An Investor's Guide to the Marcellus Shale

The EIA's most recent report on U.S. Crude Oil and Natural Gas Proved Reserves noted that the proved natural gas reserves in the Marcellus Shale gas play in Pennsylvania and West Virginia surpassed those in the Barnett Shale play of Texas to become the largest shale gas play in the United States, with proved reserves totaling nearly 43 Tcf. This is positive news for companies that invested early and substantially in this burgeoning region. With approximately 200,000 net acres in the Marcellus region Cabot Oil and Gas (NYSE: COG  ) ranks among the top players.

Cabot's gross natural gas production from the play has grown from an exit rate of 20 Mmcf per day in 2008 to more than 1.2 Bcf per day in Q1 of 2014. Dan O. Dinges, Chairman, President, and CEO, believes, "This is a tremendous accomplishment, especially considering the Company's maximum rig count in the Marcellus during this period was six rigs, with no more than 290 horizontal wells producing, highlighting the productivity of this asset."

Things are looking very positive going forward. "Second quarter production in the Marcellus has started out strong," said Dinges. "As a result, we expect sequential growth in the second quarter."

Though Cabot is anything but a pure Marcellus play, the region is a key piece to increasing FY 2014 EPS, which analysts see growing 87.15%, to $1.20. Those expectations may be responsible for the slightly high valuations. A P/E of 58 and a P/B of 7.43 could dissuade the value investor; but knowing the long-term potential and prolific nature of this play could provide some comfort. Ideally, the patient investor may look for a pullback in the coming quarters.

Chesapeake Energy (NYSE: CHK  ) is the second largest producer of natural gas in the U.S., which is pretty amazing considering that, during the last few years, it has divested natural gas assets in favor of oil, making it the tenth largest producer of liquids. In fact, this diversification has been quite rapid, moving from 60% of total revenues derived from natural gas in 2011 to 36% in 2013. During that same period, oil production increased from 29% to 56% of total revenue.

Investors are hopeful that Chesapeake can keep the positive results flowing. Fourth quarter 2013 saw natural gas production in Marcellus grow 36% year over year. Analysts seem to think that FY 2014 could see a continuation of strong EPS growth, moving up 26% to $1.90.

Perhaps the operational risks associated with drillers are a bit too much for conservative investors? In a stroke of luck, the Marcellus Shale is located near the Northeast, which is the largest consumer of natural gas in the U.S. Though drilling is prolific, and natural gas is being extracted at ever-increasing rates, the ability to transport this fuel during peak demand is lacking.

During the winter of 2013-2014, many areas in the Northeast saw record snowfall and low temperatures creating huge demands for natural gas. This served to highlight the pipeline supply constraints into the Boston and New England areas, where natural gas prices spiked.

Kinder Morgan Pipeline Partners LP (NYSE: KMP  ) is the largest pipeline operator in the U.S. One of its latest acquisitions in August of 2012 was the Tennessee Gas Pipeline (TGP), which runs through the developing Marcellus Shale region to markets in New England and the Niagara Falls area of New York. Long-term contracts with Cabot Oil and Gas, among others, provide a stable supply going forward.

Conservative, risk-adverse, or yield-oriented investors often appreciate the stability and consistent distributions that MLPs provide. These transporters act as toll collectors on owned assets that require minimal maintenance, much like a railroad. Existing pipelines are increasingly important due to the burgeoning U.S. energy market, and competition is kept at bay due to the difficulty obtaining rights of way and regulatory approval for new pipelines.

The payoff
Technological advancements in horizontal drilling and hydraulic fracturing have made drilling in the Marcellus profitable and increasingly productive. As operational costs continue to decline, well productivity increases, and more wells are drilled, the companies that participate in this play will see the benefits materialize on their balance sheets. With 43 trillion cubic feet of proved reserves, and the potential for 141 trillion cubic feet of natural gas reserves according to the U.S. Department of Energy, the Marcellus Shale is poised to potentially become the second largest natural gas discovery in the world.

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