Is the Market Wrong About Cabot Oil & Gas Corporation?

Cabot Oil & Gas (NYSE: COG  ) , the Marcellus-focused natural gas producer, was one of the best-performing energy stocks last year, with shares surging nearly 60% over the course of 2013.

But the stock has fallen 5% to date in 2014, even as shares of natural gas-focused peers Southwestern Energy, EQT, and Range Resources have risen by 15%, 16%, and 8%, respectively, since the beginning of this year.

Given Cabot's exceptional operational capabilities, industry-leading low-cost structure, and significant prospects for production, earnings, and cash flow growth, I think its exclusion from the rally among Marcellus-focused gas producers is unwarranted and that its shares present strong value.

A Marcellus shale gas drilling site in Lycoming County, Pa. Photo credit: Flickr/Nicholas A. Tonelli.

A truly exceptional operator
Cabot is essentially a pure-play natural gas producer; its primary asset is located in Pennsylvania's Marcellus shale, though it also operates oil-rich acreage in Texas' Eagle Ford shale. Over the past few years, the company has consistently delivered exceptional growth in production and reserves, while maintaining what is arguably the lowest cost structure in the industry.

Cabot's first-quarter average production surged 34% year over year to 119.9 billion cubic feet equivalent, or Bcfe, while year-end 2013 reserves jumped by 42% to 5.5 trillion cubic feet equivalent, or Tcfe. Meanwhile, first-quarter total cost per unit was $2.66 per Mcfe, down 19% from $3.29 a year earlier. As a result, Cabot is now now generating pretax returns that easily exceed 100% at a wellhead gas price of just $3 per MMBtu.

By comparison, Range Resources (NYSE: RRC  ) , another low-cost Marcellus producer, needs a gas price of $4 per MMBtu to generate returns of 96%-106%, while Chesapeake Energy (NYSE: CHK  ) earns a 117% rate of return from its northern Marcellus wells at a gas price of $4 per MMBtu. Ultra Petroleum (NYSE: UPL  ) was only generating a rate of return of 25%-50% in the Marcellus, which is why it shifted focus to higher rate-of-return opportunities in Wyoming's Jonah and Pinedale fields and Utah's Uinta Basin.

Improving returns and strong production growth, combined with higher natural gas prices, enabled the company's adjusted net income to surge 102% to $109.7 million, or $0.26 per share, during the first quarter, while operating cash flow increased 17% year over year to $255.4 million and discretionary cash flow jumped 27% to $319.5 million.

Indeed, the company is now generating free cash flow for the first time in five years and expects to do so in 2015 even with relatively conservative commodity price assumptions of $90 per barrel for West Texas Intermediate crude and $3.50 per MMBtu gas.  

Wide Marcellus differentials a near-term concern
Despite this exceptional performance and expectations for 30%-40% production growth this year and 20%-30% in 2015, Cabot's shares are slumping. In addition to the company's seemingly lofty valuation, investors are likely concerned about wide price differentials in the Marcellus due to insufficient takeaway capacity. But this should prove solely a near-term concern.

With the massive Marcellus infrastructure build-out underway, Cabot's takeaway capacity is set to improve sharply over the next few years. The company has already secured 850,000 MMBtu per day of firm capacity on Transco's Atlantic Sunrise expansion project, which is operated by Williams Partners (NYSE: WPZ  ) and is slated to go into service in 2017, and 500,000 MMBtu per day of capacity on Williams' Constitution Pipeline, which is expected to go into service in 2015.

These projects, combined with expansions of the other main pipelines that Cabot uses to ship its gas -- Kinder Morgan's Tennessee Gas Pipeline 300 Line and the Millennium Gas Pipeline -- should result in lower Marcellus basis differentials and allow the company to ramp up production to as much as three Bcf per day by the end of 2016.

Investor takeaway
Cabot's underperformance so far this year is likely due to a combination of valuation concerns and near-term fears about Marcellus pipeline takeaway capacity. But given the company's exceptionally strong prospects for production, earnings and cash flow growth, and improving pipeline takeaway capacity from the Marcellus, I think Cabot's shares no longer look pricey at roughly 22 times forward earnings and may still have significant room to run.

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