new infrastructure coming online in the second half of this year that it recently increased the low end of its 2013 production growth guidance to 44% and the high end to 54%.
As the backlog of Cabot's Marcellus wells – 37 as of the end of the second quarter – starts to fall, investors can expect production and free cash flow to grow robustly, which not only bodes well for the stock price but could also mean additional dividend increases down the line.
Fool contributor Arjun Sreekumar has no position in any stocks mentioned. The Motley Fool recommends Kinder Morgan and National Grid plc (ADR). The Motley Fool owns shares of Kinder Morgan. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.