The Market Shrugs Off Another Solid Quarter From Cabot Oil & Gas

Despite another solid quarterly financial performance, wide Marcellus price differentials continue to weigh on Cabot’s stock.

Jul 25, 2014 at 12:05PM

Cabot Oil & Gas (NYSE:COG) reported yet another solid quarterly performance on Thursday. But the market wasn't too impressed: The stock ended the day nearly 1% lower.

Despite what the market's reaction suggests, the company continues to fire on most of the metrics that matter. Production, earnings, and cash flow all grew by double digits, while costs continued to trend down. But wide price differentials in the Marcellus shale remain a major near-term concern and could continue to weigh on the stock.

Chesapeake Energy Corporation Shale Gas

A Marcellus shale drilling site. Photo credit: Chesapeake Energy Corporation

Second-quarter highlights
Cabot reported second-quarter net income of $118.4 million, or $0.28 per share, as compared to $89.1 million, or $0.21 per share, in the prior year quarter. That topped analysts' estimates by $0.03 a share. Total production jumped 34% year over year to 127.6 billion cubic feet equivalent (Bcfe), while liquids production surged to 961,000 barrels, up 64% year-over-year pro forma for last year's asset sales.

Marcellus output increased 41% year-over-year to average 1,258 million cubic feet (Mmcf) per day during the quarter, while Eagle Ford production soared 76% to 10,308 barrels of oil equivalent (Boe) per day. Cash flow from operations rose 19% to $329.6 million, up from $277.3 million in the second quarter of 2013, while discretionary cash flow rose 12% year over year to $332.3 million.

Wide differentials remain a challenge
But the biggest letdown of the quarter was natural gas price realizations, which have been a problem for the company in recent quarters and are one of the biggest factors weighing on its share price. Cabot received just $3.47 per thousand cubic feet (Mcf) for its gas production in the second quarter, down 15% year over year, and $3.78 per Mcf excluding the impact of hedges.

That amounts to an $0.89 discount to NYMEX settlement prices, which is significantly wider than the $0.60 to $0.65 per Mcf average discount the company reported in the first quarter. While that's obviously not good, it's pretty remarkable that Cabot was able to generate more than $50 million in free cash flow despite the sharply lower realized prices.

This was due in part to the company's exceptionally low total unit costs, which improved 16% over last year's comparable quarter to just $2.59 per thousand cubic feet equivalent (Mcfe). That makes Cabot one of the lowest-cost Marcellus shale producers, if not the lowest-cost producer -- obviously a huge competitive advantage.

Help is on the way
In the near-term, differentials could remain wide, which would continue to weigh on Cabot's share price. But as I have argued before, differentials should compress significantly over the next three to four years as major new infrastructure projects like the Constitution pipeline and the Atlantic Sunrise project come online.

The Constitution pipeline, which will be 75% owned by Williams Partners (NYSE: WPZ) and 25% owned by Cabot, should go into service in late 2015 or early 2016. It will boost Cabot's takeaway capacity by some 500 Mmcf per day, which is nearly 40% of its current production. Similarly, the Atlantic Sunrise project will provide an additional 850 Mmcf per day of takeaway capacity after it comes online in 2017.

Combined with Cabot's existing takeaway capacity on Kinder Morgan's Tennessee Gas Pipeline 300 Line and the Millennium Gas Pipeline, these options will greatly diversify its gas marketing options by providing access to premium markets and more favorable gas indices. As a result, basis differentials should compress significantly after 2016.

Investor takeaway
Cabot's second-quarter performance highlights the company's continued operational excellence. Despite sharply lower realized gas prices, it still managed to generate free cash flow thanks in part to solid cost management. While wide Marcellus basis differentials may remain a headwind over coming quarters, upcoming infrastructure projects should help reduce them over time. Given Cabot's underperformance this year and its exceptional growth prospects, I think it's currently a very compelling long-term buy.

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